ENTREVISTA A INSTITUCIÓN ESTATAL: PROMPYME

In the context of present inflationary conditions, it will be appropriate to provide for depreciation on the replacement cost instead of on the historical cost. This is because of the fact that depreciation is provided for replacing the asset. Sufficient funds will not be available for replacing an asset at the end of its serviceable life. If depreciation is provided on the basis of historical cost, there is substantial increase in the cost of the new asset to replace the old asset. But following difficulties may crop up when replacement cost system is used:

(a) Estimating replacement cost in advance is difficult.

(b) The method of charging depreciation on the basis of replacement cost is not recognized by income tax authorities.

(c) The method of charging depreciation on replacement cost during inflationary conditions is preferred but not during period of falling prices.

(d) According to the Companies Act, depreciation should be charged on the original cost of the asset and any deficiency or surplus arising due to sale of such asset should be transferred to the profit and loss account.

(e) Any new asset purchased, with few exceptions, is always of a better quality than the asset replaced. Hence, it is difficult to calculate the cost of the asset replaced.

These difficulties can be obviated by taking the following steps:

(a) The additional amount required for replacing the asset over and above the original cost of the asset may be estimated. Every year, an appropriate amount may be transferred from profit and loss account besides usual depreciation on asset to provide for additional amount required for replacement of the asset over and above the original cost of the asset. It may be debited to Profit and Loss Appropriation Account and credited to Replacement Reserve account.

(b) The Replacement Reserve Account may be credited every year with interest at the current rate on the accumulated balance standing on the credit of the account.

LESSON ROUND UP

– Depreciation is the process of allocation of cost of the asset to the period of its useful life. It is not the process of valuation of asset.

 – Depreciation is used for recording the expired utility of a physical asset.

– Causes of depreciation are: physical wear and tear; deterioration in value of asset; disuse; depletion; obsolescence; accidents, etc.

– Depreciation is provided to: ascertain the correct profit; present correct financial position; make provision for replacement of asset; ascertain proper cost of the product; maintain uniform rate of return; attain maximum tax benefit; to meet the legal requirements, etc.

– The main factors in measurement of depreciation are: total cost of the asset; estimated useful life; estimated residual value, etc.

– The various methods of depreciation are: fixed installment method or straight line method; diminishing balance method or written down value method and other methods.

– In order to adjust depreciation for past periods due to change of method, depreciation is to be calculated for the past period of asset used both by existing as well as by the changed method and the difference is adjusted in the current year’s asset account by giving debit or credit to profit and loss account.

GLOSSARY

Depreciation Depreciation is a process of allocating the cost of a fixed asset over its estimated useful life in a rational and systematic manner.

Useful Economic Life Useful economic life of an asset is either the period over which a depreciable asset is expected to be used by the organization or the number of production or similar units expected to be obtained from the use of the asset by the organization.

Depreciable Value It is the cost price of the asset less scrap value or salvage value of the asset.

Salvage Value The estimated value of an asset at the end of its useful life.

SELF-TEST QUESTIONS

Theory Questions

1. Why is correct calculation of depreciation necessary? 2. What are the methods of providing depreciation?

3. Discuss the various factors which are considered for calculating depreciation. 4. What are the various causes of depreciation on fixed assets?

5. Distinguish between straight line and diminishing balance methods of depreciation.

6. What do you mean by replacement cost? What are the difficulties faced while providing for depreciation on the basis of replacement cost? What steps may be taken to obviate these difficulties?

7. Distinguish between sinking fund and annuity methods of depreciation. 8. “Depreciation is a process of allocation and not of valuation”. Comment.

Practical Questions

1. Deva Ltd. charges depreciation on its plant and machinery @10% per annum on the diminishing balance method. On 31st March, 2011, the company decides to adopt straight line method of charging depreciation with retrospective effect from 1st April, 2007, the rate of depreciation being 15%. On 1st April, 2010, the plant and machinery account stood in the books at ` 2,91,600. On 1st July, 2010, a sum of` 65,000 was realised by selling a machine cost of which on 1st April, 2007 was`90,000. On 1st January, 2011, a new machine was acquired at a cost of ` 1,50,000. Show the plant and machinery account in the books of the company for the year ended 31st March, 2011.

2. A firm acquired a machine for` 5,00,000 on 1.4.2008. Depreciation was to be charged at 20% p.a. on straight line method. During 2010-11, a modification was made to improve machine’s technical reliability at a cost of`50,000 which it was considered would extend the useful to life of machine for 2 years. At the same time one important component of the machine was replaced at a cost of`10,000 because of excess wear and tear. Routine maintenance during the said accounting period cost ` 7,500. Show the machine account, provision for depreciation on machine account and charge to profit and loss account for the year ending 31st March, 2011.

3. Suman Enterprises purchased machinery on 1st April 2008 for `71,800 and paid `3,200 on its installation. New machinery was acquired for `45,000 on October 1, 2008. On 1st April 2009, first machinery was sold at`50,000 and on the same date fresh machinery was purchased for`45,000. Depreciation is provided annually on 31st March at 10% p.a on written down value method. On April 1, 2010 the firm changed the method of providing depreciation and decided to provide depreciation at 10% p.a on the original cost with retrospective effect. Prepare machinery account to ascertain the value of machinery as on 31st March 2011.

4. Simmon Ltd., charges deprecation on its plant and machinery @ 10% per annum on the diminishing balance method. On 31st March, 2011, the company decided to adopt straight line method of charging depreciation with retrospective effect from 1st April, 2008, the rate of depreciation being 15% p.a. 5. On 1st April, 2010, the plant and machinery account stood in the books of account at`5,00,000. On

1st August, 2010 a sum of`1,00,000 was realised by selling a machine the cost of which on 1st April, 2008 was`1,50,000. On 1st January, 2011 a new machine was acquired at a cost of`3,00,000. Show the plant and machinery account in the books of the company for the year ended 31st March, 2011.

Lesson 7

Preparation of Final Accounts for Sole