Insurance Policy Method of Depreciation

12/08/2008 21:06

 

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