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Karnataka class 12 commerce Accountancy Factors to be taken into account for the calculation of depreciation

Karnataka class 12 commerce Accountancy Factors to be taken into account for the calculation of depreciation 

Karnataka class 12 commerce Accountancy Factors to be taken into account for the calculation of depreciation 

Factors Affecting the Amount of Depreciation The determination of depreciation depends on three parameters, viz. cost, estimated useful life and probable salvage value.

Cost of Asset Cost (also known as original cost or historical cost) of an asset includes invoice price and other costs, which are necessary to put the asset in use or working condition. Besides the purchase price, it includes freight and transportation cost, transit insurance, installation cost, registration cost, commission paid on purchase of asset add items such as software, etc. In case of purchase of a second hand asset it includes initial repair cost to put the asset in workable condition. According to Accounting Standand-6 of ICAI, cost of a fixed asset is “the total cost spent in connection with its acquisition, installation and commissioning as well as for addition or improvement of the depreciable asset”. For example, a photocopy machine is purchased for Rs. 50,000 and Rs. 5,000 is spent on its transportation and installation. In this case the original cost of the machine is Rs. 55,000 (i.e. Rs. 50,000 + Rs.5,000 ) which will be writtenoff as depreciation over the useful life of the machine.

Estimated Net Residual Value Net Residual value (also known as scrap value or salvage value for accounting purpose) is the estimated net realisable value (or sale value) of the asset at the end of its useful life. The net residual value is calculated after deducting the expenses necessary for the disposal of the asset. For example, a machine is purchased for Rs. 50,000 and is expected to have a useful life of 10 years. At the end of 10th year it is expected to have a sale value of Rs. 6,000 but expenses related to its disposal are estimated at Rs. 1,000. Then its net residual value shall be Rs. 5,000 (i.e. Rs. 6,000 – Rs. 1,000).

Depreciable Cost Depreciable cost of an asset is equal to its cost (as calculated in point 7.5.1 above) less net residual value (as calculated in point 7.5.2,) Hence, in the above example, the depreciable cost of machine is Rs. 45,000 (i.e., Rs. 50,000 – Rs. 5,000.) It is the depreciable cost, which is distributed and charged as depreciation expense over the estimated useful life of the asset. In the above example, Rs. 45,000 shall be charged as depreciation over a period of 10 years. It is important to mention here that total amount of depreciation charged over the useful life of the asset must be equal to the depreciable cost. If total amount of depreciation charged is less than the depreciable cost then the capital expenditure is under recovered. It violates the principle of proper matching of revenue and expense.

Estimated Useful Life Useful life of an asset is the estimated economic or commercial life of the asset. Physical life is not important for this purpose because an asset may still exist physically but may not be capable of commercially viable production. For example, a machine is purchased and it is estimated that it can be used in production process for 5 years. After 5 years the machine may still be in good physical condition but can’t be used for production profitably, i.e., if it is still used the cost of production may be very high. Therefore, the useful life of the machine is considered as 5 years irrespective of its physical life. Estimation of useful life of an asset is difficult as it depends upon several factors such as usage level of asset, maintenance of the asset, technological changes, market changes, etc. As per Accounting Standard – 6 useful life of an asset is normally the “period over which it is expected to be used by the enterprise”. Normally, useful life is shorter than the physical life. The useful life of an asset is expressed in number of years but it can also be expressed in other units, e.g., number of units of output (as in case of mines) or number of working hours. Useful life depends upon the following factors :

  • Pre-determined by legal or contractual limits, e.g. in case of leasehold asset, the useful life is the period of lease.
  • The number of shifts for which asset is to be used.
  • Repair and maintenance policy of the business organisation.
  • Technological obsolescence.
  • Innovation/improvement in production method.
  • Legal or other restrictions.

Karnataka class 12 commerce Accountancy Factors to be taken into account for the calculation of depreciation 

Karnataka class 12 commerce Accountancy Factors to be taken into account for the calculation of depreciation

Karnataka class 12 commerce Accountancy Factors to be taken into account for the calculation of depreciation 

Methods of Calculating Depreciation Amount The depreciation amount to be charged for during an accounting year depends upon depreciable amount and the method of allocation. For this, two methods are mandated by law and enforced by professional accounting practice in India. These methods are straight line method and written down value method. Besides these two main methods there are other methods such as – annuity method, depreciation fund method, insurance policy method, sum of years digit method, double declining method, etc. which may be used for determining the amount of depreciation. The selection of an appropriate method depends upon the following :

  • Type of the asset;
  • Nature of the use of such asset;
  • Circumstances prevailing in the business;

As per Accounting Standard-6, the selected depreciation method should be applied consistently from period to period. Change in depreciation method may be allowed only under specific circumstances.

Karnataka class 12 commerce Accountancy Factors to be taken into account for the calculation of depreciation 

Straight Line Method This is the earliest and one of the widely used methods of providing depreciation. This method is based on the assumption of equal usage of the asset over its entire useful life. It is called straight line for a reason that if the amount of depreciation and corresponding time period is plotted on a graph, it will result in a straight line. It is also called fixed installment method because the amount of depreciation remains constant from year to year over the useful life of the asset.

Karnataka class 12 commerce Accountancy Factors to be taken into account for the calculation of depreciation 

Advantages of Straight Line Method Straight Line method has certain advantages which are stated below:

  • It is very simple, easy to understand and apply. Simplicity makes it a popular method in practice;
  • Asset can be depreciated upto the net scrap value or zero value. Therefore, this method makes it possible to distribute full depreciable cost over useful life of the asset;
  • Every year, same amount is charged as depreciation in profit and loss account. This makes comparison of profits for different years easy;
  • This method is suitable for those assets whose useful life can be estimated accurately and where the use of the asset is consistent from year to year such as leasehold buildings.

Karnataka class 12 commerce Accountancy Factors to be taken into account for the calculation of depreciation 

Limitations of Straight Line Method Although straight line method is simple and easy to apply it suffers from certain limitations which are given below.

  • This method is based on the faulty assumption of same amount of the utility of an asset in different accounting years;
  • With the passage of time, work efficiency of the asset decreases and repair and maintenance expense increases. Hence, under this method, the total amount charged against profit on account of depreciation and repair taken together, will not be uniform throughout the life of the asset, rather it will keep on increasing from year to year.

Karnataka class 12 commerce Accountancy Factors to be taken into account for the calculation of depreciation  

Written Down Value Method Under this method, depreciation is charged on the book value of the asset. Since book value keeps on reducing by the annual charge of depreciation, it is also known as ‘reducing balance method’. This method involves the application of a pre-determined proportion/percentage of the book value of the asset at the beginning of every accounting period, so as to calculate the amount of depreciation. The amount of depreciation reduces year after year.

Advantages of Written Down Value Method Written down value method has the following advantages:

  • This method is based on a more realistic assumption that the benefits from asset go on diminishing (reducing) with the passage of time. Hence, it calls for proper allocation of cost because higher depreciation is charged in earlier years when asset’s utility is higher as compared to later years when it becomes less effective.
  • It results into almost equal burden of depreciation and repair expenses taken together every year on profit and loss account;
  • Income Tax Act accept this method for tax purposes;
  •  As a large portion of cost is written-off in earlier years, loss due to obsolescence gets reduced;
  • This method is suitable for fixed assets which last for long and which require increased repair and maintenance expenses with passage of time. It can also be used where obsolescence rate is high.

Limitations of Written Down Value Method Although this method is based upon a more realistic assumption it suffers from the following limitations.

  • As depreciation is calculated at fixed percentage of written down value, depreciable cost of the asset cannot be fully written-off. The value of the asset can never be zero;
  • It is difficult to ascertain a suitable rate of depreciation

Karnataka class 12 commerce Accountancy Factors to be taken into account for the calculation of depreciation  

  • Karnataka class 12 commerce Accountancy CH1 DEPRECIATION PROVISIONS AND RESERVES
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  • Karnataka class 12 commerce Accountancy Need for charging depreciation

Karnataka class 12 commerce Accountancy Factors to be taken into account for the calculation of depreciation

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