Fixed Assets and Depreciation 11

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FIXED ASSETS AND DEPRECIATION
A fixed asset is an asset intended for use on a continuing basis in the business. These include items like
office building, office equipment, motor vehicles, furniture etc. These examples are tangible fixed assets
as they a physical existence and that they can be touched. There are also intangible fixed assets such as
goodwill, patents, trademarks. These assets though they have a continuing value they do not have a
physical existence.
Depreciation is a method charging a proportion of a fixed asset’s original cost to the profit and loss
account each year to match the revenues that the asset earns. The depreciation charge for each year
accumulates in a provision account which is netted off against the original cost of the asset in the
balance sheet. A fixed asset is eventually ‘consumed’ over its lifetime because of the following reasons.
 Use
 Passage of time
 Obsolescence
Purpose of depreciation
Assume an item of plant cost Rs50,000 and that it has a nil scrap value at the end of ten years. Since
expenditure on the asset will benefit the revenues of the next ten years, the accruals/matching concept
requires us to match the Rs50,000 costs against all of those revenues. The simplest way is to sue the
‘straight line method’ and charge Rs5,000 against revenue of each year.
Methods of calculating depreciation
There are several possible methods of calculating depreciation. The most common methods are:
1. Straight line method
2. Reducing balance method
Straight Line Method
This is the simplest and most popular method of calculating depreciation. Under this method the
depreciation charge is constant over the life of the asset.
The depreciation charge is calculated as follows.
Annual depreciation charge = Original Cost – Residual Value
Estimated Useful Life
Example – straight line method
Vijay is a sole trader with a 31 December year end. He purchased a car on 1 January at a cost of
Rs700,000. He estimates that its useful life is 5 years, after which he will trade it in for Rs200,000. The
annual depreciation charge is to be calculated using the straight line method.
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Solution – straight line method
Depreciation charge = 700,000 – 200,000
5
= 100,000 per annum
Reducing balance method
Under this method the depreciation charge is higher in the earlier years of the life of the asset. In the
first year the percentage is applied to cost but in subsequent years it is applied to the asset’s net book
value. The net book value (NBV) also known as the written down value of a fixed asset is its original cost
less the accumulated depreciation of the asset to date.
Example – Reducing balance method
A trader purchased an item of plant for Rs100,000. The depreciation charge for each of the first five
years is to be calculated, assuming the depreciation rate on the reducing balance to be 20% per annum.
Accounting for depreciation
Whichever method is used, the bookkeeping remains the same.
Example
A trader buys a motor car on 01 January 2009 for Rs500,000. It is to be depreciated on the straight line
basis over 5 years, with an assumption of a nil residual value. Show the ledger accounts for the first
three years.
Sale of fixed assets
When a fixed asset is sold, the cost of that asset together with the related accumulated depreciation
should be transferred to a fixed asset disposals account. The profit and loss on disposal is calculated by
comparing:
 The net book value of the asset at the date of sale (i.e. cost less depreciation provision)
 The proceeds of sale
Ledger account entries
Ref. Debit Credit With
1 Disposals account Fixed asset - cost account Original cost of asset
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Fixed asset - provision for
depreciation Disposals account
Accumulated depreciation up to the
date of disposal
3 Cash Disposals account Proceeds of sale
4 Disposals account Profit and Loss Profit on sale
5 Profit and loss Disposals account Loss on sale
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Example – disposal of fixed assets
Kavita’s financial year ends on 30 June. On 01 July 2003 she purchased furniture costing Rs25,000 and
paid by cheque. She decided to depreciate the furniture using the reducing balance method. On 01 July
2007 the provision for depreciation of furniture account showed a credit balance of Rs21,760. Kavita
sold all the furniture on credit to ASL Furniture Ltd for Rs3,100 on 01 July 2007.
Make the entries in Kavita’s ledger accounts for the year ended 30 June 2008.
Revaluation of fixed assets
Fixed assets are purchased to be used for longer period. In the subsequent years, the value of asset
could be higher or lower than its present book value due to inflationary condition of the economy.
Assets are valued at Historical Cost in the books of accounts.
Historical cost is the original cost of the asset at which it was purchased plus additional costs incurred on
the asset to bring it in working condition. Sometimes, the management of the business, if it thinks fit,
revalues the asset to present it at current market value. Once the asset is revalued to its market value,
then its value has to be constantly monitored to reflect the changes in the market value.
If an asset is revalued at higher cost than its original cost, the excess amount will be treated as profit on
revaluation of fixed assets and it is credited to Revaluation Reserve Account. On the other hand, if an
asset is revalued at lower cost than its original value, the balance amount will be treated as loss on
revaluation of fixed assets and it is shown in the profit & loss account of that year in which asset was
revalued.
Depreciation of a revalued asset
When a fixed asset has been revalued, the charge for depreciation should be based on the revalued
amount and the remaining useful economic life of the asset. Therefore, following an upward
revaluation, the depreciation is higher than previously and should be charged to the profit and loss
account.
Land
Land does not normally require a provision for depreciation except when subject to depletion and
changes in the desirability of its location.