MMPC 04 Unit 5: Depreciation Accounting

Class 5: IGNOU MBA – MMPC 004: Accounting for Managers

Unit 5: Depreciation Accounting

Overview of Unit 5:

Unit 5 covers Depreciation Accounting, an essential aspect of managing fixed assets over their useful life. It explains the concept of depreciation, various methods of calculating depreciation, and the accounting treatment for depreciation in financial statements. This unit is crucial for understanding how the reduction in the value of fixed assets is recorded and its impact on a company's profits.

Topics Covered in Unit 5:

5.1 Introduction to Depreciation

Depreciation is the systematic allocation of the cost of a fixed asset over its useful life. The aim of depreciation is to:

Reflect the wear and tear or obsolescence of an asset.
Allocate the cost of the asset across different accounting periods in a rational manner.
Ensure the accurate representation of the net book value of the asset on the balance sheet.

5.2 Importance of Depreciation

Depreciation is important for the following reasons:

Matching principle: It helps match the expense of using an asset to the revenue it generates.
Tax benefits: Depreciation is a non-cash expense and reduces taxable income.
Asset replacement: It helps businesses plan for the future replacement of assets by reflecting their diminishing value.

5.3 Methods of Depreciation

There are several methods used to calculate depreciation. Each method has its own application based on the type of asset and business requirements.

5.3.1 Straight-Line Method (SLM)

Concept: Under the Straight-Line Method, depreciation is charged evenly over the useful life of the asset.
- Formula:
  Depreciation per year = (Cost of Asset – Residual Value) / Useful Life of the Asset

Example of SLM:

Cost of machinery: ₹1,00,000
Residual value: ₹10,000
Useful life: 10 years
Depreciation per year = (1,00,000 – 10,000) / 10 = ₹9,000

5.3.2 Written Down Value (WDV) Method

Concept: Under the Written Down Value Method, depreciation is charged at a fixed percentage on the reducing balance of the asset.
- Formula:
  Depreciation for the year = (Cost of Asset – Accumulated Depreciation) * Depreciation Rate

Example of WDV:

Cost of asset: ₹1,00,000
Depreciation rate: 10%
Depreciation for Year 1 = ₹1,00,000 * 10% = ₹10,000
Depreciation for Year 2 = (₹1,00,000 – ₹10,000) * 10% = ₹9,000

5.3.3 Units of Production Method

Concept: Depreciation is calculated based on the actual usage of the asset, such as the number of hours it operates or units it produces.
- Formula:
  Depreciation = (Cost of Asset – Residual Value) / Estimated Total Output * Actual Output

Example of Units of Production:

Cost of machinery: ₹5,00,000
Residual value: ₹50,000
Total estimated output: 1,00,000 units
Actual output for the year: 20,000 units
Depreciation = (₹5,00,000 – ₹50,000) / 1,00,000 * 20,000 = ₹90,000

5.3.4 Sum-of-Years’ Digits (SYD) Method

Concept: SYD allocates higher depreciation in the earlier years of the asset's life and reduces it gradually.
- Formula:
  Depreciation = (Cost of Asset – Residual Value) * (Remaining Useful Life / Sum of Years' Digits)

Example of SYD:

Cost of asset: ₹1,00,000
Residual value: ₹10,000
Useful life: 5 years
Sum of years’ digits: 5+4+3+2+1 = 15
Depreciation for Year 1 = (₹1,00,000 – ₹10,000) * (5/15) = ₹30,000

5.4 Accounting for Depreciation

The accounting treatment for depreciation includes recording it as an expense in the Profit and Loss Account and reducing the book value of the asset in the Balance Sheet.

Journal Entries:

For charging depreciation:
Depreciation A/c Dr.
To Asset A/c
For transferring depreciation to the Profit and Loss Account:
Profit and Loss A/c Dr.
To Depreciation A/c

Impact on Financial Statements:

Profit and Loss Account: Depreciation is shown as an expense, reducing the company’s profit.
Balance Sheet: The asset’s book value is reduced each year by the amount of depreciation.

5.5 Factors Affecting Depreciation

Several factors influence the calculation of depreciation:

Cost of the asset: The original purchase price of the asset.
Residual value: The expected value of the asset at the end of its useful life.
Useful life: The estimated time period over which the asset will be used.
Depreciation method: The choice of depreciation method impacts how the expense is spread over time.

5.6 Depreciation Policies

Companies often have depreciation policies that determine:

The method used for each type of asset.
The rate of depreciation based on asset class.
The policy may vary for financial reporting and tax purposes.

Experiments and Real-Life Examples

Experiment: Calculate depreciation for a machine using both the Straight-Line Method and the Written Down Value Method. Compare the results and examine how they impact the profit over time.

Assignment Questions

Define depreciation and explain why it is necessary to account for depreciation in financial statements.
Compare the Straight-Line Method and Written Down Value Method of depreciation. Which method would you recommend for an asset that rapidly loses its value in the first few years? Explain why.
What is the Sum-of-Years’ Digits Method? Calculate the depreciation for an asset using this method for the first two years.
Explain the impact of depreciation on the Balance Sheet and Profit and Loss Account.

Self-Study Questions

Why is it important for companies to record depreciation on their fixed assets?
How does the choice of depreciation method affect a company’s financial statements?
Discuss the significance of residual value in the calculation of depreciation.
What factors should a company consider when deciding on a depreciation method for a specific asset?

Exam Questions

What are the different methods of calculating depreciation? Explain each method with an example.
An asset was purchased for ₹1,50,000 with an expected residual value of ₹20,000 and a useful life of 8 years. Calculate depreciation using the Straight-Line Method and the Written Down Value Method at 10% per annum for the first two years.
Why is depreciation considered a non-cash expense, and how does it affect a company’s tax liability?
What is the Units of Production Method of depreciation? Under what circumstances is it most suitable for use?

Conclusion

In this class, we have delved into the concept of depreciation, its importance, and the various methods used to calculate it. We also explored how depreciation impacts financial statements and business decision-making. Understanding depreciation is crucial for accounting managers as it ensures that fixed assets are correctly represented in financial records, and the expense is appropriately matched with revenue.

Tags MMPC 04