Unit 03 — Depreciation Accounting
Factors influencing depreciation and the two methods your syllabus names — Straight Line and Written Down Value — plus the asset-account presentation, mid-year purchases and the sale of a fixed asset, which is where the faculty's five problems actually live.
Lecture 5 — "Depreciation Accounting — Factors Influencing Depreciation, Methods of Depreciation — Straight line, Written down value" — is the last lecture marked MT in the Course Policy CP p. 3. Lecture 6 onwards is "Term Work, TEE" only. So this unit is in scope and Final Accounts is not.
The syllabus names only two methods Syllabus p. 1 — SLM and WDV. The textbook describes seven. Know all seven by name and one line (they make easy MCQs) but be able to compute only these two. All five faculty problems use only these two.
1. What Depreciation Is, and Why It Must Be Charged Core syllabus concept
1The definition to write
"Depreciation is required to be provided on FIXED assets. The question of depreciation does not arise on CURRENT assets." p. 156 — This is the exact answer to the textbook's own Descriptive Question 1: "'Depreciation is to be provided on fixed assets as well as current assets' — Discuss." The statement is false. Current assets are revalued or written down, not depreciated. Also note: Land is not depreciated, because it has no finite useful life.
2Why it exists at all: the Matching Concept
The textbook's opening paragraph ties depreciation straight back to Unit 1 p. 156: a fixed asset generates revenue over several years, so "it is necessary to charge the appropriate portion of the cost of the fixed asset against its revenue to give meaning to the concept of accounting principle — Matching concept."
Put in plain terms: if you buy a ₹5,00,000 machine that lasts five years and charge the whole ₹5,00,000 in year one, then year one shows a fake loss and years two to five show fake profits. Spreading the cost matches the expense to the revenue it helped earn.
3The three objectives — a guaranteed short question
| Objective | What to write |
|---|---|
| 1. Calculation of correct net income | Depreciation is an expense like any other and must be charged to the P&L. "If not provided, operational results would be overstated." |
| 2. Presentation of fixed assets at proper value | If depreciation is not provided, assets are overstated in the Balance Sheet. Showing an asset at cost when its value has fallen is "similar to painting a better financial picture than it is." |
| 3. Replacement of the asset | Charging depreciation retains funds in the business. Without it, profits are inflated and dividend would be distributed out of unearned profits — leaving no money when the asset needs replacing. |
"Depreciation is a mere book entry. Though depreciation is an expense, there is no actual cash outgo of funds from the firm. However, provision of depreciation reduces profits." p. 157 — It is the only expense in your syllabus that reduces profit without reducing cash. That is also why it is added back in cash-flow analysis (Unit 9, TEE only).
2. Factors Influencing Depreciation Named in the syllabus
Your syllabus names "Factors Influencing Depreciation" explicitly, and the textbook gives two different lists under two different headings. Exams have been known to ask for either, so know both and label them.
1The five causes — §7.3 "Need for Depreciation"
| Factor | What it means | Is it used to compute depreciation? |
|---|---|---|
| (A) Use of the asset | Active or passive. "If a brand new car is kept in a garage, though not used, car would depreciate, perhaps more than its actual use." | Yes. Depreciation runs from the date of acquisition or from when the asset is put to use. |
| (B) Efflux of time | A leased asset has a definite life; on expiry it ceases to exist. Time alone reduces value. | Yes. |
| (C) Obsolescence | A better machine arrives; the existing one, though physically working, has to be written off. "Pentium machines have thrown PC 286 and 386 out of use." | Only when it happens — it does not happen to all assets. |
| (D) Accidents | Repairs exceed realisable value; the asset is discarded, sold "as is where is". | Only when it happens. |
| (E) A fall in prices | Market prices drop — noticeably for computers and electronics. | No. Ignored for fixed assets, because they are not held for sale. Only current assets are affected by this. |
Textbook §7.3 pp. 156–157. The examinable distinction is the last column: only (A) and (B) are routinely considered; (C) and (D) are event-driven; (E) is deliberately excluded.
2The three computation factors — §7.7
These are the numbers that actually enter the formula p. 160:
+ carriage / freight
+ installation
+ erection
+ reconditioning (typical of a second-hand asset)
"These expenses are to be capitalised… depreciation is to be calculated on the total cost."
"Depreciation is to be calculated on the actual period of holding of the asset. If the fixed asset is purchased in the middle of the year, depreciation is to be calculated from the date of purchase… If the asset is sold in the middle of the year, depreciation is to be calculated till the date of sale." p. 160
Every single one of the five faculty problems turns on this Dep. sheet. Assets are bought on 1 October, 1 December, 1 July; sold on 30 September, 30 June, 31 January. Count the months between the date and the year end, and multiply by n/12.
| Bought / sold on | Year ends 31 March | Fraction |
|---|---|---|
| 1 April | Full year | 12/12 |
| 1 July | Jul–Mar | 9/12 |
| 1 October | Oct–Mar | 6/12 |
| 1 December | Dec–Mar | 4/12 |
| 1 January | Jan–Mar | 3/12 |
| Sold 30 September | Apr–Sep | 6/12 |
| Sold 31 January | Apr–Jan | 10/12 |
3. The Methods Core syllabus concept
1Straight Line Method — the two you must compute, part 1
THE DEFINING FEATURE: the amount is the same every year, because it is always a percentage of the original cost — never of the reducing balance.
| Merits | Demerits |
|---|---|
| Simple to compute. Works well where the asset has a fixed life, as with a lease. Writes the asset down to exactly its scrap value at the end. |
Charge to P&L is not equal, because repairs rise as the asset ages — so total cost (depreciation + repairs) climbs year after year. Indian income-tax authorities do not recognise this method. No ready funds for replacement — the depreciation amount stays invested in the business. |
2Written Down Value Method — part 2
THE DEFINING FEATURE: a fixed rate on a shrinking base, so the amount falls every year. Diminishing Balance Method is also known as Written Down Value Method — the two names are the same thing p. 158.
| Merits | Demerits |
|---|---|
| Depreciation falls as repairs rise, so the total burden on the P&L is roughly uniform over the asset's life — the single best argument for it. Recognised by the Indian income-tax authorities. Consequently the method most firms actually use p. 175. |
In the case of an addition or a sale, tedious calculations are involved. Like SLM, it provides no fund for replacement. Mathematically never reaches zero. |
| Straight Line | Written Down Value | |
|---|---|---|
| Base | Original cost, every year | Opening book value, which falls |
| Annual amount | Constant | Decreasing |
| Scrap value | Deducted first | Not used in the formula |
| Asset reaches zero? | Yes, at the end of the estimated life | No — approaches zero but never gets there |
| Total P&L charge (dep. + repairs) | Rises with age | Roughly even |
| Income tax in India | Not recognised | Recognised |
| Other names | Original Cost Method, Fixed Installment Method | Diminishing Balance Method, Reducing Balance Method |
Watch the wording of a question: "@ 10% p.a. on Original Cost Method" (faculty Q5) means SLM. "@ 15% p.a. on Diminishing Balance Method" (faculty Q2) means WDV. "by fixed installment at 10% p.a." means SLM.
3The other five methods — name and one line each
Out of computational scope, but they are ready-made MCQs and the textbook's own MCQ bank draws on exactly these p. 174.
| Method | In one line | Used for |
|---|---|---|
| Annuity | Treats the asset as an investment and charges interest on it; the write-off comes from an annuity table. Burden on the P&L is MORE than SLM or WDV, because depreciation and interest are charged. | High-value assets where the cost of capital matters. |
| Depreciation Fund = Sinking Fund | The depreciation amount is invested outside the business in safe, readily saleable securities — preferably government securities. On expiry the securities are sold to buy the new asset. | Any asset whose replacement must not disturb business operations. Its great advantage: ready cash for replacement. |
| Depletion | Depreciation on the actual quantity extracted. Mine costing ₹5,00,000 expected to yield 5,000 tons → ₹100/ton; extract 1,000 tons → ₹1,00,000. | Mines, quarries, oil wells. |
| Revaluation | Compare the valuer's figure at year end with (opening value + purchases). Opening ₹20,000 + bought ₹10,000 − closing ₹25,000 = ₹5,000 depreciation. | Livestock (cattle) and loose tools — items too numerous to account for singly. |
| Machine Hour Rate | Total cost ÷ total hours of life = hourly rate; multiply by hours actually run this year. | Machinery whose wear tracks usage rather than time. |
Livestock → Revaluation Method. · Mines and quarries → Depletion Method. · Ready funds for replacement → Sinking Fund Method. · Greater burden on the P&L → Annuity Method. All four from p. 174.
4Changing the method — §7.6
Yes, a firm can change. The requirements, which are the whole answer pp. 159–160:
- A change in the method of depreciation is treated as a change in an accounting policy — not an error, not a restatement.
- The change and the impact of the change, duly quantified, must be stated in "Notes to Accounts".
- The reason: "the reader of the financial statements should be apprised of the change and impact of change on the financial results." — the Full Disclosure convention from Unit 1.
The textbook's MCQ on this has a four-option answer where (d) is the full one: "Permitted in all cases, but change and impact of change are to be stated in Notes to Accounts."
4. Depreciation Accounting — the Two Presentations Core syllabus concept
There are exactly two ways to record depreciation, and which one a question wants changes what the Balance Sheet looks like pp. 160–161.
1Method A — credit the asset account directly
| Depreciation A/c | Dr. | xxx | |
| To Machinery A/c | xxx |
Effect on the Balance Sheet: the Machinery A/c itself shows the written-down value. You see one figure, already net.
2Method B — credit a Provision for Depreciation A/c
| Depreciation A/c | Dr. | xxx | |
| To Provision for Depreciation A/c | xxx |
Effect on the Balance Sheet: the asset account stays at original cost, always. The Provision is shown as a deduction in the inner column, with the net figure in the outer column. This is exactly what "Land & Building ₹13,00,000 Dr." and "Land & Building — Depreciation ₹1,95,000 Cr." mean in the L3 trial balance slide 20.
The textbook sets it as a True/False: "Provision for depreciation account always shows a debit balance" → False p. 174. It is an accumulating credit that offsets an asset — a contra-asset. It never appears on the assets side as a positive number.
5. Sale of a Fixed Asset Where the marks are
Four of the five faculty problems involve a sale Dep. sheet Q2–Q5. This is the examinable core of the unit.
1The arithmetic, before any journal entry
- Find the cost of the portion being sold. If only part of a machine is sold ("one-fourth of the machinery", "one third of the machinery installed on 1 April 2006"), take that fraction of the original cost.
- Accumulate the depreciation on that portion from its purchase date up to the date of sale — including a part-year at the end. Do not stop at the previous year end.
- Written Down Value = Cost of that portion − Accumulated depreciation on it.
- Compare with sale proceeds.
Proceeds > WDV → Profit on sale (credit P&L)
Proceeds < WDV → Loss on sale (debit P&L)
2The accounting procedure — §7.9, five steps
| Step | What to do | Entry |
|---|---|---|
| 1 | Open a separate Machinery Disposal A/c. | — |
| 2 | Transfer the book value of the portion sold out of the asset account. If depreciation was credited directly to the asset (Method A), transfer the WDV. | Machinery Disposal A/c Dr. To Machinery A/c |
| 2′ | If a Provision for Depreciation A/c is maintained (Method B), transfer the original cost from Machinery and the applicable accumulated depreciation from the Provision. | Machinery Disposal A/c Dr. To Machinery A/c (cost) To Provision for Depreciation A/c |
| 3 | Credit the sale proceeds (or scrap proceeds) to the Disposal account. | Cash / Bank A/c Dr. To Machinery Disposal A/c |
| 4 | Close the Disposal account — the balance is the profit or loss. | If profit: Machinery Disposal A/c Dr. / To Profit and Loss A/c If loss: Profit and Loss A/c Dr. / To Machinery Disposal A/c |
Textbook §7.9 pp. 163–164. Shortcut for exam speed: most questions ask only for the Machinery Account, in which case you can skip the separate disposal account and simply credit "By Bank A/c" for the proceeds and "By P&L A/c (loss on sale)" for the shortfall, directly in the machinery account — which is exactly what the textbook's own Illustration 2 does p. 164.
3The textbook's Illustration 2, worked in the exam layout
Neha & Co, calendar year. Machinery bought 1 Apr 2006 ₹30,000; 1 Oct 2006 ₹20,000; 1 Jul 2007 ₹10,000. On 1 Jan 2008, one third of the machinery installed on 1 April 2006 became obsolete and was sold for ₹3,000. Fixed instalment at 10% p.a. p. 164
The textbook prints that five-line calculation as a footnote below the Machinery Account, and so should you. Examiners award the working even when the final account has an arithmetic slip — and they cannot award anything if the profit or loss figure appears with no derivation. Cost of portion → depreciation year by year → WDV → sale value → profit/loss. Five lines, every time.
- Depreciating on the purchase price instead of the total cost. Faculty Q1: machine ₹96,000 + ₹24,000 cartage, repairs and installation → depreciate on ₹1,20,000.
- Forgetting the part-year in the year of sale. If the asset is sold 30 June and the year ends 31 March, you still owe three months of depreciation on it before computing the WDV.
- Using the current book value instead of the original cost for a fractional sale. "One-fourth of the machinery" means one-fourth of what it originally cost.
- Applying WDV depreciation to the original cost in later years. In WDV the base falls each year — recompute the opening balance every time.
4A wrinkle from faculty Q1 worth flagging
"ZEE Ltd purchased a second-hand machine for ₹96,000, spent ₹24,000 on cartage, repairs and installation, estimated useful life 4 years. Estimated residual value ₹72,000." Dep. sheet Q1
The 1 Jan–31 Mar 2020 stub, if asked, is \(12{,}000 \times \tfrac{3}{12} = ₹3{,}000\).
Unit 03 — How to Solve Anything works all five faculty problems in full, with the machinery account laid out year by year, plus the textbook's three illustrations, its entire 16-statement True/False bank, its MCQ bank, all eight descriptive questions and all five interview questions — and extra exam-shaped problems on top.