1 DEPRECIATION

CHAPTER

MEANING: The concept of depreciation refers to allocation of the cost

POINTS TO REMEMBER of fixed assets over their expected period of useful life. The main purpose
of depreciation is to charge it as an expense in order to find out the cost
➢ Depreciation
of production. “Depreciation is the allocation of the depreciable amount
❖Meaning of an asset over the estimated useful life.
❖Causes
Analysis of the above definitions reveals:
❖Objectives
i) Depreciation is a gradual decrease in the value of the assets.
❖Characteristics ii) Depreciation accounting is concerned with allocation of amount to
❖Factors for determination be depreciated (cost less scrap value) over the estimated useful life
❖Basic Elements period of the asset.
iii) Such depreciation amount is charged to profit and loss account.
➢ Provisions iv) Depreciation is a process of allocation, not valuation of fixed assets.
➢ Reserves

CAUSES OF DEPRICIATION:
i) Wear and tear
ii) Passage of time:
iii) Exhaustion:
iv) Obsolescence:
v) Accident:

Wear and tear: Assets get worn out because of constant use, passage of time, Such thing happens with fixed assets
like plant and machinery, furniture and fixtures, building, etc.

Passage of time: The value of the most of the fixed assets fall because of the passage of time, irrespective of the
use. Some assets have fixed legal life like lease, patent, copyright, etc.

Exhaustion: Some assets get exhausted in the process of use. Examples are: Mines, oil wells, stone quarries , etc.
These assets are known as wasting assets. The value reduces with extraction or exploitation.

Obsolescence: Obsolescence is a process of becoming obsolete or out of date. Some assets are discarded though
they are in existence and working condition. For example , a new asset has hit the market with more efficiency, low
running and maintenance cost, etc. use of the old asset becomes uneconomic. Running and maintend cost will be
increased. So the old asset is discarded and it is replaced by a new assets.

Accident: Sometimes the value of an asset reduces to zero or very negligible amount after it meets an accident.

OBJECTIVES/NEEDS FOR PROVIDING DEPRECIATION

i) To ascertain true profit
ii) True financial position
iii) For replacement of asset:
iv) Computation of tax liability
To ascertain true profit:

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The cost of the plant is to be charged to the profit and loss account over the useful life period of the plant and
machinery. So we are charging the depreciation as an expense to know the true profit during which period no cash
is paid, as it has been paid in lump sum when it was purchased.

True financial position

The balance sheet must reveal true and fair view of the financial position of the business. The asset loses its value
because of depreciation for various reasons. Value of the assets will be overstated, if shown in the balance sheet
without charging depreciation. So depreciation must be deducted from the asset to show true financial position of
the business.

For replacement of asset:

All fixed assets become commercially unviable after a fixed period of time. So the old discarded assets are to be
replaced by new ones on order to keep the business going. The depreciation so charged is accumulated over its
useful life. This amount can be used to purchase a new asset.

Computation of tax liability

Depreciation is to be charged at a specific rate prescribed by the Income Tax authorities depending upon the nature
and type of assets. Profit or loss can be calculated only after changing depreciation, so that the tax can be
appropriately levied.

CHARACTERISTICS
i) Depreciation is a non-cash or non-monetary expense. The businessman need not pay anything in cash for
depreciation.
ii) The term depreciation is applicable to only fixed assets.
iii) Depreciation is a charge against profit. This implies that true profit or loss of a business cannot be
accurately ascertained without charging depreciation.
iv) Depreciation is a process of allocation of cost.

Distinction between Depreciation Account and Provision for Depreciation Account

Depreciation Account Provision for Depreciation Account
This account is a Nominal account. This account is a provision account, always showing a
credit balance till the disposal of the asset.
At the time of charging depreciation, depreciation At the time of charging depreciation, depreciation
account is debited and asset account is credited. account is debited and provision for depreciation
account is credited.
At the end of the accounting year, depreciation account Provision for depreciation account has no place in
is closed by transferring to profit and loss account. profit and loss account . It is shown on the liabilities
side of the balance sheet and is closed by transferring
to the particular asset account, when the asset is sold.
This account shows debit balance. This account shows credit balance.
Asset is shown at written down value in the balance Asset is shown at original cost in the balance sheet.
sheet.
Depreciation account does not appear in the balance Provision for depreciation account is shown on the
sheet. liabilities side of the balance sheet.

Methods of Calculating Depriciation

i) Straight line method/Fixed installment method/Original cost method
ii) Written down value method

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Straight line method/Fixed installment method/Original cost Method:-Under this method, a
fixed percentage of the original cost of the asset is written off during each accounting period over the
useful life of the asset.

𝑪𝒐𝒔𝒕 𝒐𝒇 𝒕𝒉𝒆 𝒂𝒔𝒔𝒆𝒕−𝑹𝒆𝒔𝒊𝒅𝒖𝒂𝒍 𝑽𝒂𝒍𝒖𝒆

Depreciation:- 𝑬𝒔𝒕𝒊𝒎𝒂𝒕𝒆𝒅 𝒍𝒊𝒇𝒆

Advantages:-
a) This method is very simple to calculate and easy to apply
b) The same depreciation amount is charged every year. So comparision of income of different years
is easy
c) The value of the asset will be reduced to zero or scrap value at the end of its life time.
Disadvantages:-
a) It is based on the assumption that the asset has the same utility in different accounting periods.
But the efficiency of the asset reduces with the passage of time.
b) It does not consider loss of interest on the amount invested in the business.
c) It is difficult to calculate depreciation on subsequent addition of the asset.
d) This method is not recognized by the income tax department.

Written down value method/Diminishing Balance Method/Reducing installment method :-

Under this method , depreciation is calculated at a fixed percentage on written down value of the asset.
This method assumes that the efficiency of the asset goes on reducing as the asset grows older. So the
amount of depreciation to be charged in different accounting periods also decreases with the passage of
time.
1−𝑛 𝑅𝑒𝑠𝑖𝑑𝑢𝑎𝑙 𝑉𝑎𝑙𝑢𝑒
Rate of Depreciation = [ √ ] ×100
𝐶𝑜𝑠𝑡 𝑜𝑓 𝑎𝑠𝑠𝑒𝑡
Advantages:-
a) This method is logical as the asset grows older, depreciation goes on reducing
b) This method is recognized by the Income Tax department.
c) Fresh calculation of depreciation is not required when addition is made.
Disadvantages:-
a) As the depreciation is calculated at a fixed percentage on written down value of the asset, the value
of the asset cannot be zero.
b) It does not take into consideration the loss of interest due to investment in asset.
c) It is very difficult to calculate the amount of depreciation.
d) It takes a long time to write off the asset.

Distinction between straight line method and written down value method
Straight line method Written down value method
The rate and amount of depreciation remain the same The rate of depreciation remains the same, but the
year throughout the life period. amount of depreciation goes on reducing year after
year.
Depreciation is calculated as a percentage on the Depreciation is calculated as a percentage on the
original cost of the asset. written down value or reducing balance or book value
of the asset.
The book value of the asset becomes zero at the end of The value of the asset never comes down to zero.
the life of the asset.
As the asset grows older, the amount of repair As the asset grows older, the amount of repair
increases. But the amount of depreciation remains the increases. But the amount of depreciation decreases.
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 same. Hence, the total amount of repair and Hence, the total amount of depreciation and repair
depreciation increases year after year. It reduces the remains the same each year. It does not affect the profit
annual profit gradually. of the subsequent years substantially.
It is suitable for the assets whose repair charges are It is suitable for assets which are affected by change in
less and possibility of obsolescence is less. technology and which require more repair with the
passage of time.

FACTORS FOR DETERMINANTION OF DEPRECIATION

i) Cost of asset
ii) Estimated working life
iii) Salvage /Residual/Scrap value
iv) Provision for repairs and renewals
v) Legal provisions
vi) Additions to asset

Cost of Asset: The original cost of asset paid/payable on acquisition of asset, is increased with the amount spent
on installation, freight, loading and unloading charges, transit insurance, octroi, import duty etc. The aggregate
amount is called ‘cost of asset.’

Estimated working Life of the Asset: Technical expertise is required to estimate the working life of an asset.
Conditions under which the asset is maintained and preserved affect the life of asset. The estimated working life of
the asset may be measured in terms of years, months, days, hours, output(unit & weight) or kilometers etc.

Salvage / Residual /Scarp value of an Asset: It refers to the estimated amount which will be realized when asset
is sold, discarded, or exchanged for a new asset at the end of its working life. Cost of asset minus residual value is
called the ‘Depreciable Amount’ which is charged over the working life of asset.

Provision for repairs and renewals:- Proper repairs and renewals undertaken at regular intervals help
in keeping the asset in good estimating the amount of depreciation this factor must be taken into
consideration.

Legal provisions:- If there are some legal provisions for providing depreciation on asset the same
should be taken into consideration. Provisions of Companies Act, 2013 and Income Tax Act , 1961 are
relevant in this regard.

Additions to assets:- Any capital expenditure incurred on extension or addition to old machinery will be
subject to depreciation in the year in which the addition is made to the asset.

Distinction between depreciation, depletion, obsolescence, amortization and dilapidation,

Fluctuation:-
Depreciation Depletion Obsolescence Amortization Dilapidation Fluctuation
The term Depletion implies When an asset The process of The term Fluctuation is a
depreciation is to removal of an becomes out of writing off dilapidation temporary
be distinguished available but date or it goes out intangible assets, refers to the upward or
from other terms irreplaceable of use to new or such as goodwill, damage done to a downward
such as depletion, resource, such as, improved patents, building or other variation in the
amortization and extracting coal technology or trademarks or property during market price of
dilapidation etc. from a coal mine invention, this is license, etc., tenancy. When a fixed asset on
though they are or oil out of oil referred to as which cannot be property taken account of
well depletion is obsolescence, seen or touched is on lease is operation of the

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 used often shown in the which means called returned to the market
interchangeably profit and loss reduction or loss ‘amortisation’. landlord, he may mechanism of
account as a of usefulness of These intangible ask the lessee as demand and
revenue expense. an old asset due assets have value per agreement to supply.
to a new based on the put it in as good Fluctuation does
invention or rights and condition as it not affect the
improved design privileges those was at the time of profit and it is not
of an existing belong to owner. its leasing out. In taken into
asset. Amortisation is an order to meet the consideration.
Obsolescence may expense and cost of such This is so because
be due to various appears on the dilapidation, a depreciation is
factors: Change in debit side of provision may be concerned with
the method of income created by the original cost of
production, statement. debiting the asset.
Change in product property account
design, Change in with the
model, Change in estimated
demand of amount of
product dilapidation and
crediting the
provision for
dilapidation
account.

MEANING OF PROVISIONS
A provision refers to a certain amount set aside out of current year profits to meet uncertain liabilities
and/or losses in future which are related to the current accounting period. Such liabilities/losses are
uncertain as they have not been incurred as yet. It is necessary to make a provision for such items for
ascertaining true amount of net profit of the current year since such expenses are related to the current
period.

MEANING OF RESERVES
Reserve may be defined as the amount set aside out of profits and other surpluses to meet the future
uncertainties. Reserves are appropriations of profit.

DIFFERENCE BETWEEN RESERVE AND PROVISION

Basis Reserve Provision
1. Purpose It is created to meet an unknown It is created to meet a known
liability. liability or contingency if the
amount is not determined.
2. Nature Creation of reserves is Creation of provision is a legal
discretionary . It can be created necessity. Provision has to be
only if adequate profits have been provided even if there are losses.
earned.
3. Objectives The objective of reserve is to The objective is to provide for
strengthen the financial position of depreciation, doubtful debts and
the business. other specific liabilities.
4. Source It is created through Profit and Loss It is created through profit and loss
Appropriation Account. Therefore, account; hence it reduces the net
it reduces the divisible profit. profit.
5. Investment Reserve can be invested outside the Provision can never be invested
business. outside the business.

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 6. Treatment It is shown on the liabilities side or It is either shown on the assets side
equity and liabilities part (In case of by way of deduction from the assets
companies) under the head for which it is created or as a
‘Reserves and Surplus” in The distinct item on the liabilities side of
Balance Sheet. the balance sheet.
7. Usage It can be utilized for distribution of If cannot be utilized for distribution
dividend among shareholders. of dividend among shareholders.
8. Specific Loss It is not created to provide for a It is created to provide for a specific
specific loss and hence can be used loss and can only be used for
for any purpose. meeting that loss.

REVENUE RESERVES
In the words of kohler, Revenue reserve is “that portion or any detail thereof of the net worth or total
equity of an enterprise representing retained earnings available for withdrawal by proprietors”.

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