Financial Accounting

  • Introduction

    • Fixed asset is defined as “an asset held with the intention of being used for the purpose of producing or providing goods or services and not for resale in the normal course of business e.g., Premises, Plant and Machinery, Furniture, Land and Buildings, etc.
    • All the fixed assets are shown in the books of accounts of the business enterprise at their cost of acquisition or construction.

    Determination of Cost of Various Types of Fixed Assets

    • The cost incurred in acquiring the fixed assets not only includes the purchase price of the assets but also the incidental charges which help the assets to perform the specified task for which it has been acquired.
    • The various costs which are capitalized (to be added to the cost of the assets) differs from assets to asset. The following table explains the asset and the incidental cost to be capitalized.

    Assets

    Cost Price of the Asset

    Land

    Purchase price + brokers commission + legal fees + cost of grading or of tearing down existing structures

    Self-Constructed Assets

    All the costs incurred in construction like the cost of materials, direct labor, and indirect costs incurred during the construction period like the interest related to borrowings made to finance the project

    Buildings

    Construction cost + cost of permanent fixtures in the building + stamp fees for executing deeds + architect fees + engineers fee + other administrative overheads

    Plant and Machinery

    Purchase price + all costs of installation like transportation, erection, labor, testing expenditure

    Assets Acquired for Non – monetary Consideration

    Recorded at its fair value, i.e. the amount for which the asset could be exchanged between a buyer and a seller

    Basket Purchase (when a business entity acquires in one transaction several capital assets that are to be appear in more than one balance sheet category they are called Basket items)

    Low cost items are charged immediately as expenses. Repairs and maintenance expenses are capitalized. Expenses for replacement may either be taken as an asset or an expense
         

    Depreciation

    • Depreciation is a provision created in a company’s account towards wear tear of its assets caused by usage, passage of time, technological obsolescence, etc.

    Methods for Charging Depreciation

    • There are two methods which are basically used for charging depreciation:
    1. Straight line method

    Depreciation = (Asset Value - Salvage Value ) / Estimated useful life - In years

    1. Written Down Value Method/Diminishing Balance Method

     

    In this method the depreciation charged every year is calculated as a percentage of the outstanding balance of the asset as the beginning of that particular year and not on the original cost of the asset.

                 

    r = 1- n√s/c

                                        

    Where, r = rate of depreciation written down value method, n = estimated useful life of the asset in years, s = residual value or scrap value of the asset, c = original cost of the asset.

    • The other methods apart from the above given methods which are widely used for calculation of depreciation expenditure are:

     

    1. Sum-of-the year’s-digits method

     

    Under this method if the asset has 5 years economic useful life numbers 1,2,3,4,5 are added up and the resulting sum becomes the denominator and the number of years remaining become the numerator the for the first year would be 5/15 x cost of acquisition of the asset.

     

    1. Units-of-Production Method

     

    Under this method the depreciation rate is determined by dividing the net acquisition or construction costs (acquisition or construction costs – salvage value)/estimatednumber of units that are likely t be produced during its useful economic life.

    Depreciation Accounting – Accounting Standard-6

    • According to the standard the amount of depreciation to be charged is determined on the basis of the following three factors:
    1. historic cost;
    2. expected useful life of the asset;
    3. estimated residual value of the depreciation.

     

    • AS-6 insists that whatever be the method of depreciation selected, it should be applied consistently.

    Recording of Depreciation

    • There are two methods of recording depreciation:
    1. In the first method the asset account is directly credited for the depreciation

    The journal entry in this case would be

    •  

    To Asset a/c

    1. Under the second method the depreciation charge is credited to the depreciation provision and the written down value of the asset is shown in the balance sheet by deducting the provision from the original cost of the asset.

    The journal entries recorded under this method are:

    Depreciation a/cDr

     

    To Depreciation Provision a/c

                 After the expiry of the useful life of the asset, these two accounts are closed by                     debiting accumulated depreciation account and crediting the asset account. The balance is transferred to the P/L a/c.

    P/L a/c                                                          Dr

          To Depreciation a/c

    Partial Year Depreciation

    • When the asset is placed in service during the year the depreciation expenses is taken only for the period of the year which it was actually put to use.
    • Other types of depreciation are Replacement depreciation and Present value depreciation.
    • Depletion is the process of allocating the cost of a natural resource over its estimated useful life.