Monday, 30 May 2011

Insurance Policy Method of Depreciation:

Learning Objectives:
  1. Define and explain the insurance policy method of depreciation.

Definition and Explanation:

Insurance policy method is a slight modification of the depreciation fund method or sinking fund method. Under this method the amount represented by the depreciation fund, instead of being used to buy securities, is paid to an insurance company as premium. The insurance company issues a policy promising to pay a lump sum at the end of the working life of the asset for its replacement.
The advantage of insurance policy method is that risk of loss on the sale of investment and the trouble and expense of buying investment are avoided, while disadvantage lies that the interest received on the premiums paid is comparatively very low.
When insurance policy method is employed the policy account will take the place of the depreciation fund investment account and no interest will be received at the end of each year, but the total interest on the premiums will be received when the policy matures.

Entries:

Every years two entries will be made:
1. In the beginning:

Depreciation insurance policy account

     To Cash account

(Being the payment of premium on depreciation policy)
2. At the end of the year:

Profit and loss account

     To Depreciation fund account

(Being the amount of depreciation charged to profit and loss account)
When the policy will mature i.e., to say the amount of the policy will be received. The entry is:
3. Cash account

     To Depreciation insurance policy account

(Being the policy amount realized)
The depreciation insurance policy account will show some profit. This will be transferred to depreciation fund account, the entry being.
4. Depreciation insurance policy account

     To Depreciation fund account

(Being the policy amount realized)
The asset account will have been shown throughout at its original cost. It now be written off by transfer to depreciation fund account. The entry is:
5. Depreciation fund account

     To Asset account

Insurance Policy Method Example:

On 1st January, 1990 a business purchases a three year lease of premises for $20,000 and it is decided to make a provision for replacement of the lease by means o an insurance policy purchased for annual premium.
Show the ledger accounts dealing with this matter.

Solution:

Leasehold Account
Dr. Side
Cr. Side
1990 1990
Jan. 1 To Cash 20,000
Dec. 31 By Depreciation fund 20,000
Depreciation Fund Account
Dr. Side Cr. Side
1990 1990
Dec. 31 To Balance c/d 6,400 Dec. 31 By Profit and loss a/c 6,400


1991
Dec. 31 To Balance c/d 12,800 Jan. 1 By Balance b/d 6,400
Dec. 31 By Profit and loss a/c 6,400


12,800 12,800


1992 1992
Dec. 31 To Leasehold Property 20,000 Jan. 1 By Balance b/d 12,800
Dec. 31 By Profit and loss a/c 6,400
" By Leasehold 800


20,000 20,000


Leasehold Policy Account
Dr. Side Cr. Side
1990 1990
Dec. 31 To Cash 6,400 Dec. 31 By Balance c/d 6,400


1991 1991
Jan. 1 To Balance b/d 6,400 Dec. 31 By Balance c/d 12,800
Dec. 31 To Cash 6,400


12,800 12,800


To Balance b/d 12,800 By Cash 20,000
To Cash 6,400
800


20,000 20,000


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