Depreciation may be described as a permanent, continuing and gradual shrinkage in the book value of fixed assets. It is the cost of assets consumed in business.
Definition
According to accounting standard VI, “Depreciation is a measure of the wearing out, consumption or other loss of value of a depreciable asset arising from use, effusion of time or obsolescence through technology and market changes. 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 amortization of assets whose useful life is predetermined.”
In the words of accounting terminology bulletin number 1 of the committee on accounting procedures of American Institute of Certified Public Accountants depreciation is “A system of accounting which aims to distribute cost, or other tangile value of capital asset, less salvage if any, over the estimated useful life of the unit (which may be a group of assets) in a systematic and rational manner. It is a process of allocation and not of valuation.”
Features of depreciation
(i) Depreciation is different from fluctuation. Fluctuation is an account of change in market price.
(ii) Depreciation is used only for tangible fixed assets and not for fictitious assets.
(iii) Depreciation is a normal feature.
(iv) Depreciation is the allocation of cost of assets to the period of its life.
(v) Depreciation takes place gradually except in case of new technology.
(vi) Depreciation is different from maintenance. Maintenance means keeping the assets in working condition.
(vii) Depreciation is charged from profit and loss account.
(viii) Depreciation is reduction of book value of fixed assets.
Need for charging of depreciation
Proper Accounting of Cost of Production : It is necessary to show depreciation in profit and loss account for ascertaining the correct cost of production.
Indicates Correct Financial Position of the Organization : If depreciation is not charged on fixed assets, the balance sheet will indicate incorrect financial position of the business. That is why depreciation needs be deducted from the value of fixed tangible assets in order to show their proper value in the balance sheet.
Legal Obligation : Joint Stock Companies are under legal obligation to charge depreciation on fixed assets.
Calculation of Profits Correctly : Depreciation is a loss and must be charged to profit and loss account before the calculation of net profit or net loss.
Replacement of Assets : On account of continuous use of assets, they become useless after some years and there is a dire need to replace them by the new assets. Depreciation fund or insurance policy fund helps to replace the assets easily.
In order to ascertain correct amount of net profit, it is compulsory to deduct depreciation from fixed assets otherwise net profit will be inflated.
Factors affecting depreciation
Added Assets : Fixed assets are purchased as and when there is a need for them. While calculating depreciation on fixed assets, depreciation should be charged on additions to the asset during the year.
Life of Fixed Assets : Calculation of depreciation depends on the useful life of fixed assets. If the life is long, the amount of depreciation per year will be less and vice versa.
Obsolescence : If an asset becomes obsolete, it is no longer used. It is necessary to consider the chance of obsolescence of the asset.
Residual Value of Assets : Residual value is the value of the asset when it becomes useless. Scrap value is estimated to deduct it from the fixed asset to calculate annual depreciation.
Total Cost of Fixed Assets : Total cost of fixed assets are ascertained by adding purchase price and all other expenses to acquire it.
Causes of depreciation
Decay : Fixed assets lose their strength on account of natural causes like moisture, sunshine, storms, etc.
Accidents : Loss in the value of assets is caused by accidents also.
Wear and Tear : Value of fixed assets becomes less on account of wear and tear caused by constant use.
Passage of Time : The effective life of assets is decreasing with the expiry of time like copyrights, patents and leasehold premises.
Depletion : There is loss of mineral wealth on account of constant working of mine. Suppose a coal mine has 90,000 tons of coal and in the first year 20,000 tons of coal has been extracted, leaving 70,000 tons.
Obsolescence : When a new and improved technology comes, some assets are discarded to better and improved models as they are more efficient and economical.
Terminology used for depreciation
Amortization : It is often used as a general term to write off intangible assets such as leasehold mines, franchises, copyrights and patents which have entitlement to use for a specific period. The procedure for amortization of a portion of the cost of intangible assets, is the same as for recording depreciation of fixed assets.
Depletion : It is on account of exhaustion of natural resources such as coal & oil. The more we extract mineral wealth from the mines more they are depleted. Decrease in mineral wealth is known as depletion.
Fluctuation : Increase or decrease in the market value of fixed assets is termed as fluctuation. If the value of investment falls due to market price, they are entered at the fluctuated price.
Obsolescence : Innovations in technology make the old machinery and equipments obsolete or useless, for example black and white T.V’s were replaced by colour TV.’s.
Methods of depreciation
The depreciation to be provided for during an accounting year is the function of depreciable amount and the method of depreciation. For this, two methods are recommended by professional accounting practice in India. They are ‘Straight line method’, and ‘Written down value method.’
Straight Line Method
This method is also known as ‘Fixed Instalment Method’, ‘Equal Instalment Method’, and ‘Original Cost Method’. Under this method, the amount of depreciation is calculated by deducting the scrap value of the fixed asset from the original cost and then dividing the remainder (amount) by the number of estimated years of life of the asset as under :
For example, an asset costs Rs. 80,00,000 and its scrap Value is Rs. 1,00,000 and its estimated life is 10 years. The yearly amount of depreciation to be written off will be =
= Rs. 7,90,000 yearly.
Merits
Equal Burden of Depreciation : According to this method, equal amount of depreciation is charged to the profit and loss account every year. In this way, the burden of depreciation on the profit and loss account is equal.
Simple to Calculate : Under this method, calculation of depreciation is very simple. That is why, this method is very popular.
Knowledge of Cost with up-to-date Depreciation : The original cost of asset, under this method, is shown in the balance sheet and up-to-date depreciation is recorded as a direct reduction from it.
Assets are Completely Written
Off : According to this method of depreciation, an asset can be reduced to zero.
Demerits
Under Pressure in Later years : The efficiency and utility of machinery is much more in the earlier years than that of later years. Therefore, more depreciation should be charged in earlier years in comparison to the later ones. But according to this method, depreciation remains fixed for all the years to come.
Omission of Interest : Under this method, loss of interest on the investment is not taken into consideration. The same amount must have earned interest if it had been invested out of business.
Scrap Value : It is very difficult to ascertain scrap value of a fixed asset after a decade or two in advance from the date of installation.
Unrealistic Calculation of Zero Value : The value of assets is reduced to zero according to fixed depreciation method. But, practically, it continues to be used in business.
Difficult to Compute : In case of a number of machines in an organization with different life spans, it becomes difficult to calculate depreciation on each machinery.
Suitability
Fixed line method of depreciation suits those assets which do not incur heavy expenses on maintenance and have a shorter span of life and are also not very costly.
Method of recording depreciation
Following formal entries are recorded under this method of depreciation.
(i) For Purchases of Fixed Assets
Asset A/c Dr
To Bank/Cash A/c
(Being asset purchased for cash)
(ii) For Charging Depreciation at the End of Every year
Depreciation A/c Dr
To Asset A/c
(Being annual depreciation charged on the asset)
(iii) For entry on the sale of Asset
Bank/Cash A/c Dr
To Asset A/c
(Being asset sold for Cash)
(iv) For Loss on Sale of Assets
Profit & Loss A/c Dr
To Assets A/c
(Being loss on sale of asset)
(v) For Profit on Sale of Assets
Profit & Loss A/c Dr
To Assets A/c
(Being Profit on sale of fix assets)
Provision for depreciation
Depreciation is not directly charged to the assets account under this method. Depreciation for the accounting period is debited to the depreciation account and credited to accumulated depre-ciation account of provision for depreciation account. In this way the asset account always appears in the ledger at its original cost. The balance on the credit side of ‘Provision for Depreciation A/c’ shows the total amount of depreciation accumulated to-date. But when the particular asset is disposed off or discarded, the total accumulated depreciation for that asset is transferred to the credit side for the asset account.
After recording this entry, the balance in the provision for depreciation account will indicate the accumulated depreciation of the assets in service or unsold assets.
Journal Entries
(i) For Purchase of Assets
(i) Assets A/c Dr
To Bank A/c
(Being purchase of assets)
(ii) For Depreciation on Assets
Depreciation A/c Dr
To Accumulated Depreciation A/c
or
Provision for depreciation A/c
(Being depreciation on the asset)
(iii) For writing off Depreciation
Profit & Loss A/c Dr
To Depreciation A/c
(Being depreciation written off)
(iv) For Sale of Assets
Bank A/c Dr
Provision for Depreciation A/c Dr
Profit & Loss A/c (Loss on Sale) Dr
To Assets A/c
(Being the asset disposed off incurring
loss on sale)
Distinction between Depreciation A/c
and Provision for Depreciation A/c
Assets disposal account
When the asset is disposed off, the cost of the asset is transferred to ‘Assets Disposal Account’. This account is designed to provide a complete and clear view of all the transactions concerning the sale of an asset. The balance of assets disposal account is transferred to the profit and loss account as per the following journal entries :
Journal Entries
(i) Assets Disposal A/c Dr
To Assets A/c
(Being transfer of written down value of the asset sold to asset disposal A/c)
(ii) Provision for depreciation A/c Dr To assets Disposal A/c
(Being the transfer of depreciation to Assets Disposal A/c)
(iii) Bank A/c Dr
To Assets Disposal A/c
(Being amount received from the sale of assets)
(iv) Profit & Loss A/c Dr
To Assets Disposal A/c
(Being loss on sale of asset)
Written down value method
The value of fixed assets goes on decreasing under this method. For example, if a machinery is purchased for Rs. 90,00,000 and depreciation is charged 10% per year, the figure will be as follows.
Assets Disposal A/c Dr
To Profit & Loss A/c
(Being profit on sale of assets)
1st year on Rs. 90,00,000 @ 10%
Rs. 900,000
2nd year on Rs. 81,00,000, i.e.
Rs. = 8,10,000
3rd years Rs. – 72,90,000, i.e. 81,00,000–8,10,000 =
=7,29,000
4th year on Rs. 64,61,000 i.e. Rs. 72,90,000–7,29,000 =
= 6,46,100
It is concluded from these calculations that depreciation of each year calculated on the book value of assets at the beginning of that year, rather than on the original cost. The value of the asset and depreciation charged on it decreases every year. This method is also known as. ‘Reducing Instalment method.’
Merits
Approved by Income Tax Department : This method of providing depreciation is permissible under income tax regulations.
No Undue Pressure : The efficiency and usefulness of a machine is more in the initial years than that of the subsequent years.
Never Zero Balance : Under this method, balance of an asset is never zero. Deprecation, however small, is debited to Profit & Loss A/c so long as the asset remains in use.
Easy Calculation : It is easy to ascertain the amount of depreciation as per diminishing balance method though some new assets purchased one after the other. All the assets are grouped to calculated depreciation.
Equal Charge Against Income : The total burden of Profit and loss account, under this method, in connection with repairs and depreciation, put together, remains equal in subsequent years. The reason is simple that at the early stage depreciation is more in comparison to repair charges. But in the later years, the amount of depreciation becomes less and expenses on repairs hike. In this way, the combined amount of depreciation and repairs almost remains the same.
Demerits
Omission of Interest Factor : This method also does not take into consideration the loss of interest on the amount invested in the business.
Difficult to Determine Rate of Depreciation : The rate of providing depreciation under diminishing balance method cannot be easily calculated. The rate is often on the higher side as it involves a pretty long period to reduce an asset to its scrap value. On the other hand, if rate of depreciation is lower, the asset may become obsolete earlier.
Original Cost and up-to-date Depreciation can not be Calculated : The original cost of assets as per this method, is not given in the balance sheet. The assets are generally grouped and it becomes difficult to know their specific identity. The residue balance shown in the final account may continue even after the asset is scrapped.
Asset can not be Completely Written off : The value of an asset, under this method, even after becoming useless and obsolete cannot be reduced to zero.
Distinction between straight line and reducing cost method
- Straight line method is not applicable for income tax purpose but written down value method is applicable for income tax purpose.
- According to the straight line method, balance of the assets is reduced to zero. But balance of assets is not reduced to zero in written down value method.
- Equal amount of depreciation is charged every year under straight line method. But the amount of depreciation goes on reducing every year according to the written down value method.
- Under straight line method, depreciation is calculated at original cost. But according to written down value method, depreciation is calculated on reducing balance of assets.
- Real location is necessary when additional assets are purchased under straight line method. But the
real location of assets is not necessary as per written down value method. - Straight line method is suitable for assets like furniture, patents while written down value method is suitable for assets like plant, machinery, land and buildings.
