EPFO EO/AO 2023 General Ability Test · Question 42 of 120

Correct — B, (b) Depreciation is the process of valuation of assets. The booklet prints the 'not' of the stem in bold italic, so the item asks for the statement that is FALSE, and this is it. The other three are all sound propositions about depreciation. Depreciation is a process of ALLOCATION, not of valuation. When an asset is bought, the business pays once for a bundle of service potential that will be used up over several years. Depreciation is the systematic spreading of that cost — strictly, of the depreciable amount, which is cost less estimated residual value — over the asset's useful life, so that each year bears the share of the cost it consumed. The accounting standards on fixed assets put it in exactly those terms: depreciation is the systematic allocation of the depreciable amount of an asset over its useful life. The practical consequence is the one candidates forget. The figure left in the Balance Sheet after depreciation — the written down value — is an unexpired cost, not a valuation. It is what remains of the money spent, not what the asset would fetch. A machine bought for Rs. 10 lakh and depreciated to Rs. 4 lakh may be worth Rs. 7 lakh or Rs. 40,000 in the market; the accounts do not claim otherwise, and no entry is made to reconcile the two. Valuation of assets is a different exercise altogether, carried out by valuers for revaluation, insurance, sale or impairment, on evidence of market prices — and it is not what the annual depreciation charge is doing. The distinction also explains why the depreciation charge does not stop simply because an asset's market price has risen. Under historical cost accounting the charge is driven by the consumption of service potential, not by price movements, so an appreciating building is still depreciated over its useful life.

• (a)Depreciation is a non-cash expense. — TRUE, so it cannot answer a 'not' stem. Depreciation reduces profit but no money leaves the business in the year it is charged — the cash went out earlier, when the asset was bought, and that outflow was capital expenditure. This is why the indirect-method cash flow statement starts from net profit and adds depreciation back: it is removing a charge that never touched cash. Provision for doubtful debts and amortisation of intangibles behave the same way.
• (c)The main cause of depreciation is wear and tear caused by usage. — TRUE as textbooks state it. Physical wear and tear through use is the principal cause of depreciation of tangible fixed assets, which is why the charge is often linked to output or running hours. The statement does not claim to be the only cause and is not falsified by the others — efflux of time, which runs whether or not the asset is used, obsolescence through better technology or changed demand, depletion in the case of wasting assets such as mines, and accidents, all contribute.
• (d)Depreciation must be charged so as to ascertain true profit or loss of a business. — TRUE, and it is the matching principle stated plainly. Revenue of the year is earned partly by consuming the fixed assets, so the cost of that consumption must be set against it; omit the charge and the profit reported is not profit at all but profit plus a part of the capital consumed. Company law reinforces it — section 123 of the Companies Act, 2013 bars the declaration of a dividend except out of profits arrived at after providing for depreciation, with the useful lives in Schedule II — so paying a dividend out of undepreciated profit would be a distribution of capital.

Depreciation is the systematic allocation of the depreciable amount of a fixed asset over its useful life, where depreciable amount is historical cost (or revalued amount) less estimated residual value. Three estimates therefore drive the charge — cost, useful life and residual value — and only the first is a fact. The common methods are the straight line method, which spreads an equal amount each year and suits assets that give uniform service, and the written down value or diminishing balance method, which applies a fixed percentage to the reducing book value and so charges more in early years, matching the rising repair costs of an ageing asset. Other methods exist for particular assets: units of production for a machine measured in output, and depletion for a mine or quarry. Land is normally not depreciated, since its useful life is indefinite; a leasehold interest is amortised over the lease. Whatever method is used, the accumulated depreciation is a contra to the asset, not a fund of money — unless a business separately invests the amount, no cash is set aside by the act of charging depreciation.

Every accountancy block on this paper contains at least one depreciation item, and it is asked as a definition test rather than a computation because the definition is where candidates are loose. 'Allocation not valuation' is the single sentence that answers most of them, and it is also the sentence that explains why financial statements prepared on historical cost do not purport to show what a business is worth. The habit rewarded is checking each statement against the definition rather than against a general sense that it sounds reasonable — all four options here sound reasonable, and three of them are.

• Depreciation is the systematic allocation of the depreciable amount of an asset over its useful life — a process of allocation, not of valuation.
• Depreciable amount = cost (or revalued amount) less estimated residual value.
• Written down value in the Balance Sheet is unexpired cost, and it is not a statement of the asset's market price.
• Depreciation is a non-cash charge and is added back to profit in the indirect method of preparing a cash flow statement.
• Causes of depreciation: wear and tear from use, efflux of time, obsolescence, depletion of wasting assets, and accidents.
• Charging depreciation is an application of the matching principle — the cost consumed in earning the year's revenue is set against that revenue.
• Section 123 of the Companies Act, 2013 bars declaration of a dividend except out of profits computed after providing for depreciation; Schedule II prescribes useful lives.
• Straight line method charges a constant amount; written down value method charges a constant percentage on the reducing balance, so the charge falls each year.

• Reading the written down value as the asset's worth, and concluding that a profitable sale above book value proves the depreciation was wrong.
• Believing accumulated depreciation is a cash reserve available to replace the asset.
• Skipping the bold-italic 'not' and marking the first statement that reads as true.
• Assuming an asset whose market price is rising need not be depreciated.

Depreciation appears in EO/AO papers in three shapes — a definition or 'which statement is not correct' item like this one, a short computation under the straight line or written down value method, and a treatment question about disposal or a change of method. The definitional shape is the one that repays learning the standards' own wording, because the wrong option is usually a plausible sentence with one word swapped, as 'valuation' has been swapped in for 'allocation' here.

No directly related past PYQ was found.

• practice — not a real PYQ

  Depreciable amount of a fixed asset is :

  • (a)Its historical cost
  • (b)Its historical cost less estimated residual value
  • (c)Its market value at the end of the year
  • (d)Its written down value less accumulated depreciation

  Answer(b) Its historical cost less estimated residual value

• practice — not a real PYQ

  Under the written down value method of depreciation, the annual charge :

  • (a)Remains the same every year
  • (b)Increases every year
  • (c)Decreases every year
  • (d)Varies with the market price of the asset

  Answer(c) Decreases every year