Explain the concept of depreciation. What is the need for charging depreciation and what are the causes of depreciation?
Depreciation may be described as a permanent, continuing and gradual shrinkage in the book value of fixed assets. It is based on the cost of assets consumed in a business and not on its market value.
Every business acquires fixed assets for its use in the business over a period of time. As the benefits of these assets can be availed over a long period of time (due to their regular use), there exists continuous wear and tear and consequently fall in their value. This fall in the value of fixed assets (due to regular use or expiry of time) is termed as depreciation. A machinery that costs Rs 1,00,000 and its useful life of 10 years, its depreciation will be calculated as:
To ascertain true net profit or net loss: Correct profit or loss can be ascertained when all the expenses and losses incurred for earning revenues are charged to the profit and loss account. Assets are used for earning revenues and its cost is charged in the form of depreciation from profit and loss accounts.
To show a true and fair view of financial statements: If depreciation is not charged, assets are shown at higher value than their actual value in the balance sheet; consequently, the balance sheet does not reflect the true view of financial statements.
For ascertaining the accurate cost of production: Depreciation on plant and machinery and other assets, which are engaged in production, is included in the cost of production. If depreciation is not included, cost of production is underestimated, which will lead to low sale price and thus lead to low profit.
Distribution of dividend out of profit: If depreciation is not charged, which leads to over estimating of profit & consequently more profit is distributed as dividend, out of capital instead of the profit. This leads to the flight of scarce capital out of the business.
To provide funds for replacement of assets: Unlike other expenses, depreciation is not a cash expense. So, the amount of depreciation charged will be retained in the business and will be used for replacement of fixed assets after its useful life.
Consideration of tax: If depreciation is charged, then the profit and loss account will disclose less profit as to when the depreciation is not charged. This depicts reduced profit and thus the business will be liable for lesser tax amount.
The causes for depreciation:
Constant use: Due to constant use of the fixed assets there exists normal wear and tear that leads to fall in the value of fixed assets.
Expiry of time: With the passage of time, whether assets are used or not, its effective life decreases. The natural forces like rain, weather, etc. lead to deterioration of the fixed assets.
Obsolescence: Due to the fast technological innovations and inventions today’s assets may be outdated by tomorrow’s sophisticated assets. This leads to the obsolescence of fixed assets.
Expiry of legal rights: If an asset is acquired for a specific period of time, then, whether the asset is put to use or not, its value becomes zero at the end of its useful life.
Accident: An asset may lose its value and damage may happen to it due to mishaps such as a fire accidents, theft or a natural calamity. The loss due to accidents is permanent in nature.
Mr. Sunrise started a business for buying and selling of stationery with ₹ 5,00,000 as an initial investment. Of which he paid ₹ 1,00,000 for furniture, ₹ 2,00,000 for buying stationery items. He employed a sales person and clerk. At the end of the month he paid ₹ 5,000 as their salaries. Out of the stationery bought he sold some stationery for ₹ 1,50,000 for cash and some other stationery for ₹ 1,00,000 on credit basis to Mr. Ravi. Subsequently, he bought stationery items of ₹ 1,50,000 from Mr. Peace. In the first week of next month there was a fire accident and he lost ₹ 30,000 worth of stationery. A part of the machinery, which cost ₹ 40,000, was sold for ₹ 45,000.
From the above, answer the following :
1. What is the amount of capital with which Mr. Sunrise started business?
2. What are the fixed assets he bought?
3. What is the value of the goods purchased?
4. Who is the creditor and state the amount payable to him?
5. What are the expenses?
6. What is the gain he earned?
7. What is the loss he incurred?
8. Who is the debtor? What is the amount receivable from him?
9. What is the total amount of expenses and losses incurred?
10. Determine if the following are assets, liabilities, revenues, expenses or none of the these: sales, debtors, creditors, salary to manager, discount to debtors, drawings by the owner.
Differentiate between source documents and vouchers.
Complete the following sentences with appropriate words:
(a) Information in financial reports is based on .....................
(b) Internal users are the ..................... of the business entity.
(c) A ..................... would most likely use an entities financial report to determine whether or not the business entity is eligible for a loan.
(d) The Internet has assisted in decreasing the ..................... in issuing financial reports to users.
(e) ..................... users are groups outside the business entity, who uses the information to make decisions about the business entity.
(f) Information is said to be relevent if it is ......................
(g) The process of accounting starts with ............ and ends with ............
(h) Accounting measures the business transactions in terms of ............ units.
(i) Identified and measured economic events should be recording in ............ order.
What is a journal? Give a specimen of journal showing at least five entries.
Define accounting and state its objectives.
Enumerate informational needs of management.
Complete the following work sheet:
(i) If a firm believes that some of its debtors may ′default′, it should act on this by making sure that all possible losses are recorded in the books. This is an example of the ___________ concept.
(ii) The fact that a business is separate and distinguishable from its owner is best exemplified by the ___________ concept.
(iii) Everything a firm owns, it also owns out to somebody. This co-incidence is explained by the ___________ concept.
(iv) The ___________ concept states that if straight line method of depreciation is used in one year, then it should also be used in the next year.
(v) A firm may hold stock which is heavily in demand. Consequently, the market value of this stock may be increased. Normal accounting procedure is to ignore this because of the ___________.
(vi) If a firm receives an order for goods, it would not be included in the sales figure owing to the ___________.
(vii) The management of a firm is remarkably incompetent, but the firms accountants can not take this into account while preparing book of accounts because of ________ concept.
Deepti wants to buy a building for her business today. Which of the following is the relevant data for his decision?
a. Similar business acquired the required building in 2000 for ₹ 10,00,000
b. Building cost details of 2003
c. Building cost details of 1998
d. Similar building cost in August, 2005 ₹ 25,00,000
The book in which all accounts are maintained is known as:
(i) Cash Book
(ii) Journal
(iii) Purchases Book
(iv) Ledger
Why is it necessary for accountants to assume that business entity will remain a going concern?
If a transaction is properly analysed and recorded:
(a) Only two accounts will be used to record the transaction.
(b) One account will be used to record transaction.
(c) One account balance will increase and another will decrease.
(d) Total amount debited will equals total amount credited.
State what is end product of financial accounting?
Define revenues and expenses?
Define a computerised accounting system. Distinguish between a manual and computerised accounting system.
Differentiate between source documents and vouchers.
Describe how debits and credits are used to analyse transactions.
Describe the brief history of accounting.