• Meaning of Depreciation:–
The term refers to fall in the value or utility of fixed assets which are used in operations over the definite period of years. In other words, depreciation is the process of spreading the cost of fixed assets over the numbers of years during which the benefits of the assets is received. The fall in value or utility of fixed assets due to so many causes like wear & tear, decay, effluxion of time or obsolescence, replacement, breakdown, fall in market value etc.
• Definition of Depreciation:–
• According to the Institute of Chartered Accountant of India, “Depreciation is the measure of the wearing out, consumption or other loss of value of a depreciable assets arising from use, effluxion of time or obsolescence through technology & market changes.
• According to Pickles, “Depreciation is the permanent & continuing diminution in the quality, quantity or value of an asset.”
• According to Spicer & Pegler, depreciation may be defined as, “the measure of the exhaustion of the effective life of an assets from any cause during a given period.”
From the above definition it can be concluded that depreciation is a gradual decrease in the value of an assets from any cause.
• Need/ Necessity/Purpose/ Objective of Depreciation:–
• To find out correct cost of production: -The cost of use of the assets being the depreciation, it is necessary to take these expenses into consideration to find the correct cost of production.
• Ascertainment of true profit/ loss:– Depreciation is also an operating expenses & as such it must be considered before ascertaining net profit/ loss. The Companies Act 1956 has laid down that no dividend is to declared in any year without making provision for depreciation.
• Spreading over the cost of the asset: – Cost of the asset is incurred & recorded on a “one time” basis. But the asset is in use for a number of years. Therefore the cost of the asset is to be spread over a number of years of its useful economic life.
• True & fair view of the financial position: – Balance sheet is expected to show true & fair financial position of business. If depreciation is not provided, the balance sheet will show overvalue of the fixed assets & thus the balance sheet will fail to show true & fair financial position of the business.
• Replacement of assets: – Assets used in the business need replacement after the expiry of their service life. By providing depreciation a part of the profit of the business is kept in the business which can be used for purchase of new assets on old fixed assets becoming useless.
• Causes of depreciation:–
The causes of depreciation are as follows:
• Wear & tear: – Assets get worn or torn out on account of constant use, as is the case with plant & machinery, furniture & fixtures used in a factory.
• Exhaustion: – An asset may get exhausted through working. This is the case with mineral mines, oil wells etc. on account of continuous extraction of minerals or oil, a stage comes when the mine or well gets completely exhausted & nothing is left.
• Obsolescence: – Some assets are discarded before they are worn out because of changed conditions. For example, an old machine which is still workable may have to be replaced by a new machine because of the latter being more efficient & economical. Such a loss on account of new inventions or changed fashions is termed as loss on account of obsolescence.
• Efflux of time: – Certain assets get decreased in their value with the passage of time. This is true in case of assets like leasehold properties, patents or copyrights.
• Accidents: – An asset may meet an accident & therefore, it may get depreciated in its value.
On the basis of the above causes, it can be said that depreciation is decrease or depletion in the value of an asset due to wear & tear, lapse of time, obsolescence, exhaustion & accident.
- Methods of Depreciation:-
The following are the various methods applied for measuring allocation of depreciation cost:
• Straight Line Method: – This method is also termed as Constant charge Method. Under this method, depreciation is charged for every year will be the constant amount through the life of the asset. Accordingly depreciation is calculated by deducting the scrap value from the original cost of an asset & the balance is divided by the number of years estimated as the life of the asset. The following formula for calculating the periodic depreciation charge is
Depreciation = Original cost of assets – Scrap value
Estimated life of asset
• Simple & easy to calculate.
• Original cost of asset reduced up to scrap value at the end of estimated life.
• Estimated useful life of the asset can be estimated under this method.
• It does not consider intensity of use of assets.
• It ignores any additions or opportunity cost while calculating depreciation.
• It ignores effective utilization of fixed assets, it becomes difficult to calculate correct depreciation rate.
• Under the assumption of constant charges of maintenance of assets it is impossible to calculate true depreciation.
This method is applied generally in the case of those assets which have small value or which do not require many repairs and renewals such as patents, short leases, furniture etc. & sometimes used for plant & machinery.
• Written Down Value Method: – This method is also known as fixed percentage on declining base method or reducing installment method. Under this method depreciation is charged at fixed rate on the reducing balance every year. Accordingly the amount of depreciation gradually reducing every year. The depreciation charge in the initial period is high depreciation charge in initial period is high & negligible amount in the later period of the asset.
• Merits: –
1) This method is accepted by Income Tax authorities.
2) Impact of obsolescence will be reduced at minimum level.
3) Fresh calculation is not required when additions are made.
4) Under this method the depreciation amount is gradually decreasing & it will affect the smoothing out of periodic profit.
• Residual value of the asset cannot be correctly estimated.
• It ignores interest on investment on opportunity cost which will lead to difficulty while determining the rate of depreciation.
• It is difficult to ascertain the true profit because revenue contributions of the asset are not constant.
• The original cost of the asset cannot be brought down to zero.
This method is most suited to plant & machinery, where additions take place very often & question of repairs is also important.
• Change in the Method of Depreciation: – sometimes a change in the method of depreciation may be required. For example a firm may change the method of depreciation from fixed installment to reducing balance method or vice versa. In such a case, there can be two different situations:
• Change in method of depreciation may be desired from the current year onwards. In such a case, depreciation will be charged according to the new method from the current year.
• Change in method of depreciation may be desired from back date. This will require necessary adjustments to be made in the current year for any extra or less depreciation charged in earlier years. In such a case, the best course would be to compute the amount of depreciation which has already been charged according to the new method. The difference, if any should be credited or debited to the asset account in the current year & should be shown as a separate charge or income in the profit & loss account of the current years of the firm.
- Factors to be considered while deciding the amount of depreciation:-
While deciding the amount of depreciation, the following are the three important factors shall be taken into consideration.
• Cost of the asset: – The cost of the asset includes the invoice price of the asset, less any trade discount plus all costs essential to bring the asset to a usable condition. It should be noted that financial charges, such as interest on money borrowed for the purchase of the asset, should not be included in the cost of the asset.
• Estimated scrap value: – The term scrap value means the residual or the salvage value which is estimated to be realized on account of the sale of the asset at the end of its useful life. In determining the scrap value, the cost to be incurred in the disposal or removing of the asset should be deducted out of the total realizable value.
• Estimated useful life: – This is also termed as economic life of the asset. This may be calculated in terms of years, month, hours, and unit of output of other operating measures such as kilometers in case of a taxi or a truck.
- Difference between Fixed Instalment Method & Written Down Value Method:-
• Depreciation is charged at certain percentage each year on original cost of fixed asset.
• Amount of depreciation remains the same i.e. fixed each year as it is charged on original cost.
• If the additional asset purchased has the same life as that of the previous one, no fresh calculation is required. If the life-time of additional assets differs from that of the original asset, separate calculation is necessary.
• Value of fixed asset can be reduced to zero.
• As the asset gets older & older the total burden of depreciation & repairs goes on increasing affecting the profit or loss.
• Depreciation is charged at certain percentage on reduced balance of each year.
• Percentage of depreciation to be charged remain the same but amount of depreciation goes on decreasing each year as it is charged on reduced balance of each year.
• Additions to the asset do not generally need fresh calculations, except in the first year of addition, if it is made sometime during the year.
• Value of fixed asset cannot be reduced to zero.
• Total burden remains nearly the same.