Vasanth Fabrics: Depreciation on an Asset Bought and an Asset Sold Mid-Year
Vasanth Fabrics, a sole proprietor in Tiruppur, keeps a Machinery Account at original cost and a separate Provision for Depreciation Account, charging depreciation at 10% per annum on original cost. On 1 April 2023 the Machinery Account stood at ₹12,00,000 and the Provision for Depreciation Account showed a credit balance of ₹4,50,000. On 1 October 2023 a machine bought on 1 April 2020 for ₹2,40,000 was sold for ₹1,35,000, and the sale proceeds were credited directly to the Machinery Account. On 1 January 2024 a new machine was purchased for ₹3,60,000 and installed the same day. A junior accountant has proposed charging a full year's depreciation on the new machine, on the reasoning that depreciation is 'for the year', and charging no depreciation at all on the machine sold, since it is no longer held on 31 March 2024. The proprietor wants the correct figures before he signs the final accounts.
1. Compute depreciation for the year ended 31 March 2024 with working notes, and state the profit or loss on the sale of the machine.
Read the worked answer
Depreciation is charged for the period the asset was actually used, because the expense must be matched with the revenue it helped to earn.
| Working | ₹ |
|---|---|
| Machinery held throughout the year: (12,00,000 − 2,40,000) × 10% | 96,000 |
| Machine sold: 2,40,000 × 10% × 6/12 (1 April to 30 September) | 12,000 |
| New machine: 3,60,000 × 10% × 3/12 (1 January to 31 March) | 9,000 |
| Total depreciation for the year | 1,17,000 |
Loss on sale: accumulated depreciation on the machine sold = three full years to 31 March 2023 (2,40,000 × 10% × 3 = 72,000) plus six months of the current year (12,000) = ₹84,000. Book value on the date of sale = 2,40,000 − 84,000 = ₹1,56,000. Sold for ₹1,35,000, therefore loss ₹21,000, to be written off to the Profit and Loss Account. Note that the ₹12,000 of current-year depreciation on this machine is part of the ₹1,17,000 above; it is charged to the Provision account and then removed along with the asset, so it is not double-counted.
2. Show how the sale is recorded when a Provision for Depreciation Account is maintained, and give the closing balances of the Machinery Account and the Provision for Depreciation Account.
Read the worked answer
With a provision account, the asset account stays at cost and never carries depreciation.
Machinery Account
| Dr | ₹ | Cr | ₹ |
|---|---|---|---|
| 1.4.23 To Balance b/d | 12,00,000 | 1.10.23 By Bank (sale) | 1,35,000 |
| 1.1.24 To Bank (purchase) | 3,60,000 | 1.10.23 By Provision for Depreciation | 84,000 |
| 1.10.23 By Profit and Loss (loss) | 21,000 | ||
| 31.3.24 By Balance c/d | 13,20,000 | ||
| 15,60,000 | 15,60,000 |
Provision for Depreciation Account
| Dr | ₹ | Cr | ₹ |
|---|---|---|---|
| 1.10.23 To Machinery | 84,000 | 1.4.23 By Balance b/d | 4,50,000 |
| 31.3.24 To Balance c/d | 4,83,000 | 31.3.24 By Depreciation (P and L) | 1,17,000 |
| 5,67,000 | 5,67,000 |
Reasoning: the ₹84,000 sitting in the provision against the sold machine must leave the books with it, otherwise future depreciation would be charged on an asset that no longer exists. Closing provision = 4,50,000 + 1,17,000 − 84,000 = ₹4,83,000. The balance sheet shows machinery at 13,20,000 − 4,83,000 = ₹8,37,000.
3. Quantify the effect on profit of the junior accountant's proposal, and explain the accounting principle that his proposal violates.
Read the worked answer
Take the two halves separately rather than netting them by intuition.
| Item | Correct | Junior's proposal | Effect on depreciation |
|---|---|---|---|
| New machine | 9,000 | 36,000 (full year) | +27,000 |
| Machine sold | 12,000 | Nil | −12,000 |
| Total | 1,17,000 | 1,32,000 | +15,000 |
Depreciation would be overstated by ₹15,000, so profit would be understated by ₹15,000, and the closing provision would be ₹4,98,000 instead of ₹4,83,000. The error is not self-correcting within the year: the new machine's excess ₹27,000 would be repeated in every following year at 10% of cost, and the sold machine's ₹12,000 would never be recovered.
The proposal violates the matching principle (charge the expense to the periods that enjoy the benefit) and, in the case of the sold machine, the accrual concept - six months of use is a cost of this year whether or not the asset is still held on the closing date. It also contradicts the consistency assumption, since the firm has always charged pro-rata depreciation on additions and disposals.