Depreciation

By:
Anuja Rastogi
 Meaning of Depreciation
• Depreciation may be described as a permanent, continuing and
gradual shrinkage in the book value of fixed assets.
• It is based on the cost of assets consumed in a business and not on its
market value.
– According to Institute of Cost and Management Accounting, London (ICMA)
terminology “The depreciation is the diminution in intrinsic value of the
asset due to use and/or lapse of time.”
– Accounting Standard-6 issued by The Institute of Chartered Accountants of
India (ICAI) defines depreciation as “a measure of the wearing out,
consumption or other loss of value of depreciable asset arising from use,
effluxion of time or obsolescence through technology and market-change.
Depreciation is allocated so as to charge fair proportion of depreciable
amount in each accounting period during the expected useful life of the
asset. Depreciation includes amortisation of assets whose useful life is pre-
determined”
 Depreciation
• Depletion/Exhaustion – Some assets are of wasting
nature due to constant extraction of raw materials.
By extraction of natural resources, their deposits
are depleted. Decrease in such mineral wealth due
to extraction is termed as depletion.
– Mines, quarries, oil wells etc. come under this category.
• Amortization – Decrease in the value of intangible
assets like patents, copyright, trademark etc.
 Causes of Depreciation
• By Constant Use: The constant use of any asset by a business causes wear and tear,
which causes a decrease in the value of those assets. As a result, the capacity of the
asset to serve in the business is reduced.
• By Passing of Time: The value of assets also decreases when an asset is exposed to
forces of nature like wind, rain, etc., even if it is not put to any use.
• By Obsolescence: Obsolescence is also one main reason for depreciation. An existing
asset can become outdated in some time due to technological changes, improvements
in production methods, changes in market demand, etc., as a result, the demand for
the asset decreases, as the old asset is not able to fulfill the requirements of the
business.
• By Expiration of Legal Rights: There are some assets that are used in the business for a
certain time period. The time period is determined by an agreement in which the
tenure to use that particular asset is mentioned. Example: Patents, Copyrights, Lease,
etc.
• By Accident: Assets can be destroyed due to some abnormal factors, such as
earthquakes, floods, etc. This leads to a decrease in the value of the asset. Thus, it
needs to be taken into account.
Features of Depreciation
• 1. Decrease in the Book Value of Fixed Assets: Depreciation is a decline in the book value
of a fixed asset and not the market value of the fixed asset, as depreciation is always
calculated as a fixed percentage of cost price.
• 2. Non-Cash Expenses: Depreciation is a non-cash expense because it does not involve
any outflow of cash. It is simply a charge to reduce the recorded cost of an asset over its
useful life. In the cash flow statement, depreciation is added back to the profit in the
operating activities section.
• 3. Continuous Process: Depreciation is a continuous process of reduction in the value of
the fixed assets, as every year depreciation is charged on the fixed assets, and the
depreciable amount is deducted from the book value of the asset.
• 4. Charge Against Profit: Depreciation is a charge against profit, i.e., depreciation is
charged even if the firm is at loss. It is done because the asset has to be replaced at the
end of its useful life, and actual profit can only be ascertained when depreciation is
deducted from operational profit in the income statement.
• 5. Tax Benefit: It provides a tax benefit to the company, as the depreciation is adjusted to
the profit before the payment of taxes. By this, the taxable income is reduced and the
firm has to pay less tax on a decreased profit.
 Objectives of depreciation
• 1. Knowledge of True Profits
– When an asset is purchased, it is nothing more than payment in advance for an expense. For example,
purchasing a building for $100,000 for business purposes will save rent in the future.
– However, after a certain number of years, the building will become useless. The cost of the building is,
therefore, nothing except paying rent in advance for years.
– Any paid rent would have been charged as an expense to determine the true profits made by the
business during a particular period.
– Therefore, the amount paid for the purchase of the building should be charged over the period for which
the asset would be serviceable.
• 2. True Financial Position
– The assets depreciate in their value on account of various factors.
– To present a true state of affairs of the business, the assets should be shown in the balance sheet, at
their proper values.
– In case depreciation is not charged, the balance sheet will not indicate a true view of the state of affairs
of the business.
• 3. Replacement of Assets
– The business uses assets to earn revenue. On account of constant use or lapse of time and similar other
causes, a stage may come when the assets need to be replaced. Providing depreciation retains a part of
the business profits, which can purchase new assets.
• 4. Correct Cost of Production
– Depreciation is a cost of production, and if depreciation is not charged, the cost of production so
determined will not be correct.
 Depreciation Accounting
• Following are the three important factors which should be considered for
determining the amount of depreciation to be charged to the Profit and
Loss Account in respect of a particular asset.
– 1. 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 useable 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.
– 2. Estimated scrap value. The term scrap value means the residual or the salvage value
which is estimated to be realised 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 realisable value.
– 3. Estimated useful life. This is also termed as economic lift of the asset. This may be
calculated in terms of years, months, hours, units of output of other operating
measures such as kilometers in case of a taxi or a truck.
Method of Recording Depreciation
• There are two methods of recording depreciation in
depreciation accounting.
• Direct Method (No Provision for Depreciation
Account is Maintained)
– You can charge depreciation by debiting the
Depreciation Account and crediting the respective Asset
Account. Further, close the Depreciation account by
transferring the amount to the Profit and Loss Account
at the end of the year. The asset account then appears
in the Balance Sheet at its written down value that is,
cost less depreciation at the end of the year.
Direct Method
of providing
depreciation
 Indirect Method
• Indirect Method (Provision for Depreciation Account is
Maintained)
– You have to debit the amount of depreciation to the
Depreciation Account and credit it to the Provision for
Depreciation Account (or Accumulated Depreciation Account, if
so maintained). The amount of depreciation is then trans­ferred
to Profit and Loss Account at the end of the year. However, the
Asset Account will appear at cost.
– Further, the accumulated depreciation appears either shown as
a deduction from the asset or the same may appear in the
liability side of the Balance Sheet. Let’s take a look at the journal
entries that are different from the direct method. The other
entries will remain same.
Indirect method
of depreciation
Methods of Providing Depreciation
• There are various methods used for providing depreciation on fixed assets.
The management of a business enterprise has to select the most
appropriate method based on the consideration of various factors such as
nature of the asset, use of the asset and circumstances that prevail in the
business. The following are the different methods of providing
depreciation:
– 1. Straight line method or Fixed instalment method or Original cost method
– 2. Written down value method or Diminishing balance method
– 3. Sum of years of digits method
– 4. Machine hour rate method
– 5. Depletion method
– 6. Annuity method
– 7. Revaluation method
– 8. Sinking fund method
– 9. Insurance policy method