8 – Accounting and Depreciation for Fixed Assets

Introduction:

Fixed assets account for a sizable component of the company’s total assets. As a result, their presentation in the financial statements is critical. Fixed assets are equally significant in determining profit and presenting the organisation’s financial status.

8.1 Definition and Meaning of Fixed Assets

In many businesses, fixed assets are classified as land, buildings, plant and machinery, cars, furnishings and fittings, goodwill, patents, trademarks, and designs.

As per Accounting Standard – 10 (AS – 10), “Fixed asset is an asset held to be used to produce or provide goods or services and is not held for sale in the normal course of business”. Thus, fixed assets are those acquired and retained in the business for an extended period to carry on the business. These are not for resale. As per AS-10, land, buildings, plants, machinery, and vehicles comprise fixed assets, which are not for resale but kept in the business for producing goods and services.

8.1.1 Accounting Method for Historical Cost of Tangible Assets

1. The cost of fixed assets includes the purchase price, import tariffs, non-refundable taxes, and any directly related cost of bringing the assets into operating order for their intended use. The direct attributable expenses are as follows:

(a) site preparation,

(b) initial shipping and handling costs,

(c) installation cost, such as a unique foundation for the plant and

(d) professional fees such as architects’ and engineers’ fees. The financing cost is associated with delayed credits or borrowed cash for the building or acquiring fixed assets.

2. Administration and other general overhead expenses are typically excluded from the cost of fixed assets since they do not directly relate to a specific fixed cost. The cost of starting up and completing the project, including test runs and experimental production, is typically capitalised as an indirect construction cost component.

3. If the time between when the project is ready to begin commercial production and when commercial production begins is extended, all expenses spent during this time are charged to the P&L A/c. However, expenditures incurred during this period are sometimes classified as delayed revenue expenditures.

4. To determine the gross book value of self-constructed fixed assets, all costs directly related to specific assets, as well as those that are due to the building activity in general and can be attributed to particular assets, are considered.

5. When acquiring a fixed asset in exchange for another asset, the cost is typically established regarding the fair market value of the consideration supplied. If the asset’s fair market value obtained is more prominent, it may be reasonable to evaluate it. An alternative way to record an asset exchange that is sometimes used, mostly when the assets being traded are similar, is to record the asset that was bought at the net book value of the asset that was given up, with any cash or other consideration received or paid being taken into account.

6. Subsequent fixed asset investments for improvement should be contributed to the gross book value. The gross book value includes only expenditures that improve the future benefits of an existing asset above its previously assessed standard performance.

7. The cost of a capital addition to an existing asset that forms an essential element of the existing asset is generally added to its gross book value.

8. a fixed asset is deducted from the financial accounts on disposal.

9. Fixed assets that have been retired from active use and are being retained for disposal are indicated at less than their net book and net realisable value and are shown separately in the financial statements.

• Gains or losses on disposal are usually reflected in the profit and loss statement in historical cost financial statements.
• If a fixed asset already revalued is sold, the difference between the net proceeds and the net book value is usually added to the profit and loss statement. The only time this is not the case is when the loss is due to an increase that was recorded as a credit to the revaluation reserve but has not been reversed or used. In that case, the loss is charged directly to the account. The amount in revaluation reserve that remains after the retirement or disposal of an asset relating to that asset may be transferred to the general reserve.

8.1.2 Fixed Asset Valuation Methodology

According to AS-10, two methods exist for calculating the gross book value of fixed assets: historical cost and revaluation. A fixed asset’s gross book value is its historical cost or the sum substituted for historical cost in the financial statements books of account. This amount is referred to as net book value when it is shown net of accumulated depreciation.

1st Illustration: On September 30, 2007, Aditya Co. Ltd. purchased machinery from Hindustan Machine Tools Ltd. for a quoted price of 400 lakhs, with a cash discount of 5% granted for prompt payment. The indicated price includes an 8% Value Added Tax (VAT). The company incurred the following additional expenses:

Transit insurance                                                                 4,00,000

Transportation charges                                                       10,00,000

Foundation charges                                                            3,00,000

Installation charges                                                             5,00,000

The company borrowed 360 lakh from HDFC Bank at 16% annual interest. The machinery was ready for use on 31, 2008. Ascertain the cost of the machinery.

Solution:

Calculation of Cost of Acquisition of Machinery (In Lakhs)

Quoted Price of Machinery	400
Less: 5% Cash Discount of quoted price	20
Price after discount	380
Add: VAT @8% on quoted price	32	412
Add:     Transit insurance	4
Transportation charges	10
Foundation charges	3
Installation charges	5	22
Interest on loan
@ 16% on 360 for 6 months (from 1.10.07 to 31.3.2008)		28.8
Cost of Acquisition of Machinery
		462.8

 

8.1.3 Accounting Method for Revalued Tangible Assets

Accounting for evaluating fixed assets is a widely acknowledged and desired practice. A competent valuer does the valuation of fixed assets in this case. The following guiding concepts from AS-10 should be kept in mind when implementing this method:

1. When revaluing a fixed asset in financial statements, a whole class of assets should be revalued, or assets for revaluation should be selected systematically.

2. A revaluation of a class of assets in financial statements should not result in the net book value of that class being more significant than the recoverable amount of assets in that class.

3. When a fixed asset is revalued, any accrued depreciation at the time of the revaluation shall not be charged to the profit and loss statement.

4. An increase in net book value resulting from revaluation of fixed assets should be credited directly to owners’ interests under the heading of revaluation reserve, except that it may be credited to the profit and loss statement if it is related to and not more significant than a decrease resulting from revaluation previously recorded as a charge to the profit and loss statement. A fall in net book value resulting from fixed asset revaluation should be charged immediately to the profit and loss statement, except when such a decline is connected to an increase previously recorded as a credit to revaluation reserve that has not been later reversed or utilised.

5. When selling a fixed asset that has already been revalued, the difference between the net proceeds from the sale and the asset’s net book value should be charged or credited to the profit and loss statement. However, a loss can be charged directly to the account if it is related to an increase recorded as a credit to the revaluation reserve and has not been reversed or used.

 

Illustration 2: On January 1, 2003, Amar Club paid 150 lakhs for a plant. For 2003, 2004, 2005, and 2006, the machine was depreciated straight-line at 10% per year. The machine was revalued at 135 lakhs on January 1, 2007, and this was adopted. What will the plant’s carrying cost be on December 31, 2008? There will be no change in the plant’s economic life.

Solution:

Calculation of Carrying Cost of Plant        (In lakhs)

 

Purchase of Plant on 1st Jan. 2003                                                        150

Less: Depreciation @10% p.a. for 4 years 150 x 10 x 4                          60

100

 

Balance on 1st January 2007	90
Add: Credit given due to revaluation (135-90)	45
Revaluation of plant	135
Less: Depreciation for 2007
(as the remaining life of the plant is only 6 years, therefore, 1/6 of the revalued plant will be 1/6 of 135)	22.5
Balance on 1st Jan., 2008	112.5
Less: Depreciation for 2008	22.5
Balance of plant on 31st Dec. 2008	90.00

8.1.4 Special Case Valuation of Fixed Tangible Assets

In such circumstances, the principles outlined in the AS-10 are used to value fixed assets. These are as follows:

1. Although the legal title does not vest in the firm in the case of fixed assets acquired on hire purchase terms, such assets are recorded at their cash worth, which, if not readily available, is determined by assuming a suitable interest rate. They are shown in the balance sheet with an appropriate narration to show that the enterprise does not entirely own them.

2. When a business holds fixed assets jointly with others (other than as a partner in a firm), the balance sheet shows the amount of its stake in such assets and the proportion in the original cost, accumulated depreciation, and write-down value. Alternatively, the pro-rata cost of such jointly held assets is combined with the cost of analogous fully-owned assets. The specifics of such jointly owned assets are listed separately in the fixed assets register.

3. When numerous assets are purchased for a consolidated price, the consideration is allocated relatively to each asset, as established by competent valuers.

8.1.5 Intangible Asset Valuation

For the appraisal of fixed assets of a peculiar type (intangible assets), the following AS-10 guiding principles are followed:

Goodwill

1. Generally, goodwill is recorded in the books only when some payment in money or money’s worth is made. When a firm is acquired for a price (payable in cash, shares, or otherwise) that is greater than the worth of the business’s net assets, the excess is referred to as ‘goodwill.’ It is derived from an enterprise’s commercial contacts, trade name or reputation, or other intangible benefits.

2. Goodwill is written off over time as a matter of financial prudence. However, many businesses do not write off goodwill but keep it as an asset.

Patent

1. Patents are typically acquired in two ways:

(i) through purchase, in which case they are valued at the purchase price plus incidental expenses, stamp duty, and so on; and

(ii) through development within the enterprise, in which case identifiable costs incurred in developing the patents are capitalised. Patents are typically written off during their legal term of validity or working life, whichever is shorter.

Know-how

1. Generally, know-how is documented in the books only when a monetary or monetary-worth consideration has been paid. There are two kinds of know-how:

(i) Concerning industrial processes; and

(ii) Concerning plans, blueprints, and drawings of buildings, plants, or machinery

Know-how linked to building plans, blueprints, drawings, and plant and machinery is capitalised under the appropriate asset headings. In such circumstances, depreciation is determined based on the whole cost of the assets, including the cost of the capitalised know-how. Manufacturing process know-how is typically expensed in the year it is incurred.

Where the amount paid for know-how is a composite sum for the above-mentioned types, such consideration is allocated among them reasonably.

The consideration for the delivery of know-how consists of recurring annual payments such as royalties, technical assistance fees, research contributions, and so on, which are charged to the profit and loss statement each year.

8.1.6 Disclosure of Fixed Assets

The financial statements must include the following information:

1. Gross and net book values of fixed assets at the beginning and end of an accounting period, reflecting additions, disposals, acquisitions, and other movements;

2. Expenditure incurred on account of fixed assets during construction or acquisition; and

3. Revalued amounts were substituted for historical costs of fixed assets. The method used to compute the quantities revalued, the nature of indices used, the year of any appraisal made, and whether an external valuer was used were also specified.

8.2 Depreciation on Fixed Assets: Meaning and Definition

The fall or loss in the value of assets is referred to as depreciation. Depreciation is the permanent decrease in the value of depreciable assets due to their use in the operation of a business. Land, forest, goodwill, cattle, and R&D are not depreciable assets. Depreciation is not apparent like other business expenses are and is not considered when calculating the company’s profit/loss. However, this is not the case with asset depreciation. Its monetary value is similarly not fixed. It is based on prior knowledge. Some business owners do not account for asset depreciation and do not remove gross profit from net profit when calculating net profit.

One thing to remember is that depreciation is determined on fixed assets and deducted from profit to determine net profit. Of course, present assets may lose value. Current asset value losses are computed based on cost or market price, whichever is less. The valuation of current assets is done solely for the balance sheet.

Depreciation occurs in all fixed assets for a variety of causes. There are a few examples of assets whose values increase, such as land, antiques, and old artworks. Depreciable assets, according to Accounting Standard-6, are those that:

1. are expected to be used during more than one accounting period,

2. have a limited useful life, and

3. are held by an enterprise for use in the production or supply of goods and services, rental to others, or administrative purposes and not for sale in the ordinary business.

8.2.1 Definitions

In AS-6, depreciation is defined as “Depreciation is a measure of wearing out, consumption, or other loss of value of a depreciable asset, arising from use, affluxion of time or obsolescence through technology and market changes. Depreciation is allocated to change a fair proportion of the depreciable amount in each accounting period during the asset’s expected useful life. Depreciation includes amortisation of assets whose useful life is predetermined.”

As per International Accounting Standards Committees, “Depreciation is the allocation of the depreciable amount of an asset over its estimated useful life. Depreciation for the accounting period is charged to income either directly or indirectly”.

According to J.H. Burton, “Depreciation is the shrinkage in the value of an asset at a given date as compared with its value at a previous date”.

The above definition clearly states that depreciation is a gradual fall in the value of assets for several reasons.

8.2.2 The Importance of Depreciation

Depreciation is provided in the books in the following ways:

1. To present the assets in the balance sheet at their actual value: Fixed assets are subject to depreciation, which is represented against fixed assets in the balance sheet. As a result, the balance sheet presents an honest and fair picture of the company’s financial status. If we do not make a provision for depreciation on fixed assets, the balance sheet will not reflect the true worth of the assets.

2. Determining the correct gains or losses: The genuine profit can only be determined after deducting all costs from a period’s revenue. Because assets are employed to generate income in the firm, their value decreases due to such corporate use. As a result, such a decrease in value should be viewed as a cost and deducted from profit. Payment for the purchase of assets should be viewed as anticipated expenses and spread out over time to determine the genuine profit.

3. Establish a fund for asset replacement: If depreciation on fixed assets is provided and charged against profit each year, the profit will be reduced by the amount of depreciation. If the money is moved to a fund account, a depreciation fund will be created after the machine’s life expires to replace the fixed assets.

As a result, we can see that depreciation is vital in determining the exact amount of profit, presenting a genuine and fair financial picture of the business, and replacing assets when their useful lives expire.

8.2.3 Depreciation Recording Methods

There are two ways to report depreciation on fixed assets in the owner’s books:

1. When a provision for depreciation account is kept: The amount of depreciation is transferred to the provision for depreciation account each year under this technique, and the assets are recorded in the books at their original cost. When assets are sold at the end of their useful life, the sales proceeds and the amount of provision for depreciation are moved to the assets account. The profit and loss statement records profit or loss from the sale of assets. The following diary entries are recorded in the owner’s books using this method:

(i) When depreciation is charged on Assets:

Depreciation Account                                                                    Dr.

To Provision for Depreciation Account

(ii) When depreciation is transferred to P&L Account:

P&L Account                                                                                 Dr.

To Depreciation Account

(iii) When assets are sold on the expiry of the useful life of the Assets:

Provision for Depreciation Account                                                Dr.

To Assets Account

(iv) If there is any profit on the sale of Assets:

Assets account                                                                              Dr.

To P&L Account

(v) If there is any loss on the sale of Assets:

P&L Account                                                                                 Dr.

To Assets Account

2. When the Provision for Depreciation Account Is Not Maintained: In this case, the depreciation on the assets is transferred to the assets account rather than the provision for depreciation account, and the assets are shown in the balance sheet at the written down value (cost of assets minus depreciation). Depreciation is recorded as an item in the profit and loss account. The following diary entries are recorded in the owner’s books using this method:

(i) When depreciation is charged on Assets:

Depreciation Account                                                                    Dr.

To Assets Account

(ii) When depreciation is transferred to the P&L Account:

P&L Account                                                                                  Dr.

To Depreciation Account

(iii) If the assets are sold at a profit on the expiry of the useful life of Assets:

Cash Account                                                                                Dr.

To Assets Account To P&L Account

(iv) In the case of loss, the following entry is passed:

Cash Account                                                                                Dr.

P&L Account                                                                                 Dr.

To Assets Account

8.3 Methods for Calculating Depreciation

Several approaches are used to allocate depreciation across assets’ useful lives. The technique used to provide depreciation is chosen based on various elements, such as asset types, business nature, and business situations.

These methods are as follows:

1. Straight Line Method
2. Written Down Value Method or Diminishing Balance Method
3. The Annuity Method
4. Sinking Fund Method vs. Depreciation Fund Method
5. Insurance Policy Procedure
6. Method of Revaluation
7. Method of Depletion
8. Method of calculating machine hour rates

 

8.3.1 Straight Line Method

This strategy is sometimes referred to as the fixed instalment method. In this method, depreciation is calculated on the original cost using a predetermined percentage while keeping the scrap value of the assets in mind. The amount of depreciation remains uniform/fixed under this strategy, and the asset’s value becomes zero at the end of its life. It can also be computed using the following formula:

Depreciation = Original Cost – Scrape Value/Asset Life in Year

Merits

The following are the advantages of this method:

1. This procedure is quite basic and straightforward.
2. At the end of the asset’s life, the entire value is divided by the asset’s life, and the asset’s value becomes zero.
3. This strategy is appropriate for assets that deteriorate physically, such as buildings and leasehold holdings.

Despite the numerous benefits listed above, this approach has the following drawbacks:

1. The quantity of depreciation remains constant over time; however, the number of repairs and renewals grows.
2. Under this strategy, the amount of depreciation is not invested outside the corporation, which results in a lack of interest.
3. Depreciation is calculated individually if any other asset is purchased during the year.
4. Income tax rules do not accept this strategy.

Illustration 3: Fixed Installment Method

On April 1, 2006, Mr. Ramesh paid $24,000 for used equipment. He spent $10,000 on refurbishment and installation. Depreciation is written off at 10% per year on the initial cost. On June 30, 2008, the machine was deemed inappropriate and sold for $20,000.00. Prepare the machine account from 2006 to 2008, assuming accounts are closed every year on December 31st.

Solution:

In the books of Mr. Ramesh

Machine Account

Date	Particulars	( )	Date	Particulars	( )
2006			2006
April 1	To Cash A/c	34,000	Dec. 31	By Depreciation	2,550
	(24,000 + 10,000)			(for 9 months)
			Dec. 31	By Balance c/d	31,450
		34,000			34,000
2007			2007
Jan. 1	To Balance b/d	31,450	Dec. 31	By Depreciation A/c	3,400
				(for 12 months)
			Dec. 31	By Balance c/d	28,050
		31,450			31,450
2008			2008
Jan. 1	To Balance b/d	28,050	June 30	By Depreciation A/c	1,700
				(6 months)
				By Cash A/c (Sale)	19,000
				By P&L A/c (Loss)	7,350
		28,050			28,050

 

Working Note:

1. Cost of Machine = 24,000 + 10,000 = 34,000
2. Depreciation for 2006 = 34,000 ‘ 10/100 ´ 9/12 = 2, 550
3. Depreciation for 2007 = 34,000 ´ 10/100 = 3, 400

 

8.3.2. Written Down Value Method or Diminishing Balance Method

Depreciation for 2008 (for 6 months) = 34,000 ´ 10/100 ´ 6/12 = 1,700

Illustration 4: On April 1, 2004, Abhimanyu & Co. paid $90,000 for furniture. The furniture’s expected useful life is four years, with a scarp value of $10,000. Calculate depreciation using the fixed line approach and illustrate a four-year furniture account, assuming the corporation keeps a provision for depreciation account.

Solution:

Depreciation Calculation

Depreciation equals Original Cost – Scrap Value/Economic Life = 90,000 – 10,000/4 = 20,000

Furniture Account

Date	Particulars	( )	Date	Particulars	( )
2004			2005
April 1	To Bank A/c	90,000	March 31	By Balance c/d	90,000
		90,000			90,000
2005			2006
April 1	To Balance b/d	90,000	March 31	By Balance c/d	90,000
		90,000			90,000
2006 April 1   2007 April 1	To Balance b/d       To Balance b/d	90,000	2007 March 31   2008 March 31	By Balance b/d       By Provision for Depreciation A/c By Balance c/d	90,000
		90,000			90,000
		90,000			80,000 10,000
		90,000			90,000

 

Provision for Depreciation Account

Date	Particulars	( )	Date	Particulars	( )
2005			2005
March 31	To Balance c/d	20,000	March 31	By Depreciation A/c	20,000
2006			2005
March 31	To Balance c/d	40,000	April 1	By Balance b/d	20,000
			2006
			March 31	By Depreciation A/c	20,000
		40,000			40,000
2007			2006
March 31	To Balance c/d	60,000	April 1	By Balance b/d	40,000
			2007
			March 31	By Depreciation A/c	20,000
		60,000			60,000
2008			2007
March 31	To Furniture A/c	80,000	April 1	By Balance b/d	60,000
			2008
			March 31	By Depreciation A/c	20,000
		80,000			80,000

 

Distinction between Fixed Instalment Method and Diminishing Value Method of Depreciation Fixed Assets

Basis of Difference	Fixed/Straight Line Method	Diminishing Value Method
1. Basis of charge and amount of depreciation.	Depreciation is calculated based on the original cost of the asset, i.e. Cost scrap value, if any No. Of the useful life of assets (in years). The amount of depreciation remains constant (fixed) every year.	Depreciation is a certain percentage of the value of assets. The amount of depreciation decreases every year.
2. Value of assets	The value of an asset becomes zero at the end of its life.	Asset value can never be zero even though the asset becomes obsolete/useless.
3.   Burden of depreciation.	The burden of depreciation remains uniform as the amount of depreciation remains constant every year.	The burden of depreciation is heavier initially but becomes lighter in the subsequent years.
4. Suitable system.	This method is suitable for assets where the cost, scrap value, and life of the asset are easily known and the burden of repairs is minimal or remains constant.	The method is suitable for such assets where the cost, scrap value of investment, and life of the asset cannot be ascertained quickly, and the burden of repairs also increases.
5.  Income Tax point of view.	This system is not recognized under income tax rules.	This method is considered suitable under income tax rules.
6.  Effect on profit and loss a/c	The depreciation repairs charges were lower in the beginning but increased in subsequent years. Though the amount of depreciation remains constant, the amount of repairs increases because of higher maintenance changes	The total change in P&L A/C Due to Depreciation and Repair Charges remains constant. Although depreciation decreases, the repair charges increase, and the overall burden on P&L remains constant.

 

Modifications to the Depreciation Method

According to the accounting consistency convention, once management adopts a depreciation method, it should be used consistently. However, due to legislative requirements, Accounting Standard requirements, or other factors, management may modify the process of providing depreciation on assets from a decreasing balance method to a fixed instalment method or vice versa. When management wishes to change the method of depreciation, the following two options are available:

1. The method of charging depreciation can be modified beginning with the current year. This is called a projected change. In such a case, a new technique of charging depreciation from the current year throughout the remaining economic life of the assets is used.
2. There is a difficulty when the method of charging depreciation is altered from the back date or retrospective year. In such a case, asset depreciation is computed using the new technique from the backdate. Similarly, depreciation on assets is determined using the traditional method (which is already shown in the books). The amounts of these two depreciations are then compared. Suppose the depreciation estimated by the new approach exceeds the amount calculated by the old method. In that case, the excess is credited to the assets account in the current year and indicated on the debit side of the P&L A/c. If the estimated amount of depreciation using the new approach is less than the amount calculated using the old method, the difference is debited to the assets account in the current year and the credit side of the P&LA/c.

8.3.3 The Annuity Method

Depreciation on assets is computed using this method by considering the cost of the assets and interest on the assets. The annuity method is a compounded interest approach that calculates depreciation based on the assumption that depreciation and the average cost of capital to finance the assets are constant over the asset’s life. This method considers interest and the cost of assets when computing the amount of depreciation. Every year, the amount of interest is charged from the assets account, and the amount of depreciation is added to the assets account. The interest rate is calculated using the asset’s opening balance. So, it (interest) declines year after year, but the amount of depreciation remains constant, as determined by annuity tables. This depreciation is the amount the asset’s value is reduced to zero.

In other words, if a company spends $50,000 on a plant and only depreciates it by $10,000 a year, it will have a fund of $50,000 after five years to replace the new plant. In this scenario, one item is overlooked: interest. This indicates that if this corporation invested $50,000 in securities rather than buying assets, it would receive some interest in addition to the $50,000 investment. The amount of depreciation is calculated using this approach by adding the depreciation and interest. The amount of depreciation is calculated using an annuity table. The following journal entries are transmitted for depreciation and interest using this procedure.

1.When depreciation is charged on Assets

Depreciation Account                                                          Dr.

To Assets Account

2. When interest on the cost of assets is calculated and showed

Assets Account                                                                   Dr.

In Assets Account

3. When interest is transferred to P&L A/c

Interest Account                                                                 Dr.

To P&L Account

Illustration 6: Annuity Method

A Plastic Manufacturing Firm takes a lease costing 4,00,000 for 4 years. It decided to write off this lease using the annuity method. You are given from the annuity table that to write off the lease on the Annuity Method at 5 percent interest per annum, the amount to be written off annually as depreciation amounts to 1,12,804.

Show lease account for all four years.

Solution:

Lease Account

Date	Particulars	( )	Date	Particulars	( )
1st year	To Bank A/c	4,00,000	1st year	To Depreciation A/c	1,12,804
	To Interest A/c	20,000		To Balance c/d	3,07,196
		4,20,000			4,20,000
2nd year	To Balance b/d	3,07,196	2nd year	By Depreciation A/c	1,12,804
	To Interest A/c	15,360		By Balance c/d	2,09,752
		3,22,556			3,22,556
3rd year	To Balance b/d	2,09,752	3rd year	By Depreciation A/c	1,12,804
	To Interest A/c	10,488		By Balance c/d	1,07,436
		2,20,240			2,20,240
4th year	To Balance b/d	1,07,436	4th year	By Depreciation A/c	1,12,804
	To Interest A/c	5,368
		1,12,804			1,12,804

 

8.3.4 Sinking Fund Method vs. Depreciation Fund Method

This strategy is structured so that the collected money is immediately available to replace the assets when their useful life expires. This method uses the amount of depreciation on assets to build a sinking fund. Every year, an equivalent amount of depreciation is invested in government or marketable securities, and the interest earned on these assets is also reinvested in the same securities. When the assets’ economic life expires, the securities are sold in the market, and the proceeds are used to replace the old assets. If any profit or loss is realised from the sale of these securities, it is transferred to the profit and loss account. The following journal entries are given to use this method:

1. At the end of the first year, when depreciation (which is calculated with the help of the sinking fund table) is charged and transferred to the sinking fund or depreciation fund account –

Depreciation Account                                                          Dr.

To Sinking Fund Account

2. When the depreciation account is transferred to P&L Account

P&L Account                                                              Dr.

To Depreciation Account

Alternatively, in the place of above two entries, the following entry may be passed

P&L Account                                                              Dr.

To Sinking Fund Account

3. When, at the end of 1st year, an equivalent amount to the depreciation is invested in some securities

Sinking Fund Investment Account                                       Dr.

To Cash/Bank Account

4. At the end of the second year, when interest on the first year’s sinking fund investment is received

Bank Account                                                                      Dr.

To Sinking Fund Account

5. When depreciation on assets is charged

P&L Account                                                              Dr.

To Sinking Fund Account

6. When the annual Installment of depreciation, along with the interest received on the previous year’s investment, is invested in some securities

Sinking Fund Investment Account                                       Dr.

To Bank Account

(For the subsequent years, the same pattern has been adopted.)

7. On the expiry of the economic life of the assets, if S.F. investments are sold at a profit

Bank Account                                                                      Dr.

To Sinking Fund Investment Account

To Sinking Fund Account (profit on sale)

If there is a loss on the sale of investment:

Bank Account                                                                      Dr.

Sinking Fund Account                                                         Dr.

To Sinking Fund Investment A/c

8. When old assets are sold

Bank Account                                                                      Dr.

To Assets Account

9. When the balance of the sinking fund account is transferred to the assets account

Sinking Fund Account                                                         Dr.

To Assets Account

10. The balance of the assets account (if any) was transferred to the P& L account

P&L Account (loss)                                                    Dr.

To Assets Account

Or

Assets Account                                                                   Dr.

To P&L Account (Profit)

 

8.3.5 Insurance Policy Procedure

The strategy is comparable to the sinking fund strategy. Using this approach, the firm takes out an insurance policy to replace the assets. The annual depreciation determines the premium paid, whereas the firm purchased other securities using the sinking fund approach. The amount of the premium, plus interest, is deposited with the insurance company. The insurance coverage matures when the useful life of the assets expires. The insurance company makes the sum available upon maturity and uses it to purchase new assets. As a result, this strategy provides greater security and liquidity to the money. The following journal entries are passed using this method.

1. When depreciation is charged:

P&L Account                                                                        Dr.

To Depreciation Fund Account

2. When the amount of premium is paid

Depreciation Fund Policy Account                                        Dr.

To Bank Account

3. When the amount of policy is received from the insurance company on maturity

Bank Account                                                                      Dr.

To Depreciation Fund Policy Account

4. There may be profit or loss on the policy that is transferred to the depreciation fund account. The, the following entry is passed for profit

For Profit:

Depreciation Fund Policy Account                                        Dr.

To Depreciation Fund Account

For Loss:

Depreciation Fund Account                                                 Dr.

To Depreciation Fund Policy Account

5. When new assets are acquired:

Assets Account                                                                   Dr.

To Bank Account

8.3.6 Method of Revaluation or Appraisal

Depreciation is determined based on asset revaluation, as the name implies. Experts revalue the assets after a year or interval. The difference in valuation between the two eras is referred to as the period’s depreciation or appreciation. This strategy is commonly utilised in the cases of livestock, copyrights, and patents.

8.3.7 Method of Depletion

It is often referred to as a production process. This strategy applies to natural assets such as coal mines, oil wells, etc. These are taken for excavation on a contract basis for a set amount of time. In this situation, depreciation is calculated based on production. To calculate the annual amount of depreciation, first estimate the total output for the contract period, then divide the total depreciable cost by the total production and multiply by the annual output. In the shape of a formula:

Annual Depreciation = Annual Output/Total Estimated Output

8.3.8 Machine Hours Rate Method

This method is utilised when calculating depreciation based on the operating hours of a machine or facility. The machine hour rate is calculated by dividing the original cost of the plant or machinery by the total number of working hours of the machine or plant. To calculate annual depreciation, multiply the machine hour rate by the total working hours of the machine/plant in a year. This technique can be explained using the formula –

Machine Hour Rate = Original Machine Cost/Total Working Hours of the Machine Throughout Its Life

Annual Depreciation = Machine Hour Rate x Working Hours Per Year

Unlike the straight-line method, this method of charging depreciation frequently includes a percentage for calculation. The depreciation is calculated using two separate values.

8.4 Reserves and Provisions

Every firm, whatever its style of organisation, prefers to conduct its operations prudently to be prepared for all eventualities—both foreseen and unexpected. This is accomplished, among other things, by making provisions and establishing reserves while preparing financial accounts.

8.4.1 Interpretation of Provisions

The phrase ‘provision’ refers to an amount written off or retained to provide for depreciation, renewals, or decline in the value of assets or any unknown future liability which cannot be established with reasonable accuracy.

If the amount of responsibility is known or can be ascertained, a definite liability, such as liability for outstanding interest, should be created. Provisions include provisions for questionable debts, provisions for depreciation, provisions for repairs, provisions for debtor discounts, provisions for taxation, and provisions for legal damages that are anticipated to result from pending litigation.

Because the provision is a charge against the profit for the year, it is debited to the profit and loss account before calculating the net profit for the year. It is presented in the balance sheet after specific liabilities on the liability side. It should be underlined that provision must be made regardless of whether a firm makes a profit, as failure to do so results in a breach of prudential business behaviour.

8.4.2 Reserves and Their Importance

The term “reserve” refers to a sum set aside from earnings (as determined by the profit and loss account) or other surpluses not intended to satisfy any liability, contingency, commitment, or legal necessity. As a result, reserve accounts for amounts that are neither a liability nor a provision. It is a profit allocation rather than a charge on current revenues.

The proprietors own it over the money they give. If a sum equal to a reserve is invested in outside securities, it is referred to as a ‘Reserve Fund,’ but if this requirement is not met, it is referred to as a ‘reserve.’

When a fund is used for a particular purpose, it is referred to as “Specific Reserve”; otherwise, it is referred to as “General Reserve.” Examples are Capital Reserve, General Reserve, Contingency Reserve, Dividend Equalization Reserve, Debenture Redemption Fund, and other reserves.

8.4.3 The Value of Provisions and Reserves

A commercial firm in general, and a corporate enterprise in particular, may believe it is appropriate to establish some mechanism to shield itself from the repercussions of knowing obligations and losses it may be compelled to pay. In some situations, it may also be considered more acceptable to decrease the amount that proprietors can draw as profit to conserve firm resources to satisfy specific substantial demands for them in the future. One example of such a requirement is the much-needed growth of corporate activities on a larger scale. This is offered as an explanation for the importance of provisions and reserves in corporate operations and accounting.

The cash set aside may be used to meet specific requirements, such as asset repairs and renewals, meet a future liability or loss, strengthen the undertaking’s general financial situation, or redeem a long-term liability, such as debentures.

8.4.4 Distinction

Identifying and comprehending the specific scope of ‘provisions’ and ‘reserves’ necessitates explaining their differences to clarify their functions in business and accounting.

The purpose of a provision is to fulfil a specific liability, whereas a reserve is to meet the future legal responsibilities or investment requirements of a corporation for expansion.

Mode of Production: A provision is a charge against the year’s profit and loss account that must be generated even if earnings are not expected. A reserve is a profit appropriation that can be established from either profit gained throughout the year or from existing excess, such as a contingency reserve.

Balance Sheet Presentation: A provision is typically shown on the balance sheet as a deduction from the item for which it was generated on the asset side or as a liability following current liabilities as part of external equities. A reserve is a separate item on the liabilities side of a balance sheet.

Utilization: In practice, very severe constraints are imposed on using provisions in company operations to ensure they are used for the intended purpose. In contrast, the balance of the general reserve, or any account of this type, is always available for legitimate business needs. Reserves generated under specific legal duties, such as “Capital Redemption Reserve or Debenture Redemption Reserve,” must be used exclusively within the legal framework.

Identification with Operations: A provision covers a specific liability or expected loss on a single item. As a result, they cannot be separated from business operations, and investing outside of the firm is not an option. Because reserves are general, they can be invested outside of the firm to eliminate the potential of their non-availability in the event of a necessity and to generate some extra money with their assistance. However, businesses do not always require outside investment of reserves.

8.4.5 Different Kinds of Provisions

The number of provisions a firm keeps depends on its needs, determined by the volume, scope, and type of its operations. Generally, a business establishes and maintains provisions for taxation, repairs and renewals, depreciation, debtor discounts, bad and doubtful debts, and so on. However, provisions for questionable debts and debtor discounts have been explored at suitable stages.

When it is inevitable that a debt will not be collected, it is written off as a bad debt. However, it is also possible that some of the outstanding debts will not be fully repaid. This will result in a loss for the company. As a result, it is customary to make a reasonable provision for dubious debts when calculating profit or loss. The balance statement does not reflect the exact position of many debtors. After writing off all known bad debts, the provision for dubious debts is generally computed as a fixed proportion of the total amount outstanding from various debtors. Provision for Doubtful Debts is often called “Provision for Bad Debts” or “Provision for Bad and Doubtful Debts.”

A provision for doubtful debts is made by debiting the amount of questionable debts from the profit and loss account and crediting the provision for doubtful debts account. As a result, the journal entry for establishing such a provision is as follows:

Profit and Loss A/c                                                             Dr.

To Provision for Doubtful Debts A/c

Bad debts incurred during the year are initially deducted from the ‘provision for doubtful debts’ account. As a result, the beginning balance of the provision for questionable debts account may be insufficient to cover the present amount of bad debts and the requirements of future doubtful debts. This deficit will be covered by a charge to the profit and loss account at the end of the fiscal year. In this situation, the annual amount specified must be increased to account for any unused surplus representing credit balance. When there is a provision for bad debts in the books, the following journal entries must be made:

1. For writing off further bad debts given outside the trial balance:

Bad Debts A/c                                                                    Dr.

Sundry Debtors A/c

2. For transferring the total bad debts to the provision for Bad Debts Account:

Provision for Doubtful Debts A/c                                         Dr.

Bad Debts A/c

3. For debiting the Profit and Loss Account with the amount of new provision plus the excess of bad debts over the old provision:

Profit and Loss A/c                                                   Dr.

Provision for Doubtful Debts A/c

4. For crediting the Profit and Loss Account with excess of the old provision over the total bad debts plus new provision, if any:

Provision for Doubtful Debts A/c                               Dr.

Profit and Loss A/c

8.4.6 Types of Reserves

Reserves are usually classified into two types: capital reserves and revenue reserves.

1. Capital Reserve: Capital Reserve’ refers to an accounting strategy for preserving earnings. The amount placed aside as ‘Capital Reserve’ adds stability to a business’s finances. A capital reserve is created due to either a gain on the sale of long-term assets or the settlement of liabilities. Again, capital nature may arise due to the primary transaction of being capital nature. For example, a premium is paid for the sale of equity shares. Furthermore, due to legal obligations, revenue reserves may be allocated to capital reserves. The capital reserve does not include any free balance used for profit distribution. This critical component alone supplies much-needed financial stability to a corporate venture.

Capital reserves are created from profits derived from the revaluation of fixed assets after all restrictions have been met, profits derived from the sale of fixed assets, and profits derived from the re-issuance of shares forfeited by a company’s shareholders.

Shares are being issued at a premium.

Profits realised as a result of company mergers and acquisitions

Profit made before the establishment of a company; creation of capital Redemption Reserve upon redemption of preference shares. The credit balance of capital reserves is always shown on the liabilities side of the balance sheet.

The capital reserve account is deducted whenever this reserve is used. It is also essential to indicate how capital reserves are used during an accounting period in the balance sheet, either in its body or as a footnote to the financial statements. This is because the use of capital reserve is subject to stringent constraints, both imposed by law and enforced by accounting standards.

2. Revenue Reserve: Revenue reserves are formed from profit, which is often distributable. All distributable profits are not always available for dividend payment since a particular portion may be required to be set aside for business purposes, either by law (minimum) or managerial decision (more incredible amount). Only after that will the profit be available for distribution as a dividend.

Revenue reserves include the General Reserve, Dividend Equalisation Reserve, and Debt Redemption Reserve (created only after the complete redemption of the debenture under whose trust deed it was created).

3. General Reserve: A general reserve is the retention of a percentage of revenue income for the betterment of an enterprise’s overall financial state and health in general.

A significant aspect of the general reserve is its prominent role in corporate finance. Establishing and maintaining general reserve aids in realising specific, well-defined goals, particularly in financial management.

Preserving resources that might otherwise be squandered at the price of responsible management can improve the company’s overall financial condition.

Arrangements for dealing with unforeseen and extraordinary losses, regardless of their nature.

Creating opportunities for the expansion of corporate activities. The general reserve is generated by debiting the profit and loss appropriation account and crediting the general reserve account. The latter account is recorded on the liabilities side of the balance sheet. When this account’s balance is utilised for any purpose, the general reserve account gets deducted.

Any use of general reserve must be documented on the balance sheet. The Companies Act includes a variety of regulations regarding the control, establishment, and use of general reserves. This emphasises its significance in the operation of corporate enterprises. A word of caution is needed regarding the frequently perceived role of general reserve. A general reserve often bolsters a company’s overall financial condition. However, this depends on accurately appraising the company’s assets and obligations. The balance on general reserve indicates an enterprise’s financial health when assets and liabilities are properly valued, but it is not in the absence of this critical condition.

4. Reserves for Specific Purposes: In modern times, a company undertaking various business operations to achieve its goal of increasing its value. Some contingency problems can be addressed and financially managed by making arrangements for known or anticipated contingencies. As a precaution, management may want to provide a second defence against some of these eventualities. A special reserve is established for a specific purpose. It cannot be used for any other reason than the one for which it was designed. There could be an infinite number of reserves in business, each with its unique feature specified by the precise function for which it is intended. However, there is an undertone of shared features among them.

They are narrowly concentrated from the standpoint of their use since they are designed for one or more distinct purposes.

-A businesslike strategy for managing these reserves may include investing their balances outside the business.

-As credit balances, all specified reserves are shown on the liabilities side of the balance sheet.

-The amount is debited to the reserve’s account when a specific reserve is drawn. Management decides on allocations for the reserves at the time of financial statement preparation, and the equivalent credit is given to the profit and loss appropriation account.

8.5 Revised Statements of Accounting Standards (AS 6) – Depreciation Accounting

The wording of the amended Accounting Standard (AS) 6, ‘Depreciation Accounting,’ issued by the Council of the Institute of Chartered Accountants of India, is as follows.

Introduction

This Statement addresses depreciation accounting and applies to all depreciable assets, except the following categories, which require special consideration:

• Forests, plantations, and similar regenerative natural resources;
• Wasting assets, including expenditure on mineral exploration and extraction, oils, natural gas, and similar non-regenerative resources;
• Research and development expenditure;
• Goodwill; and
• Livestock.

This assertion is likewise not applicable to land unless it has a limited useful life for the enterprise.

Different firms use different depreciation accounting policies. An enterprise’s accounting procedures for depreciation must be disclosed to appreciate the picture offered in its financial statements.

Definitions

The following terms are used in this statement with their respective definitions:

• Depreciation measures the wear and tear, consumption, or other loss of value of a depreciable asset caused by usage, the passage of time, or obsolescence due to technological and market developments. Depreciation is allocated so that a reasonable proportion of the depreciable value is charged in each accounting period during the asset’s projected helpful life. Amortisation of holdings with a predetermined useful life is included in depreciation.
• Depreciable assets are assets that (i) are expected to be used over multiple accounting periods, (ii) have a limited useful life, and (iii) are held by an enterprise for use in the production or supply of goods and services, for rental to others, or administrative purposes and not for sale in the ordinary course of business.
• The useful life of a depreciable asset is either (i) the period during which the asset is expected to be employed by the enterprise or (ii) the number of production or comparable units estimated to be produced from the asset’s usage by the enterprise.
• The depreciable amount of a depreciable asset equals its historical cost or another quantity substituted for historical cost in the financial statements, less the expected residual value.

Explanation

1. Depreciation substantially impacts the calculation and reporting of an enterprise’s financial status and results of operations. Depreciation is paid in each accounting period based on the depreciable amount, regardless of an increase in the market value of the assets.

2. The assessment of depreciation and the amount to be charged in an accounting period are typically based on the three variables listed below:

-The historical cost of the depreciable asset or another amount substituted for the historical cost of the depreciable asset where the investment has been revalued;

-The expected useful life of the depreciable asset; and

-The estimated residual value of the depreciable asset.

3. A depreciable asset’s historical cost represents the money outlay or equivalent in connection with its procurement, installation, commissioning, and additions to or improvements to it. The historical cost of a depreciable asset may fluctuate due to an increase or decrease in long-term liability due to currency fluctuations, price adjustments, duty increases, or other comparable causes.

4. A depreciable asset’s useful life is shorter than its physical life and is:

-Predetermined by legal or contractual limits, such as the expiration dates of related leases;

-Directly governed by extraction or consumption;

– Dependent on the extent of use and physical deterioration due to wear and tear, which again depends on operational factors, such as the number of shifts for which the asset is to be used, repair and maintenance policy of the entity

5.  Determining a depreciable asset’s useful life is an estimate usually based on various factors, including previous experience with similar types of assets. Such estimation is more difficult for an asset that uses new technology, is used in the creation of a new product, or is used in the provision of a new service, but it is still required on some fair basis.

6. Any capital addition or extension to an existing asset that forms an integral element of the existing asset is depreciated throughout the asset’s remaining useful life. However, as a practical measure, depreciation is occasionally granted on such additions or extensions at the rate applicable to an existing asset. Any addition or extension that has its own identity and can be used after the old asset is disposed of is depreciated independently based on an estimate of its useful life.

• Usually, determining an asset’s residual value is challenging. If such a value is deemed trivial, it is regarded as nil. If the residual value is anticipated to be significant, it is estimated at the time of acquisition/installation or subsequent asset appraisal. The realisable worth of identical assets that have reached the end of their useful life and have operated under conditions similar to those in which the asset will be utilised would be one of the bases for establishing the residual value.
• The amount of depreciation to be provided in an accounting period requires management to apply judgment in light of technical, commercial, accounting, and regulatory criteria. It may, therefore, require periodic assessment. Suppose it is determined that the original estimate of an asset’s useful life needs to be updated. In that case, the asset’s unamortised depreciable amount is charged to revenue over the revised remaining useful life.
• Several approaches exist for allocating depreciation over the useful life of assets. Straight-line and lowering balance methods are the two most widely used in industrial and commercial companies. The management of a business chooses the most appropriate method(s) depending on a variety of critical aspects, such as (i) the type of asset, (ii) the nature of the asset’s usage, and (iii) the circumstances of the firm. Occasionally, a mixture of more than one method is utilised. Depreciation is frequently allocated fully in the accounting period in which depreciable assets with no significant value are acquired.
• The statute that governs an entity may provide the basis for calculating depreciation. For example, the Companies Act of 1956 specifies depreciation rates for specific assets. When management’s assessment of the useful life of a business asset is shorter than that contemplated by the requirements of the applicable statute, the depreciation provision is estimated appropriately using a higher rate. If management’s assessment of the asset’s useful life is more significant than that contemplated by the statute, a depreciation rate lower than that contemplated by the law can be applied only in line with the act’s conditions.
• When depreciable assets are disposed of, abandoned, demolished, or destroyed, the net excess or deficiency, if considerable, is separately declared.
• The depreciation method is used consistently to give comparable results of the enterprise’s activities from period to period. A change from one method of providing depreciation to another is made only if it is required by statute, for conformity with an accounting standard, or if it is determined that the change would result in a more acceptable preparation or presentation of the enterprise’s financial statements. When the depreciation method changes, depreciation is recalculated using the new method from when the asset enters service. The deficit or surplus resulting from the retrospective recomputation of amortisation by the new method is adjusted in the accounts in the year when the depreciation method is changed. If the method changes result in a deficiency in depreciation compared to previous years, the shortage is charged to the profit and loss statement. If the method modification results in a profit, the profit is credited to the profit and loss statement. This type of adjustment is recognised as a change in accounting policy, and the impact is quantified and disclosed.
• Where an asset’s historical cost has changed due to the circumstances described in paragraph 6 above, depreciation on the revised unamortised depreciable amount is granted prospectively over the item’s residual helpful life.

Disclosure

• The depreciation techniques employed, total depreciation for the period for each asset class, gross amount of each class of depreciable assets, and corresponding cumulative depreciation are declared in the financial statements, along with other accounting policies. The depreciation rates or usable lifetimes of assets are stated only if they deviate from the significant rates stipulated in the enterprise’s governing statute.
• If depreciable assets are revalued, the provision for depreciation is based on the revalued amount based on an assessment of the asset’s remaining useful life. If the revaluation has a meaningful influence on the amount of depreciation, it is declared separately in the year in which the revaluation is performed.
• A change in depreciation method is recognised as a change in accounting policy and is notified as such.

(The Accounting Standard comprises this Statement’s paragraphs 20-29.) The Standard should be read in conjunction with paragraphs 1-19 of this Statement and the ‘Preface to the Statements of Accounting Standards.’

• During the useful life of a depreciable asset, the depreciable amount should be methodically allocated to each accounting period.
• The depreciation method chosen should be implemented consistently from one period to the next. A change from one method of providing depreciation to another should be implemented only if it is required by statute or for conformity with an accounting standard or if the change is thought to result in a more acceptable preparation or presentation of the enterprise’s financial statements. When the depreciation method is changed, depreciation should be recalculated using the new method from when the asset enters service. The deficit or surplus resulting from the retrospective recomputation of amortisation by the new method should be corrected in the accounts in the year when the depreciation method is changed. If the method changes result in a deficiency in depreciation compared to previous years, the shortage should be charged to the profit and loss statement. If the method modification results in a profit, the profit should be credited to the profit and loss statement. Such a change should be considered a change in accounting policy, with the impact measured and disclosed.
• The useful life of a depreciable asset should be calculated after taking the following considerations into account:
  1. Physical wear and tear;
  2. Obsolescence; and
  3. Legal or other restrictions on the asset’s usage.

The useful life of vital depreciable assets or classes of depreciable assets should be examined regularly. When the expected useful life of an asset is updated, the unamortised depreciable amount should be charged over the revised remaining useful life.

• Any addition or extension that forms a part of an existing asset shall be depreciated over the asset’s remaining useful life. Depreciation on such additions or extensions may also be provided at the same rate as on the current asset. Depreciation should be provided independently based on an estimate of its useful life, where an addition or extension keeps a separate identity and can be used after the current asset is disposed of.
• Where the historical cost of a depreciable asset has changed due to an increase or decrease in long-term liability due to exchange fluctuations, price adjustments, duty changes, or other similar factors, depreciation on the revised unamortised depreciable amount should be provided prospectively over the asset’s residual helpful life.
• If depreciable assets are revalued, the provision for depreciation should be based on the revalued amount and an estimate of the assets’ remaining valuable lives. If the revaluation has a meaningful influence on the amount of depreciation, it should be stated separately in the year in which the revaluation is performed.
• If a depreciable asset is disposed of, discarded, demolished, or destroyed, the net excess or deficiency, if considerable, should be separately declared.
• In the financial statements, the following information should be disclosed:
  1. The historical cost or other amount substituted for the historical cost of each class of depreciable assets;
  2. Total depreciation for the period for each class of assets and
  3. The related accumulated depreciation.
• In addition to the disclosure of other accounting policies, the following information should be included in the financial statements:
  1. The depreciation techniques employed and
  2. The depreciation rates or usable lifetimes of the assets, if they differ from the principal rates, are stated in the enterprise’s statute.