Tag: Osmania University B.com Notes

Depreciation

Depreciation is the accounting term used for assets such as buildings, furniture and fittings, equipment etc. Companies use this to record the diminishing value of their assets as they are used in the business from the time of purchase of such assets. Hence cost is allocated periodically as value lost due to usage (as expense affecting the business’s net income) and the declining value of assets is recorded (affecting the value of business). Different methods exist in calculating the depreciation amount and these are different depending on the asset type. The depreciation is calculated from the time an asset is used / placed for service and the depreciation is recorded periodically. Depreciation is calculated taking the cost of the asset, the expected useful life of the asset, residual value of the asset and percentage where necessary. Depreciation is not taken into account once the full cost of the asset is recovered / the asset is no longer in the company’s possession (i.e. sold, stolen and fully depreciated). Two main ways exist in calculating depreciation and they are the straight line (which allows deducting the same amount each year over the life of the asset) and reducing balance method / declining balance method (which provides for a higher charge in the first year and reducing amount throughout the asset life).

Depletion

Depletion is an accounting concept which is used mostly in mining, timber, petroleum or other similar industries. Being similar to depreciation, depletion allows accounting for the reduction of the resource’s reserve. There are two main types of depletion calculation: cost depletion (where cost of the resource allocated over the period) and percentage depletion (the percentage of the property’s gross income where percentage is specified for each mineral).

When dealing with a natural resource also referred as a mineral asset the concept of depreciation or amortization cannot be applied. “Depletion” is a form of a systematic reduction in the value of a natural resource based on the rate at which it is being used.

For example: A coal mine has 10 Million tonnes of coal and the coal extraction is happening at the rate of 1 Million tonnes per year. In this case, depletion rate would be 10% p.a. since at this rate of extraction the coal mine is being depleted at 10% per year.

Though both have similar concepts, difference between depreciation and depletion exist as mentioned below.

1. Depreciation is on tangible assets whereas depletion is on non-renewable resources.
2. Depreciation is the deduction of the asset value due to aging, whereas depletion is the actual physical reduction of the company’s natural resources (accounting for consumption).

Amortization

Prorating cost of an “Intangible Asset” over the period during which benefits of this asset are estimated to last is called Amortization. The concept of amortization is also used with leases & debt repayment.

Amortization is for Intangible assets whereas depreciation is for tangible fixed assets. Examples of intangible assets are copyrights, patents, software, goodwill, etc.

1. Normal Physical Wear and Tear:

Due to normal use of the assets, the assets deteriorate physically, which results in reduction in their value.

2. Efflux of Time:

Certain intangible assets have fixed life span such as Trade Marks, Patents or Copyrights etc. The value of such assets decreases anyway with the passage of time irrespective of the fact business enterprise is using them or not.

3. Obsolescence:

Research & Development leads to innovations, in the form of better and technically advanced machines that scrap old machines even though they may be capable of being run physically.

In that case there may be a permanent decrease in the market prices of certain assets like Computers, Motor Cars etc. This results in decline in the value of old machines. Obsolescence is a loss arising from outdating and replacing the existing asset with the new and improved model of that asset.

4. Accidents:

Destruction or damage caused by an accident may result in reducing the value of assets.

Factors Affecting Depreciation:

As already stated, depreciation is not an attempt to record the changes in the market value of the asset but a systematic allocation of the total cost of depreciable asset (capital expenditure) to expenses (revenue expenditure) over the useful life of the asset because market value of some assets may increase in short run but even then the depreciation process continues. Based on the matching principle a reasonable portion of capital expenditure (i.e. the cost of the asset) should be charged to revenue during the useful life of an asset.

The calculation of amount of depreciation expense for an accounting period is affected by the:

(i) Actual cost of the asset

(ii) Estimated useful life of the asset

(iii) Estimated residual value of the asset.

It is worth mentioning here that out of three factors, two factors are based on just estimation and only one factor is based on actual. Thus, calculation of depreciation expense is just an estimated loss in value of assets and not the real and exact decrease in value of an asset.

Now we shall move on to discuss each of the above factors in detail:

1. Actual Cost of the Asset:

Actual cost or historical cost means the acquisition cost of the asset and includes all incidental expenses which are necessary to bring the asset to its present condition and location. Examples of such expenses are installation charges, freight inwards or expenses incurred for improvements of such assets and which are of capital nature.

2. Estimated Useful Life of the Asset:

Estimated useful life of the asset is either:

(i) The period over which a depreciable asset is expected to be used by the enterprise or

(ii) The number of production or similar units expected to be obtained from the use of the asset by the enterprise.

3. Estimated Residual or Scrap Value of the Asset:

Residual or scrap value is the expected value which may be realized when the asset is sold or exchanged at the end of its estimated useful life. When residual value is significant, it should be taken into consideration for computing depreciation. However, an insignificant residual value can be ignored for computation of depreciation.

Depreciation is a continuous process, but we don’t record depreciation daily. Actually, the total amount of depreciation to be charged on any asset is an advance expenditure which has been paid by the enterprise at the time of acquisition of such asset.

In other words, this expenditure should be treated like deferred expenditure and only adjusting entries, for charging reasonable and appropriate amount of depreciation to revenue in the income statement, are required to be passed every year.

• For the presentation of assets in the balance sheet at their proper value: Depreciation must be charged to each fixed asset for the true and fair presentation of assets in the balance sheet. The depreciation is deducted from the cost or book value of assets each year.
• For the replacement of assets: The fund equal to the amount of the depreciation is created which will remain in the firm. After the expiry of the life of asset, the same fund can be utilized to replace the new asset.
• For the determination of correct cost of production: Correct cost of production cannot be ascertained if the depreciation is not charged to the fixed assets. Thus, it is necessary to include amount of depreciation in the calculation of cost of each product.
• For the determination of true profit or loss: Depreciation is also an expense like repair and maintenance which must be included in profit and loss account to ascertain the correct profit or loss of a business for the year.

Objectives or Need for Providing Depreciation:

(a) To ascertain true profits:

Depreciation is a charge for capital assets used in earning profits and therefore, it should be viewed as business expenditure. Unless proper charge for this expense is made in accounts, the correct profit cannot be ascertained.

(b) To show the assets at their proper values:

Depreciation must be accounted for in order to show the assets at their proper values and thereby present a true and fair view of the financial position of the business. Unless depreciation is provided, the value of the assets will be overstated in the Balance Sheet and it will not reflect the true and fair view of the business.

(c) To create funds for replacement of assets:

Depreciation is non-cash expenditure. Hence, the amount of depreciation charged to Profit and Loss account remains in the business and the amount thus accumulated during the working life of the asset provides funds for its replacement at the end of the working life of the asset.

(d) To keep the capital in tact:

If depreciation is not charged, the amount of profit will be inflated. If such profits are distributed among the owners, then it will amount to the distribution of fixed capital from the business. In the long run it will affect the financial health of the business.

(e) Statutory Need: Provision of depreciation is a statutory need:

Section 205 of the Indian companies Act has made compulsory for a joint stock company to provide for depreciation before distributing the profits as dividends.

A suspense account is an account used temporarily or permanently to carry doubtful entries and discrepancies pending their analysis and permanent classification.

A suspense account is a general ledger account in which amounts are temporarily recorded. The suspense account is used because the appropriate general ledger account could not be determined at the time that the transaction was recorded.

It is useful to have a suspense account, rather than not recording transactions at all until there is sufficient information available to create an entry to the correct accounts. Otherwise, larger unreported transactions may not be recorded by the end of a reporting period, resulting in inaccurate financial results.

It can be a repository for monetary transactions (cash receipts, cash disbursements and journal entries) entered with invalid account numbers. The account specified may not exist, or it may be deleted/frozen. If one of these conditions applies, the transaction should be directed to a suspense account.

In branchless banking (BB): Banking through mobile for unbanked – these accounts are used for ‘money-in-transit’. For example, sender sends payment from US ACH account to a BB mobile number in Japan. The customer receives an alert on their mobile to withdraw this money from a BB agent. Until they withdraw, the remittance stays in a suspense account, earning the financial institute or the BB enabler float/interest on that money. When customer withdrawal is completed, the money moves from the suspense account to the account of the agent who facilitated the cash withdrawal.

A suspense account is an account in the general ledger in which amounts are temporarily recorded. A suspense account is used when the proper account cannot be determined at the time the transaction is recorded. When the proper account is determined, the amount will be moved from the suspense account to the proper account. It can also be used when there is a difference between the debit and credit side of a closing or trial balance, as a holding area until the reason for error is located and corrected.

Suspense accounts should be cleared at some point, because they are for temporary use. Suspense accounts are a control risk.

An accountant was instructed to record a significant number of journal entries written by the controller of a large company. Unfortunately, there was one amount that did not have an account designated. In order to complete the assignment by the deadline, the accountant recorded the “mystery” amount in the general ledger Suspense account. When the controller is available, the accountant will get clarification and will move the amount from the Suspense account to the appropriate account.

The following steps will be followed to ascertain the correct cash book balance

i) The first step is to put the balance of pass book as the starting point Showing balance as per pass book.

ii) The cheques deposited but not yet collected are added.

iii) All the cheques issued but not yet presented for payment, amounts directly deposited in the bank account are deducted.

iv) All the items of charges such as interest on overdraft, payment by bank on standing instructions and debited by the bank in the pass book, but not entered in cash book, bills and cheques, dishonoured etc are added.

v) All the credits given by the bank such as interest on dividends collected etc and direct deposits in the bank are deducted

vi) Adjustments for errors are made according to the principles of rectification of errors.

vii) Now, the net balance shown by the statement should be same as shown by the cash book.

Illustration

From the following particulars, ascertain the Bank balance as per Pass Book as on 31st December.

1. The Bank balance as per Cash Book on the date was Rs 11,500.
2. Cheques issued but not cashed before that date amounted to Rs 1,750.
3. Cheques paid into Bank, but not cleared before December amounted to Rs 2,150.
4. Interest on Investments collected by the Bank but not entered in the Cash Book amounted to Rs 275.
5. Local cheque paid in but not entered in the Cash Book Rs 300.
6. Bank Charges debited in the Pass Book Rs 25.

With adjustment in Cash Book:

If the balance at Bank, as per the Cash Book adjusted, it will be Rs 12,050, thus:

An accounting system is a system that is employed in a company to organize financial information. It can be either manual or computerized. The main reason why you should be using an accounting system is to keep track of expenses, income, and other activities. Basically, keep an eye on all data that affect the finances of a business organization.

Accounting system helps businesses to keep track and manage their financial transactions. That includes sales, purchases, assets and liabilities. Business accounting system is particularly helpful when you need to generate reports. As a business owner you probably already know that proper data reports impact greatly the process of decision making. In the past all data where gathered manually. Luckily today we are living in a computerized age.

Types of Accounting Systems

• Managerial Accounting

    This type of accounting provides managers with necessary information for planning and operations control. Under managerial is cost accounting and lean accounting. Cost accounting records the cost incurred by the business for various transactions and operations. Lean accounting is for process examinations to determine how to reduce cost and eliminate wasting resources while increasing value.

• Inventory Accounting

    These provide a means to track and plan inventory levels and other activities that are related. Barcode tracking and RFID are some of the common inventory accounting systems available.

• Industry Specific Accounting

This refers to a system tailored for a specific industry. For example, a system for a sales business and legal accounting have significant differences. Each has their specific requirements suited for the different industries.

• Not-for-Profit Accounting

This type of accounting has its unique requirements too. It mainly involves ensuring that finances are channeled to the right direction. The system should be able to produce expenditure reports.

Classification of Accounts in Accounting

• Personal Account
• Real Account

1. Tangible Real Account
2. Intangible Real Account

• Nominal Account

Personal Account

These accounts types are related to persons. These persons may be natural persons like Raj’s account, Rajesh’s account, Ramesh’s account, Suresh’s account, etc.

These persons can also be artificial persons like partnership firms, companies, bodies corporate, an association of persons, etc.

Real Accounts

These account types are related to assets or properties. They are further classified as Tangible real account and Intangible real accounts.

Tangible Real Accounts

These include assets that have a physical existence and can be touched. For example – Building A/c, cash A/c, stationery A/c, inventory A/c, etc.

Intangible Real Accounts

These assets do not have any physical existence and cannot be touched. However, these can be measured in terms of money and have value. For Example: Goodwill, Patent, Copyright, Trademark, etc.

Nominal Account

These accounts types are related to income or gains and expenses or losses. For example: – Rent A/c, commission received A/c, salary A/c, wages A/c, conveyance A/c, etc.