Unit-1

Definition of Accounting

Accounting can be defined as a process of reporting, recording, interpreting, and summarising

economic data. The introduction of accounting helps the decision-makers of a company to
make effective choices, by providing information on the financial status of the business.

The American Institute of Certified Public Accountants (AICPA) had defined accounting as
the “art of recording, classifying, and summarising in a significant manner and in terms of
money, transactions, and events which are, in part at least, of financial character, and
interpreting the results thereof”.

Today, accounting is used by everyone and a good understanding of it is beneficial to all.

Accountancy act as a language of finance. To understand accounting efficiently, it is important
to understand the aspects of accounting.
 Economic Events- It is a consequence of a company has to undergo when the
number of monetary transactions is involved. Such as purchasing new machinery,
transportation, machine installation on-site, etc.

 Identification, Measurement, Recording, and Communication- The accounting

system should be outlined in such a way that the right data is identified, measured,
recorded, and communicated to the right individual at the right time.

 Organization-In refers to the size of activities and level of a business operation.

 Interested Users of Information- It is about communicating important financial

information to the customers, according to which they will make the correct
decision.

Fundamentals of Accounting
 Assets- The economic value of an item that is possessed by the enterprise is referred
to as Assets. To put it in other words, assets are those items that can be transformed
into cash or that generate income for the enterprise shortly. It is useful in paying any
expenses of the business entity or debt.

 Liabilities- The economic value of an obligation or debt that is payable by the

enterprise to another establishment or individual is referred to as liability. To put it
in other words, liabilities are the obligations that are rising out of previous
 transactions, which are payable by the enterprise, through the assets possessed by
the enterprise.

 Owner’s Equity- Owner’s equity is one of the 3 vital segments of a sole

proprietorship’s balance sheet and one of the main aspects of the accounting
equation: Assets = Liabilities + Owner’s Equity. It depicts the owner’s investment
in the trade minus the owner’s withdrawal from the trade + the net income since the
business concern commenced.

Objectives of Accounting

The main objectives of accounting are:

To maintain a systematic record of business transactions

 Accounting is used to maintain a systematic record of all the financial transactions in
a book of accounts.
 For this, all the transactions are recorded in chronological order in Journal and then
posted to the principle book i.e., Ledger.

To ascertain profit and loss

 Every businessman is keen to know the net results of business operations
periodically.
 To check whether the business has earned profits or incurred losses, we prepare
a “Profit & Loss Account”.

To determine the financial position

 Another important objective is to determine the financial position of the business to
check the value of assets and liabilities.
 For this purpose, we prepare a “Balance Sheet”.

To provide information to various users

 Providing information to various interested parties or stakeholders is one of the
most important objectives of accounting.
 It helps them in making good financial decisions.

To assist the management

 By analyzing financial data and providing interpretations in the form of reports,
accounting assists management in handling business operations effectively.
Characteristics of Accounting:

The following attributes or characteristics can be drawn from the definition of Accounting:
(1) Identifying financial transactions and events
 Accounting records only those transactions and events which are of financial nature.
 So, first of all, such transactions and events are identified.
(2) Measuring the transactions
 Accounting measures the transactions and events in terms of money which
is considered as a common unit.
(3) Recording of transactions
 Accounting involves recording the financial transactions of inappropriate books
of accounts such as journals or Subsidiary Books.
(4) Classifying the transactions

 Transactions recorded in the books of original entry – Journal or Subsidiary books

are classified and grouped according to nature and posted in separate accounts
known as ‘Ledger Accounts.
(5) Summarising the transactions
 It involves presenting the classified data in a manner and in the form of statements,
which are understandable by the users.
 It includes a Trial balance, Trading Account, Profit and Loss Account, and Balance
Sheet.
(6) Analysing and interpreting financial data
 Results of the business are analyzed and interpreted so that users of financial
statements can make a meaningful and sound judgment.
(7) Communicating the financial data or reports to the users
 Communicating the financial data to the users on time is the final step of accounting
so that they can make appropriate decisions.

Nature of Accounting
Let us now discuss the nature of accounting in detail:
 Accounting as an Art
 Accounting as a Science
 Accounting as Ideology
 Accounting as a Language
  Accounting as a Historical Record
 Accounting as a Commodity
 Accounting as an Economic Reality
 Accounting as an Information System

Accounting as an Art- The word ‘art’ refers to the way of performing something.
Accounting is the art of recording, classifying and summarising financial data. Accounting is
a systematic method that consists of definite techniques and their appropriate application,
which requires applied skills and expertise. Thus, by nature, accounting can be considered as
an art.
Accounting as a Science- ‘Science’ is all about obtaining knowledge about a systematic
pattern through observation and investigation. Similarly, accounting is the science of
recording and pre- sending the financial data of an economic entity by observing and
investigating the economic events through established methods.
Accounting as an Ideology- Ideology refers to a system of ideas and views regarding certain
concepts or practices carried out in the world. Different ideologies form the basis of different
economic or political theories and policies. Accounting is also considered as an ideology
because it is considered as a means of justifying the current social, economic and political
arrangements.
Accounting as a language- Accounting is also called the language of business because the
activities of an organisation are reported in the form of financial reports and statements using
accounting language. Accounting defines a certain set of procedures that are used to create
financial data for a business.
Accounting as a historical record- Historical accounting records of an organisation help in
getting information on past transactions of a business as well as profits earned and losses
made.
Accounting as a commodity- Accounting information is viewed as a commodity. It is so
because there is demand for such accounting information in the financial markets. For
example, share market investors study the financial and accounting reports of companies
before buying their shares.
Accounting as an economic reality- Accounting is also considered to be a means of
demonstrating the current financial position of an organisation. Accounting professionals
must try to mirror the current economic reality in the financial statements of an organisation.
Accounting as an information system- The main components of an information system are
information source (input), processing, communication channel, output and receiver. In
accounting, the input data is collected from different business activities and later processed to
make it more meaningful. The resultant output (interpretation of data) is communicated to
various users such as the government, suppliers, researchers, investors, managers, creditors,
etc. through various channels such as electronic and print media.

Scope of Accounting
The scope of accounting has been widening with the changes in the economy and societal
demands. It extends to business, trade, government, financial institutions, individuals and
families and various other avenues. The following points explain the scope of accounting in
different areas:
 Business Organisations
 Non-Profit Organisations
 Government Organisations
 Professionals
 Individuals

Business Organisations
Accounting is widely applicable in the business sector. It is rightly called ‘Language of
Business’. The main objective of every business is to earn profits. Financial transactions of a
business concern are recorded in the books of accounts to ascertain operating results and
determine the financial position.
Non-profit organisations
Accounting also has scope in non-profit organisations. These organisations record their
transactions such as the donations received, subscription given by members and all the
expenditures. To do so, statements such as receipt and payment account, income and
expenditure account and balance sheet are prepared as per the rule of accounting.

Government Organisations
The scope of accounting also exists in central and state-owned organisations. These
organisations use the system of accounting for various purposes such as determining the
income, calculating expenditure and proper running of the administration. Apart from that,
interpretation and evaluation of accounting data is required for performing national planning,
pre- paring financial budget, determining national progress or regress and so on.
Professionals
Professionals like engineers, doctors, lawyers and sportspeople also maintain their accounts to
keep a tab on their income and expenditure and determine their income tax liability.
Individuals
Individuals also perform financial transactions to earn their livelihood. They also do some form
of accounting to obtain financial information; thereby making personal economic decisions

Branches of Accounting

The following are the main branches of accounting:

(a) Financial accounting:

Financial Accounting is that branch of accounting that involves identifying, measuring,

recording, classifying, and summarising business transactions, i.e., it involves the steps from
Identifying, Recording transactions to Summarisation, and communicating the financial data.

(b) Cost accounting:

Cost Accounting is a branch of accounting that is concerned with the process of ascertaining
and controlling the cost of products or services.

(c) Management Accounting

Management accounting refers to that branch of accounting which is concerned with presenting
the accounting information in such a way that helps the management in planning and
controlling the operations of a business and in decision making.

Steps of the Accounting Process:

The accounting process is the process of collecting, recording, classifying, summarising, and
communicating financial information to the users for judgment and decision-making. The
following steps are involved in the accounting process:

(1) Identification: It is the process of identifying and analyzing business transactions.

(2) Recording: For recording, we use ‘Journal’ or Subsidiary Books.

(3) Classification of transactions: Classification means the segregation of transactions on

the basis of nature and posting them in a format known as Ledger Account.

(4) Summarisation: It includes the preparation of Trial Balance and Financial Statements.
 (5) Analysis & Interpretation: It includes an assessment of the financial reports and making
some meaningful conclusions.

(6) Communicating information to the users: It includes sharing the financial reports
and interpreting results to the users of financial statements.

Define the term Bookkeeping, Accounting, and Accountancy.

Bookkeeping Book Keeping is a part of accounting and it is the process of identifying,

measuring, recording, and classifying financial transactions.

Accounting Accounting is a wider concept and actually, it begins where Book Keeping
ends. It includes summarizing, interpreting, and communicating the financial
data to the users of financial statements.

Accountancy Accountancy refers to systematic knowledge of the principles and techniques

which are applied in Accounting.

What is the Difference between Bookkeeping and Accounting?

Parameters Bookkeeping Accounting

Scope Bookkeeping involves identifying, In addition to bookkeeping, Accounting also

measuring, recording & classifying includes summarizing, interpreting, and
financial transactions in the ledger communicating the financial data to the
accounts. users of financial statements.

Objective The main aim is to maintain The main aim is to ascertain the profitability
systematic records of financial and financial position of the business.
transactions.

Stage It is a primary stage of accounting It is a second stage and begins

where bookkeeping ends.

Nature of This job is routine and repetitive in This job is analytical in nature.
job nature.

Level of Bookkeeping does not require special It requires specialized skills to analyze, so it
skills skills. It is performed by Junior Staff. is performed by senior staff.
Advantages of Accounting
The following are the main advantages of accounting:
1. Provide information about financial performance
 Accounting provides factual information about financial performance during a given
period of time
 Like, profit earned or loss incurred over a period and financial position at a
particular point in time.
2. Provide assistance to management
 Accounting helps management in business planning, decision-making, and
exercising control. For this, it provides financial information in the form of reports.
3. Facilitates comparative study
 By keeping systematic records and preparation of reports at regular
intervals, accounting helps in making a comparison.
4. Helps in settlement of tax liability
 Systematic accounting records help in the settlement of various tax liabilities. Such
as – Income Tax, GST, etc.
5. Helpful in raising loan
 Banks and Financial Institutions grant a loan to the firm on the basis of appraisal of
the financial statement of the firm.
6. Helpful in decision making
 Accounting provides useful information to the management for taking decisions.

Limitations of Accounting
The following are the limitations of accounting:
 Accounting is not precise: Accounting is not completely free from personal bias or
judgment.
 Accounting is done on historic values of assets: Accounting records assets at their
historical cost less depreciation. It does not reflect their current market value.
 Ignore the effect of price level changes: Accounting statements are prepared at
historical cost. So, changes in the value of money are ignored.
 Ignore the qualitative information: Accounting records only monetary
transactions. It ignores the qualitative aspects.
 Affected by window dressing: Window dressing means manipulation in accounting
to present a more favorable position of the business than the actual position.
Users of Accounting Information:
Users may be categorized into internal users and external users.
(A) Internal Users
 Owners: Owners contribute capital to the business and thus they are exposed
to maximum risk. So, they are always interested in the safety of their capital.
 Management: Accounting information is used by management for taking
various decisions.
 Employees: Employees are interested in the financial statements to assess the ability
of the business to pay higher wages and bonuses.
(B) External Users
 Banks and financial institutions: Banks and Financial Institutions provide loans to
businesses. So, they are interested in financial information to ensure the safety and
recovery of the loan.
 Investors: Investors are interested to know the earning capacity of the business and
the safety of the investment.
 Creditors: Creditors provide the goods on credit. So they need accounting
information to ascertain the financial soundness of the firm.
 Government: The government needs accounting information to assess the tax
liability of the business entity.
 Researchers: Researchers use accounting information in their research work.
 Consumers: They require accounting information for establishing good accounting
control, which will reduce the cost of production.

Qualitative Characteristics of Accounting Information

Qualitative characteristics are the attributes of accounting information, which enhance
its understandability and usefulness:
 Reliability: Reliability implies that the information must be free from material error
and personal bias.
 Relevance: Accounting information must be relevant to the decision-
making requirements of the users.
 Understandability: Information should be disclosed in financial statements in such
a manner that these are easily understandable.
 Comparability: Both intra-firm and inter-firm comparisons must be possible
over different time periods.
Basis of Accounting
The basis of accounting refers to the methodology under which revenues and expenses are
recognized in the financial statements of a business. When an organization refers to the
basis of accounting that it uses, two primary methodologies are most likely to be
mentioned. They are noted below.
Cash Basis of Accounting

Under the cash basis of accounting, a business recognizes revenue when cash is
received, and expenses when bills are paid. This is the easiest approach to recording
transactions and is widely used by smaller businesses.

Accrual Basis of Accounting

Under the accrual basis of accounting, a business recognizes revenue when earned and
expenses when expenditures are consumed. This approach requires a greater knowledge
of accounting, since accruals must be recorded at regular intervals. If a business wants to
have its financial statements audited, it must use the accrual basis of accounting, since
auditors will not pass judgment on financial statements prepared using any other basis of
accounting.
Modified Cash Basis of Accounting
A variation of these two approaches is the modified cash basis of accounting. This concept is
most similar to the cash basis, except that longer-term assets are also recorded with
accruals so that fixed assets and loans will appear on the balance sheet. This concept better
represents the financial condition of a business than does the cash basis of accounting.
Generally Accepted Accounting Principles or GAAP is a defined set of rules and procedures
that needs to be followed in order to create financial statements, which are consistent with the
industry standards.

GAAP helps in ensuring that financial reporting is transparent and uniform across industries.
As financial information is based on historical data, therefore in order to facilitate comparison
between data from various sources, GAAP must be followed.

GAAP is developed by the Financial Accounting Standards Board (FASB) The following
GAAP principles can be discussed:

1. Principle of Consistency: This principle ensures that the organizations use consistent
standards while recording transactions.
2. Principle of Regularity: This principle states that all accountants abide by the rules and
regulations as per GAAP.
3. Principle of Sincerity: This principle states that an accountant should provide an
accurate depiction of the financial situation of a business.
4. Principle of Permanence of Method: This principle states that consistent practices and
procedures should be followed for financial reporting purposes.
5. Principle of Prudence: This principle states that financial data should be reasonable,
and factual and should not be based on any speculation.
6. Principle of Continuity: This principle states that the valuation of assets is based on the
assumption that the business will be continuing its operations in the future.
7. Principle of Materiality: This principle lays emphasis on the full disclosure of the true
financial position of the business.
8. Principle of Periodicity: This principle states that business entities should abide by the
commonly accepted accounting periods for financial reporting such as yearly, half-
yearly, etc.
9. Principle of Non-compensation: This principle states that no business entity should
expect compensation in return for providing accurate information in financial reporting.
10. Principle of Good Faith: This principle states that all the parties involved in financial
reporting should be honest in reporting the transactions.
 CONCEPTS & CONVENTIONS IN ACCOUNTING
Accounting provides financial information about a business organization. For this
information to be prepared on a uniform basis entire accounting is based on certain
principles which are listed below:‐
Accounting Principles

Accounting Concepts Accounting Conventions

a) Entity concept a) Disclosure
b) Dual aspect concept b) Materiality
c) Going concern concept c) Consistency
d) Money measurement concept d) Conservatism
e) Cost concept
f) Accounting period concept
g) Accrual concept
h) Periodic matching of cost and Revenue concept
i) Realization concept

ACCOUNTING CONCEPTS
Concepts represent abstract ideas that serve to systematize function. It is an opinion
formulated over the years based on experience. The following are the accounting concepts:‐

1] ENTITY CONCEPT
For accounting purposes the "business" is treated as a separate entity from the proprietor(s).
This concept helps in keeping private affairs of the proprietor away from the business affairs
Thus a proprietor invests Rs 1,00,000/‐ in the business, it is deemed that the proprietor has
given Rs 1,00,000/‐ to the "business" and it is shown as a "liability" in the books of the
business. (because business has to ultimately repay to the proprietor). Similarly, if the
proprietor withdraws Rs 10,000/‐ from the business it is charged to him.
Accounting entity concept enables to record transactions between business and the proprietor.
It ensures that accounting records reflect only the activities of the business. It separates
business transactions from personal transactions of the proprietor. This concept is applicable
to all forms of business organisations. Although in the eyes of law a sole trader & his
business or the partners & their business are one & the same, for accounting purposes they are
regarded as separate entities. It is the "business" with which we are concerned.
2] DUAL ASPECT CONCEPT
As per this concept, every business transaction has a dual effect. According to Dual
Aspect Concept, every transaction has two aspects:
1) It increases one asset and decreases another asset.
2) It increases an asset and simultaneously increases liability.
3) It decreases an asset and increases another asset.
4) It decreases an asset and decreases a liability.
5) It increases one liability and decreases another liability.
6) It increases a liability and increases an asset.
7) It decreases liability and increases other liability.
8) It decreases a liability and decreases an asset.
Example:‐ If goods are purchased on cash basis for Rs 1,00,000 stock of goods is increased
and balance of cash is decreased.

3] GOING CONCERN CONCEPT (CONTINUITY OF ACTIVITY)

Enterprise is normally viewed as a going concern that is continuing in operation for the
foreseeable future. It is assumed that the enterprise has neither the intention nor the necessity
of liquidation of curtailing materially the scale of the operation. It is assumed that the business
concern will continue for a fairly long time, unless & until it has entered into a state of
liquidation. It does not imply permanent existence but simply stability & continuity for a
period sufficient to carry business plans. It implies that assets are acquired for utilisation &
not for sale. Similarly, depreciation on assets is provided on the basis of expected lives of the
assets rather than on their market values.
e.g. :‐ If book value of a machine is Rs 1,00,000/‐ and net realisable value is Rs 80,000/‐
businessman will ignore realisable value and provide depreciation on book value.

4] MONEY MEASUREMENT CONCEPT

In accounting, everything is recorded in terms of money. Events or transactions which cannot
be expressed in terms of money are not recorded in the books of accounts, even if they are
very important or useful for the business. Purchase and sale of goods, payment for expenses
and receipt of income are monetary transactions which find place in accounting. Death of an
executive, resignation of a manager, integrity of persons are the events which cannot be
expressed in money. These are not included in accounting systems.
Transactions which affect business materially but not convertible in money cannot be
recorded in the books of accounts. To assess financial health of business it is necessary to
decide total value of assets & liabilities. e.g. A business concern has a big building
constructed on a plot of 1000 sq. ft., furniture consisting of 20 chairs, 10 tables and 10 Godrej
cupboards, amount to be received from the customers for 5000 units sold on credit, amount
payable to supplier for 300 units purchased. From the above details it is very difficult to assess
financial health unless the above items are expressed in terms of money. It is clear that non‐
monetary events cannot be recorded in the books of accounts. The transactions, events or
assets which are expressed in terms of equivalent monetary value are recorded in the books of
accounts.

5] COST CONCEPT (OBJECTIVITY CONCEPT): ‐

This concept does not recognise the realisable value, the replacement value of the real worth
of an asset. Thus as per cost concept :‐
1) An asset is ordinarily recorded at the price paid to acquire it i.e. at its cost, and
2) This cost is the basis for all subsequent accounting for the assets.
The cost concept does not mean that the asset will always be shown at cost. It only means that
the cost becomes the basis for all subsequent accounting for the asset. Thus the asset recorded
at cost at the time of purchase may systematically be reduced by the process of depreciation.
The cost concept also implies that if nothing has been paid to acquire an asset, it cannot be
shown as an asset in the books of accounts.

6] ACCOUNTING PERIOD CONCEPT:‐

An accounting period is the interval of time at the end of which the income statement and
financial position statement (balance sheet) are prepared to know the results and resources of
the business.

7] ACCRUAL CONCEPT: ‐
It implies recording of revenues & expenses of a particular accounting period, whether they
are received/ paid in cash or not. Under cash system of accounting, the revenues & expenses
are recorded only if they are actually received/ paid in cash irrespective of the accounting
period to which they belong. But under accrual method, the revenues & expenses relating to
that particular accounting period only are considered. The Accountant records revenues as
they are earned and expenses as they are incurred.
Illustration 1:‐ Mr. Memo pays to Mr. Nemo ` 5,000 on 15th March, 2015 for service to be
rendered from 1st April to 30th June, 2015. Has Mr. Memo earned revenue on March, 15? Solution:‐
Mr. Nemo has not earned any revenue. He has received cash but not rendered service. On 15th
March, under accrual method, Mr. Nemo will record unearned Service Revenue. It is liability
because he has an obligation to perform a service in future.
Illustration 2 :‐ Ms. Isha purchases a goods of ` 80,000 from Ms. Lara by paying a cash of
`30,000 & sells at ` 1,00,000 of which the customers paid only ` 75,000.
Illustrate the concept of accrual.
Solution :‐Revenue of Ms. Isha is ` 1,00,000 & not ` 75,000 received from the customer
Expenses are ` 80,000 (cost incurred for the revenue) & not ` 30,000 paid by her to supplier
Hence profit as per accrual concept is ` 20,000 (Revenue ‐ Expenses)

8] PERIODIC MATCHING OF COST AND REVENUE CONCEPT

This concept is based on the period concept. Making profit is the most important objective
that keeps the proprietor engaged in business activities. That is why most of the accountant’s
time is spent in evolving techniques for measuring the profit/profitability of the concern. To
ascertain the profit made during a period, it is necessary to match “revenues” of the period
with the “expenses” of that period. Income (profit) earned by the business during a period is
compared with the expenditure incurred to earn the revenue.

9] REVENUE RECOGNITION (REALISATION CONCEPT)

According to this concept profit should be accounted for only when it is actually realised.
Revenue is recognised only when sale is affected or the services are rendered. Sale is
considered to be made when the property in goods passes to the buyer and he is legally liable
to pay. However, in order to recognise revenue, receipt of cash is not essential. Even credit
sales result in realisation, as it creates a definite asset called debtor. Similarly income like
commission, interest, rent etc. are shown in Profit & Loss Account on accrual basis though
they may not be realised in cash on the date of preparing accounts.

ACCOUNTING CONVENTIONS
Conventions are the customs or traditions guiding the preparation of accounting statements.
They are adapted to make financial statements clear and meaningful. They represent usage or
methods generally accepted and customarily used. These exist in cases where there are
different alternatives, which are equally logical and some of these are generally accepted
having consideration of cost, time, habit or convenience. Following are the accounting
conventions: ‐
1] CONVENTION OF DISCLOSURE
This means that the accounts must be honestly prepared and they must disclose all material
information. The accounting reports should disclose full and fair information to the
proprietors, creditors, investors and others. The term disclosure only implies that there must
be a sufficient disclosure of information which is of material interest to proprietors, and
potential creditors and investors

2] CONVENTION OF MATERIALITY
The accountant should attach importance to material details and ignore insignificant details.
If this is not done, accounts will be overburdened with minute details. Therefore, keeping the
convention of materiality in view, unimportant items are either left out or merged with other
items. Whether the information is material or not depends upon the circumstances of the case
& common sense. The rule to be kept in mind is that if omission of the information impairs
the decision or conduct of its user, it should be regarded as material.
However, an item may be material for one purpose but immaterial for another, material for
one concern but immaterial for another or material for one year but immaterial for the next
year.

3] CONVENTION OF CONSISTENCY
The comparison of one accounting period with the other is possible only when the convention
of consistency is followed. It means accounting from one accounting period to another should
on the same basis. If stock is valued at cost or market price whichever is less this principle
should be followed every year. Any change from one method to another would lead to
inconsistency. However consistency does not mean non‐ flexibility. It should permit
introduction of improved techniques of accounting.

4] CONVENTION OF CONSERVATISM
As per this convention, all prospective losses are taken into consideration but not all
prospective profits. In other words, anticipate no profit but provide for all possible losses.
This convention is being criticized on the ground that it goes not only against the convention
of full disclosure but also against the concept of matching cost & revenues. It encourages the
creation of secrete reserves by making excess provisions for depreciation, bad and doubtful
debts etc. The income statement shows a lower net income & the balance sheet overstates the
liabilities & understate the assets.
Following are the examples of application of conservatism:
1) Making provision for doubtful debts and discount on debtor
2) Not providing for discount on creditor
3) Valuing stock in trade at cost or market price whichever is less.
4) Creating provisions against fluctuations in the price of investments.
5) Showing joint life policy at surrender value and not at the paid up amount.
6) Amortization of intangible assets like goodwill which has an indefinite life.

Depreciation
“Depreciation” means the decline in the value of fixed assets due to use, passage of time, or
obsolescence. In other words, if a business enterprise procures a machine and uses it in the
production process then the value of the machine declines with its usage. Even if the machine
is not used in the production process, we cannot expect it to realize the same sales price due to
the passage of time or the arrival of a new model (obsolescence). It implies that fixed assets
are subject to a decline in value and this decline is technically referred to as depreciation.

Meaning of Depreciation
According to the Institute of Cost and Management Accounting, London (ICMA)
terminology “The depreciation is the diminution in the intrinsic value of the asset due to use
and/or lapse of time.”
Accounting Standard-6 issued by The Institute of Chartered Accountants of India (ICAI)
defines depreciation as “a measure of the wearing out, consumption or other loss of value of
depreciable asset arising from use, effluxion of time or obsolescence through technology and
market change. Depreciation is allocated so as to charge fair proportion of depreciable
amount in each accounting period during the expected useful life of the asset. Depreciation
includes amortization of assets whose useful life is pre-determined.”

The subject matter of depreciation, or its base, is ‘depreciable’ assets which.

• “are expected to be used during more than one accounting period.
• have a limited useful life; and
• are held by an enterprise for use in production or supply of goods and services, for rental to
others, or for administrative purposes and not for the purpose of sale in the ordinary course
of business.”
Similar terms related to Depreciation
Depreciation, Depletion, Obsolescence and Amortization:
The terms depreciation, depletion, obsolescence and amortization are used often
interchangeably. However, these different terms have been developed in accounting usage for
describing this process for different types of assets. These terms have been described as
follows:
Depreciation: Depreciation is concerned with charging the cost of man-made fixed assets to
operation (and not with determination of asset value for the balance sheet). In other words, the
term depreciation is used when expired utility of physical asset (building, machinery, or
equipment) is to be recorded.
Depletion: This term is applied to the process of removing an available but irreplaceable
resource such as extracting coal from a coal miner or oil out of an oil well. Depletion differs
from depreciation in that the former implies removal of a natural resource, while the latter
implies a reduction in the service capacity of an asset.
Amortization: The process of writing off intangible assets is termed as amortization. The
intangible assets like patents, copyrights, leaseholds and goodwill are recorded at cost in the
books of account. Many of these assets have a limited useful life and are, therefore, written off.
Obsolescence: It refers to the decline in the useful life of an asset because of factors like (i)
technological advancements, (ii) changes in the market demand of the product, (iii) legal or
other restrictions, or (iv) improvement in production process.
Dilapidations: Dilapidation provisions are the liabilities to put back a property at the end of
the lease into the same condition it was when you commenced the lease.
Therefore, any change in the condition of a property during the lease my creates a liability.
This is one area that companies often fail to account for correctly.

Causes of Depreciation
These have been very clearly spelt out as part of the definition of depreciation in the Accounting
Standard 6 and are being elaborated here.
1. Wear and Tear due to Use or Passage of Time- Wear and tear means deterioration, and
the consequent diminution in an assets value, arising from its use in business operations
for earning revenue. It reduces the asset’s technical capacities to serve the purpose for,
which it has been meant. Another aspect of wear and tear is the physical deterioration. An
asset deteriorates simply with the passage of time, even though they are not being put to
any use. This happens especially when the assets are exposed to the rigours of nature like
 weather, winds, rains, etc.
2. Expiration of Legal Rights- Certain categories of assets lose their value after the
agreement governing their use in business comes to an end after the expiry of pre-
determined period. Examples of such assets are patents, copyrights, leases, etc. whose
utility to business is extinguished immediately upon the removal of legal backing to
them.
3. Obsolescence- Obsolescence is another factor leading to depreciation of fixed assets. In
ordinary language, obsolescence means the fact of being “out-of-date”. Obsolescence
implies to an existing asset becoming out-of-date on account of the availability of better
type of asset. It arises from such factors as: • Technological changes; • Improvements in
production methods; • Change in market demand for the product or service output of the
asset; • Legal or other description.
4. Abnormal Factors- Decline in the usefulness of the asset may be caused by abnormal
factors such as accidents due to fire, earthquake, floods, etc. Accidental loss is permanent
but not continuing or gradual. For example, a car which has been repaired after an
accident will not fetch the same price in the market even if it has not been used.

Need for Providing Depreciation

The need for providing depreciation arises on account of the following points:
1. To Ascertain the Profits or Losses: The true profits or losses could be ascertained when
all costs of earning revenues have been properly charged against them. Fixed assets like
building, plant and machinery, furniture, motor vehicles etc are important tool in earning
business income. But the cost of the fixed asset is not charged to profit and loss of the
accounting period in which the asset is purchased. Therefore, the cost of the fixed asset
less its salvage value must be allocated rationally to the periods that receive benefit from
the use of the asset. Thus, depreciation is an item of business expense and must be
provided for a proper matching of costs with the revenue.
2. To show the Asset at its Reasonable Value: The assets decrease in their value over a
period of time on account of various reasons such as passage of time, constant use,
accidents, etc. Therefore, if the depreciation is not charged then the asset will appear in the
balance sheet at the over stated value. This practice is unfair as the balance sheet would
fail to present the true financial position.
3. Replacement of assets: Business assets become useless at the expiry of their life and,
therefore, need replacement. The cash resources of the concern are saved from being
 distributed by way of dividend by providing for depreciation. The resources so saved, if
set aside in each year, may be adequate to replace it at the end of life of the asset.
4. To Reduce Income Tax: If tax is paid on the business income without providing for
depreciation then it will be in excess to the actual income tax. This is a loss to the
business. Thus, for calculating tax, depreciation should be deducted from income similar
to the other expenses as depreciation is a chargeable expense and results in tax benefit.

FACTORS AFFECTING DEPRECIATION

In order to assess depreciation amount to be charged in respect of an asset in an accounting
period the following three important factors should be considered:
I. Cost of the asset: The knowledge about the cost of the asset is very essential for
determining the amount of depreciation to be charged to the profit and loss account.
The cost of the asset includes the invoice price of the asset less any trade discount plus
all costs essential to make the asset usable. Cost of transportation and transit insurance
are included in acquisition cost. However, the financial charges such as interest on
money borrowed for the purchase for the purchase of the asset should no be included in
the cost of the asset.
II. Estimated life of the asset: Estimated life generally means that for how many years an
asset could be used in business with ordinary repairs for generating revenues. For
estimating useful life of an asset one must begin with the consideration of its physical
life and the modifications, if any, made, factors of obsolescence and experience with
similar assets. In fact, the economic life of an asset is shorter than its physical life. The
physical life is based mostly on internal policies such as intensity of use, repairs,
maintenance and replacements. The economic life, on the other hand, is based mostly
on external factors such as obsolescence from technological changes.
III. Scrap Value of the Asset: The salvage value of the asset is that value which is
estimated to be realized on account of the sale of the asset at the end of its useful life.
This value should be calculated after deducting the disposal costs from the sale value of
the asset. If the scrap value is considered as insignificant, it is normally regarded as nil.
Methods of Calculating Depreciation Amount
The depreciation amount to be charged for during an accounting year depends upon the
depreciable amount and the method of allocation. For this, two methods are mandated by law
and enforced by professional accounting practice in India. These methods are the straight-line
method and written down-value method. Besides these two main methods, there are
other methods such as – the annuity method, depreciation fund method, insurance policy
method, sum of years digit method, double declining method, etc. which may be used for
determining the amount of depreciation. The selection of an appropriate method depends upon
the following:
• Type of the asset; • Nature of the use of such asset; • Circumstances prevailing in the
business; As per Accounting Standard-6, the selected depreciation method should be applied
consistently from period to period. Change in depreciation method may be allowed only under
specific circumstances.

Straight Line Method

Under this method, an equal portion (amount) of the cost of the asset is allocated as
depreciation to each accounting year over a period of its effective life. This is done so as to
reduce the value of the asset equal to zero or its salvage or scrap value.
It is based on the assumption that depreciation is a function of time rather than of use and the
service potential of the asset is assumed to decline by an equal amount each year.

The annual depreciation charge will be computed as under:

Calculation of Rate of Depreciation:
The depreciation rate is one, which will charge the entire depreciable cost over the estimated
life of the asset.
The rate of depreciation can be calculated as follows:
Merits:
1. It is very simple to operate and easy to understand.
2. Since the same amount is charged as depreciation every year, it does not take into account
the seasonal fluctuations of the use of asset.
3. The asset account can be reduced to zero or its scrap value at the end of the estimated life
of the asset, if so desired.

Demerits:
1. The depreciation charge and maintenance expenses will be less in the beginning and more
towards the end. But the depreciation charged will remain constant every year. Hence this
method fails to even out the charges as per actual loss.
2. As the method is based on time factor and ignores the actual usage of the asset, it is
illogical. It is not necessary that an asset is put to use equally over its life time. Many
factors may necessitate the uneven usage of the asset over the year. In such case, this
method proves unsuitable.
3. This method does not take into account the interest on capital invested in the asset.
4. This method creates complications in respect of additions to assets with different life
spans requiring separate calculations.
5. It ignores time value of money (discount factor). Hence the reported income may not be
true.

Suitability:
This method is suitable under the following cases:
(a) When the usage of the asset is uniform from year to year,
(b) When the asset is relatively of small value,
(c) Possibility of obsolescence is very low, and
(d) No large scale repairs and renewals are required during its life time. This method
is generally applied for writing down assets like furniture, patents and short leases.

Written Down Value Method of Depreciation:

It is also known as Reducing Balance or Reducing Installment Method or Diminishing Balance
Method. Under this method, the depreciation is calculated at a certain fixed percentage each
year on the decreasing book value commonly known as WDV of the asset (book value less
depreciation).
The use of book value (the balance brought forward from the previous year) and fixed rate of
depreciation result in decreasing depreciation charges over the life span of the asset.
While applying the depreciation rate both salvage or scrap value and removal costs are ignored.
It is not possible to reduce the book value to zero; but it can be reduced close to its salvage
value at the end of its useful life.

The rate of depreciation may be determined using the following formula:

Merits:
The following are the advantages of this method:
a) As this method equalizes the total charges of using the asset (i.e., the amount of
depreciation plus repair charges) from year to year, it is considered more equitable than
straight-line method. This is because depreciation charges decline each year whereas
repair charges increase year by year.
b) It matches the service of the asset with the depreciation charge. When asset is more
efficient in the initial years, higher depreciation is charged compared to later years. It is
true about fixed assets such as motor vehicles.
c) It recognizes the risk of obsolescence by charging the major part of depreciation in the
early years of the life of the asset.
d) It results in a better cash flow through tax deferral as under this method, the net income to
be taxed is lower in the initial years and higher in subsequent years.
e) As and when additions are made to the asset, fresh calculations of depreciation are not
necessary.
f) Income-tax authorities recognize this method.

Demerits:
The main drawbacks of this method are as follows:
(a) In subsequent years the original cost of the asset is completely lost sight of.
(b) The asset can never be reduced to zero.
(c) This method does not take into consideration the interest on capital invested in the asset.
(d) This method requires elaborate book-keeping. The determination of correct rate of
depreciation is a complex task.
Suitability:
This method is most suitable to those assets that have more efficiency in the beginning and late
on decreases year after year. This method is usually adopted for plant and machinery, fixtures
and fittings, motor vehicles, etc.