MEANING OF DEPRECIATION
Generally, the term depreciation is used to denote decrease in value but in accounting, this term is used to denote decrease in the book value of fixed asset. Depreciation is the permanent and continuous decrease in the book value of a fixed asset due to use, affluxion of time, obsolescence, expiration of legal rights or any other cause. According to the Institute of Chartered Accountants of England and Wales, “Depreciation represents that part of the cost of a fixed asset to its owner which is not recoverable when the asset is finally out of use by him. Provision against this loss of capital is an integral cost of conducting the business during the effective commercial life of the asset and is not dependent on the amount of profit earned”.
Depreciation is not the result of fluctuations in the value of fixed assets since, the fluctuation is concerned with the market price of the fixed asset whereas the depreciation is concerned with the historical cost.
An analysis of the definition given above highlights the characteristics of depreciation as follows :
- It is related to fixed assets only.
- It is a fall in the book value of an asset.
- The fall in the book value of an asset is due to the use of the asset in business operations, effluxion of time, obsolescence, expiration of legal rights or any other cause.
- It is a permanent decrease in the book value of an asset.
- It is a continuous decrease in the book value of an asset.
Depreciation, Depletion and Amortisation
The terms depreciation, depletion and amortisation are used often interchangeably. However, these different terms have been developed in accounting usage for describing this process for different types of assets. These terms have been described as follows:
Depreciation is concerned with charging the cost of man made fixed assets to operation (and not with determination of asset value for the balance sheet). In other words, the term ‘depreciation’ is used when expired utility of physical asset (building, machinery, or equipment) is to be recorded.
This term is applied to the process of removing an available but irreplaceable resource such as extracting coal from a coal miner or oil out of an oil well. Depletion differs from depreciation in that the former implies removal of a natural resource, while the latter implies a reduction in the service capacity of an asset.
The process of writing off intangible assets is termed as amortisation. The intangible assets like patents, copyrights, leaseholds and goodwill are recorded at cost in the books of account, Many of these assets have a limited useful life and are, therefore, written off.
It refers to the decline in the useful life of an asset because of factors like (i) technological advancements, (ii) changes in the market demand of the product, (iii) legal or other restrictions, or (iv) improvement in production process.
Meaning of Depreciation Accounting
According to the American Institute of Certified Public Accountants (AICPA), “Depreciation Accounting is a system of accounting which aims to distribute cost or the basic value of tangible capital assets less salvage (if any), over the estimated useful life of the unit (which may be group of assets) in a systematic and rational manner. It is a process of allocation and not of valuation.
7.2 CAUSES OF DEPRECIATION
The main causes of depreciation include the following :
- Physical wear and tear : When the fixed assets are put to use, the value of such assets may decrease. Such decrease in the value of assets is said to be due to physical wear and tear.
- With the passage of time : When the assets are exposed to the forces of nature like whether, winds, rains, etc., the value of such assets may decrease even if they are not put to any use.
- Changes in economic environment : The value of an asset may decrease due to decrease in the demand of the asset. The demand of the asset may decrease due to technological changes, changes in the habits of consumers etc.
- Expiration of legal rights : When the use of an asset (e.g., patents, leases) is governed by the time bound arrangement, the value of such assets may decrease with the passage of time.
7.3 NEED FOR PROVIDING DEPRECIATION
The need for providing depreciation in accounting records arises due to any one or more of the following objectives to be achieved :
- To ascertain true results of operations : For proper matching of costs with revenues, it is necessary to charge the depreciation (cost) against income (revenue) in each accounting period. Unless the depreciation is charged against income, the result of operations would stand overstated. As a result the Income Statement would fail to present a true and fair view of the result of operations of an accounting entity.
- To present true and fair view of the financial position : For presenting a true and fair view of the financial position, it is necessary to charge the depreciation. If the depreciation is not charged, the unexpired cost of the asset concerned would be overstated. As a result, the Position Statement (i.e. the Balance Sheet) would not present a true and fair view of the financial position of an accounting entity.
- To ascertain the true cost of production : For ascertaining the cost of production, it is necessary to charge depreciation as an item of cost of production. If the depreciation on fixed assets is not charged, the cost records, would not present a true and fair view of the cost of production.
- To comply with legal requirements: In case of companies, it is compulsory to charge depreciation on fixed assets before it declares dividend [Sec. 205(1) of the Companies Act, 1956].
- To accumulate funds for replacement of assets : A portion of profits is set aside in the form of depreciation and accumulated each year to provide a definite amount at a certain future date for the specific purpose of replacement of the asset at the end of its useful life.
7.4 BASIC ELEMENTS OF DEPRECIATION
In order to assess depreciation amount to be charged in respect of an asset in an accounting period the following three important factors should be considered :
- Cost of the asset : The knowledge about the cost of the asset is very essential for determining the amount of depreciation to be charged to the profit and loss account. The cost of the asset includes the invoice price of the asset less any trade discount plus all costs essential to make the asset usable. Cost of transportation and transit insurance are included in acquisition cost. However, the financial charges such as interest on money borrowed for the purchase for the purchase of the asset, should no be included in the cost of the asset.
- Estimated life of the asset : Estimated life generally means that for how many years or hours an asset could be used in business with ordinary repairs for generating revenues. For estimating useful life of an asset one must begin with the consideration of its physical life and the modifications, if any, made, factors of obsolescence and experience with similar assets. Infact, the economic life of an asset is shorter than its physical life. The physical life is based mostly on internal policies such as intensity of use, repairs, maintenance and replacements. The economic life, on the other hand, is based mostly on external factors such as obsolescence from technological changes.
- Value of the Asset : The salvage value of the asset is that value which is estimated to be realised on account of the sale of the asset at the end of its useful life. This value should be calculated after deducting the disposal costs from the sale value of the asset. If the scrap value is considered as insignificant, it is normally regarded as nil
7.5 METHODS OF CALCULATING DEPRECIATION
The following are various methods of allocating depreciation in use :
- Fixed instalment method or straight line method.
- Machine hour rate method.
- Diminishing Balance method.
- Sum of years digits method
- Annuity method
- Depreciation Fund Method 7. Insurance Policy Method
- Depletion Method.
- Straight Line Method : This is also known as fixed instalment method. Under this method the depreciation is charged on the uniform basis year after year. When the amount of depreciation charged yearly under this method is plotted on a graph paper, we shall get a straight line. Thus, the straight line method assumes that depreciations is a function, of time rather than use in the sense that each accounting period received the same benefit from using the asset as every other period. The formula for calculating depreciation charge for each accounting period is :
amount of annual Depreciation =
This method has many shortcomings. First, it does not take into consideration the seasonal fluctuations, booms and depression. The amount of depreciation is the same in that year in which the machine is used day and night to that in the another year in which it is used for some months. Second, it ignores the interest on the money spent on the acquisition of that asset. Third, the total charge for use of asset (i.e., depreciation and repairs) goes on increasing form year to year though the assets might have been use uniformly from year to year. For example, repairs cost together with depreciation charge in the beginning years is much less than what it is in the later year. Thus, each subsequent year is burdened with grater charge for the use of asset on account of increasing cost on repairs.
. Machine Hour Rate Method : In case of this method, the running time of the asset is taken into account for the purpose of calculating the amount of depreciation. It is suitable for charging depreciation on plant and machinery, air-crafts, gliders, etc. :
assets whose life can be measured in terms of working time.
3. Written Down Value Method : This is also known as Diminishing Balance method. Under the diminishing balance method depreciation is charged at fixed rate on the reducing balance (i.e., cost less depreciation) every year. Thus, the amount of depreciation goes on decreasing every year
Merits of Diminishing Balance Method : (i) It is very easy to understand and calculate the amount of depreciation despite the early variation in the book value after depreciation (ii) This method put an equal burden for use of the asset on each subsequent year since the amount of depreciation goes on decreasing for each subsequent year while the charge for repairs goes on increasing for each subsequent year. (iii) This method has also been approved by the income tax act applicable in India (iv) Asset is never reduced to zero because if the rate of depreciation is (say) 20%. Then even when asset is reduced to very small value, there must remain the 80% of that small value as on written off balance.
Demerit : (i) It ignores the interest on the capital committed to purchase that asset. (ii) It does not provide adequately for replacing the asset at the end of its life. (iii) The calculation of rate of depreciation is not so simple. (iv) The formula for calculating the rate of depreciation can be applied only when there is some residual of the asset.
Suitability :This method is suitable in those cases where the receipts are expected to decline as the asset gets older and, it is believed that the allocation of depreciation of depreciation ought to be related to the pattern of assets expected receipts.
- Sum of Years digits (SYD) Method: Under this method also the amount of depreciation goes on diminishing in the future years similar to that under diminishing Balance method.
5)Annuity Method : Sofar we have described such methods of charging depreciation which ignore the interest factor. Also, some times it becomes inconvenient for a company to follow any of the methods discussed earlier. Under such circumstances the company may use some special depreciation systems. Annuity method is one of these special systems of depreciation. Under this system, the depreciation is charged on the basis that besides losing the acquisition cost of the asset the business also loses interest on the amount used for purchasing the asset. Here, interest refers to that income which the business would have earned otherwise if the money used in buying the asset would have been committed in some other profitable investment. Therefore, under the annuity method the amount of total depreciation is determined by adding the cost of the and interest thereon at an expected rate. The annuity table is used to help in the determination of the amount of depreciation
Evaluation of Annuity Method
Merits : (i) This method keep into account interest on money spent on the purchase of the asset. (ii) The value of the asset become zero at the end of life.
Demerits. (i) This method is comparatively more difficult than the methods discussed so far. (ii) It makes no arrangement of money to replace the old asset with the new one at the expiry of its life. (iii) Under this method the burden on the profit and loss account is no similar in each year because the depreciation remains constant year after year but the interest goes on decreasing.
Depreciation Fund Method : Business assets become useless at the expiry of their life and, therefore, need replacement. However, all the methods of depreciation discussed above do not help in accumulating the amount which can be readily available for the replacement of the asset its useful life comes to an end Depreciation fund method takes care of such a contingency as it incorporates the benefits of depreciating the asset as well as accumulating the necessary amount for its replacement. Under this method, the amount of depreciation charged from the profit and loss account is invested in certain securities carrying a particular rate of interest. The interest received on the investment in such securities is also invested every year together with the amount of annual depreciation. In the last of the life of asset the depreciation amount is set aside interest is received as usual. But the amount is not invested because the amount is immediately needed for the purchase of new asset. Rather all the investments so far accumulated are sold away. Cash realised on the sale of investments is utilised for the purchase of new asset. The following accounting entries are generally made in order to work out this system of depreciation.
- At the end of the first year
(i) for setting aside the amount of depreciation : The amount to be charge by way of depreciation is determined on the basis of sinking Fund Table given as an Appendix at the end of every book of accountancy.
Depreciation Account Dr.
To Depreciation Fund Account (or Sinking Fund A/c) (ii) For investing the amount charged by way of depreciation :
Depreciation Fund Investment A/c Dr.
To Bank A/c
In the second and subsequent years
- For receiving interest. The interest on the balance of Depreciation Fund Investment outstanding in the beginning of each year will be received by the end of the year. This entry is :
Bank Account Dr.
To Depreciation Fund Account
- For setting aside the amount of depreciation
Profit and Loss A/c Dr.
To Depreciation Fund A/c
- For investing the amount
Depreciation Fund Investment A/c Dr.
To Bank A/c
(Annual instalment of depreciation and interest received invested)
- In the last year
- For receiving interest :
Bank A/c Dr.
To Depreciation Fund A/c
- For setting aside the amount of depreciation Profit and loss A/c Dr.
To depreciation Fund A/c
Note : In the last year no investment will be made, because the amount is immediately required for the purchase of new asset.
- For the sale of investment :
Bank A/c Dr.
To Depreciation Fund Investment A/c
- For the transfer of profit or loss on sale on investments : The profit or loss on the sale of these investments is transferred to the Depreciation Fund Account.
The entry for loss :
Depreciation Fund A/c Dr.
To Depreciation Fund Investment A/c
The entry for profit
Depreciation Fund Investment A/c
To Depreciation Fund A/c (v) For the sale of old asset :
Bank A/c Dr.
To asset A/c
- The depreciation fund is transferred to asset account and any balance left in the asset account is transferred to profit and loss account. The entry is :
Depreciation Fund A/c. Dr. To asset A/c
- The balance in Asset Account represents profit or loss. Therefore it will be transferred to the profit and loss account.
- The cash realised on the sale of investments and the old asset is utilised for the purchase of new asset.
. Insurance Policy Method : Under this method, instead of investing the money in securities an insurance policy for the required amount is taken. The amount of the policy is such that it is adequate to replace the asset when it is worn out. A fixed sum equal to the amount do depreciation is paid as premium every year. Company receiving premium allows a small rate of interest on compound basis. At the maturity of the policy, the insurance company pays the agreed amount with which the new asset can be purchased
Depletion Method : This is also known as productive output method. In this method it is essential to make an estimate of the units of output the asset will produce in its life time. This method is suitable in case of mines, queries, etc., where it is possible to make an estimate of the total output likely to be available.
METHODS OF RECORDING DEPRECIATION
In order to record depreciation, a provision for depreciation may or may
not be maintained. In case a ‘Provision for Depreciation Account’ is maintained, the respective asset appears at its original cost since the depreciation is credited to ‘Provision for Depreciation Account’ instead of the ‘Respective Asset Account’. In case a ‘Provision for Depreciation Account’ is not maintained, the respective asset appears at a written down value since the depreciation is credited to the ‘Respective Asset Account’.
SALE OF AN ASSET
An enterprise may sell an asset either because of obsolescence or inadequacy or even for other reasons. In case an asset is sold during the course of the year, the amount realised should be credited to the Asset Account. The amount of depreciation for the period of which the asset has been used should be written off in the usual manner. Any balance in the Asset Account will represent profit or loss on disposal of the asset. This balance in the Asset Account should be transferred to the profit and loss account.
Depreciation on an asset purchased in the course of a year
Two alternatives are available regarding charging of depreciation on assets which have been bought during the course of an accounting year. These are as follows :
- Depreciation may be charged only for the part of the year for which the asset could have been made available for use after purchase of it.
- Depreciation may be charged for the full year irrespective of the date of purchase. It will be ascertained at the given rate of depreciation. The Income tax authorities also permit this.
Important Note : If there is no specific instruction in the question about depreciation, the students should give the assumption made by them in this regard. But, in case rate of depreciation has been given as a certain percentage per annum and the purchasing date has been given, it is suggested to calculate depreciation only for the part of the year for which the asset has been made available for its use.
7.8 CHANGE OF DEPRECIATION METHOD
To ensure comparability of results from year to year, it is essential that once a method of depreciation is selected by the management it should be followed consistently. However, sometimes a change in the method of depreciation may be required. The change may be required either because of statutory compulsion or required by an accounting standard or change would result in more appropriate presentational the financial statements.
The change in the 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 the Method of Depreciation from a back date
Sometimes a change in the method of depreciation is effected retrospectively. In such a case, the following steps are required :
- Find out the depreciation which has already been charged according to the old method or at the old rate.
- Compute the amount of depreciation that is to be charged according to the new method form the back date upto the end of the previous year.
- Find the difference, if any, under (i) and (ii) mentioned above.
- In the current year in addition to the depreciation for the current year charge also the difference found under step (iii).
Depreciation is a gradual reduction in the economic value of an asset from any cause. The depreciation occurs because of constant use, passage of time, depletion, obsolescence, accidents and permanent fall in the market value. The need for providing depreciation arises to ascertain the profit or losses, to show the assets at its reasonable value, for replacement of assets, to reduce income tax, etc. The various methods of allocating depreciation include : fixed instalment methods, machine hour rate method, diminishing balance method, sum of years digits method, annuity method, depreciation fund method, insurance policy method and depletion method. The straight line method is very suitable particularly in case of those assets which get depreciated more on account of expire of period i.e. lease hold properties, patents etc. Diminishing balance method is suitable in those cases where the receipts are expected to decline as the asset gets older and, it is believed that the allocation of depreciation ought to be related to the pattern of assets expected receipts. In case an asset is sold during the course of the year, the amount realised should be credited to the Asset Account. The amount of depreciation for the period of which the asset has been used should be written off in the usual manner. Any balance in the Asset Account will represent profit or loss on disposal of the asset.
Depreciation: It is the gradual and permanent decrease in the value of an asset from any cause.
Depletion: Depletion refers to the reduction in the workable quantity of a wasting asset.
Obsolescence: It represents loss in the value of an asset on account of its becoming obsolete or out of date.
Fixed instalment method: Under this method, the assets are depreciated at a fixed amount throughout its life span.
Written down value method: Under this method, the depreciation is calculated every year on the diminishing value of the asset.
- SELF ASSESSMENT QUESTIONS
- Why is it necessary to calculate depreciation ? Discuss various factors which are considered for calculating depreciation
- How do the matching principle and going concern concept apply to depreciation.
- Distinguish between the following :
- Straight line method and diminishing balance method.
- Annuity method and depreciation Fund method.
- Depreciation and depletion
- Explain the circumstances under which different methods of depreciation can be employed.
- Discuss the advantages and disadvantage of Insurance Policy Method and Straight Line Methods.
- What is ‘sum of the year-digits method’ to depreciation ? In what way does it differ from sinking fund method of depreciation