Depreciation

Definition“Depreciation is the permanent and continuing diminution in the quality, quantity or value of an asset”

The Institute of Chartered Accountants of England and Wales defines depreciation as “that part of the cost of a fixed asset to its owner which is not recoverable when the asset is finally put 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 upon the amount of profit earned”

Meaning of depreciation accounting

According to the American Institute of Certified Public Accountants, ‘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

Causes of Depreciation

Causes of Depreciation• Physical Wear & Tear: When fixed assets are

put to use, the value of each asset may decrease. Such decrease is due to physical wear & tear.

• With passage of time: When the assets are exposed to the forces of nature like weather, winds, rains etc the value of such assets may decrease even if they are not put to any use.

Causes of Depreciation contd.

• Changes in economic environment: The value of an asset may decrease due to decrease in the demand of an asset. The demand for an asset may decrease due to technological changes, changes in the habits of customers 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.

Need for charging depreciation

• To ascertain true results of operations: as it is necessary to charge depreciation (cost) against income

• To Present true and fair view of the financial position: If the depreciation is not charged, the unexpired cost of the asset concerned would be overstated.

• To comply with legal requirements: Section 205(1) of the Companies Act, 1956 and section 32 of the Income Tax Act, 1961 requires it.

Factors affecting the amount of depreciation• Historical Cost: of a depreciable asset implies the

cost incurred on its acquisition, installation, commissioning and for additions to or improvements thereof which are of capital nature

• Expected useful life: of a depreciable asset implies either the period over which it is expected to be used or number of production units expected to be obtained from it

• Estimated residual value: of a depreciable asset implies the value expected to be realised on its sale or exchange on expiry of its useful life

Methods of Recording DepreciationThere are two methods1.When a provision for depreciation account is

maintained

2.When a provision for depreciation account is not maintained

Methods of Depreciation Following are some of the methods of providing depreciation•Straight Line Method•Diminishing Balance / Written Down Value •Sum of years digits Method•Machine hour rate Method•Depletion Method

Straight Line Method• Also termed as Fixed Installment Method.

• Depreciation is charged evenly every year through out the effective life of the asset.

• E.g. If an asset has been purchased for Rs 10,000 and it will have a scrap value of Rs 1,000 at the end of its useful life of 10 years, the amount of depreciation to be charged every year will be computed as follows

Depreciation = (Rs 10,000 – Rs 1,000)/10 years = Rs 900 each year

The depreciation can also be mentioned as a % of cost of asset. In this case its 9% ( 10,000 / 900 X 100)

Straight Line Method (cont)Merits:

1. Easy to understand and easy to calculate amount of depreciation.

2. The book value of the asset becomes zero or equal to its scrap value at the end of its useful life

Demerits1. The total charge for use of asset goes on

increasing from year to year. But this method charges depreciation uniformly over useful life

Diminishing Balance/Written Down Value

• Depreciation is charged on the book value or WDV (written down value) of the asset each year.

• Book value is equal to year end value of the asset less depreciation

• e.g. if the cost of an asset is Rs 20,000 and the rate of depreciation is 10%, the amount of depreciation in the first year will be a sum of Rs 2,000. In the second year, the depreciation will be on the book value i.e. Rs 18,000 (20,000- 2,000) and so on

Merits:1.The total charge (i.e. depreciation plus repairs)

remains almost uniform year after year, since in earlier years the amount of depreciation is more and the amount of repairs and renewals is less whereas in later years the amount depreciation is less and the amount of repairs and renewals is more.

Demerits:1. It is difficult to calculate rate of depreciation.2.It takes very long time to write an asset down

to scrap value

Sum of years digits (SYD) Method

• This method is on the pattern of WDV method. The amount of depreciation charged goes on decreasing every year.

• The depreciation is calculated as per following formula:

E.g. If cost of an asset is Rs 10,000 and it has an effective life of 5 years the amount of depreciation to be written off each year will be computed as follows:

1st Year: 5 X 10,000 = Rs 3,333 1+ 2 + 3 + 4 + 5

2nd Year : 4 X 10,000 = Rs 2,666 1 + 2 + 3 + 4 + 5

3rd Year: 3 X 10,000 = Rs 2,000 1 + 2 + 3 + 4 + 5

4th Year: 2 X 10,000 = Rs 1,333 1 + 2 + 3 + 4 + 5

5th Year: 1 X 10,000 = Rs 667 1 + 2 + 3 + 4 + 5

Total depreciation = 3,333+2,666+2,000+1,333+667for 5 years = 10,000 (Approx)

Machine Hour Rate Method• Also known as “Service Hours Method”• The working life of machines is estimated in

terms of hours (not years) for which it is expected to be used and depreciation for a particular year is calculated on the basis of hours for which the machine has worked during the year.

• Under this method, depreciation is provided by means of a fixed rate per hour calculated by dividing the value of asset by estimated number of effective working hours during the useful life of the asset.

Depletion (Productive Output) Method

• The life of the asset is estimated in terms of output which could be raised during its life and depreciation is related to the quantity of output and not passage of time

• This method is usually used for wasting assets like mines, quarries etc

• Depletion refers to physical deterioration by exhaustion of natural resources (ore deposits in mines, oil wells, quarries, timber stands etc.)

Basis of Distinction Straight Line Method Written Down Value

Basis of calculation Depreciation is calculated at a fixed percentage on the original cost in each year

Depreciation is calculated at a fixed percentage on original cost (in first year) and on book value (in subsequent years)

Amount of depreciation The amount of depreciation remains constant over the years

The amount of depreciation goes on decreasing

Total charge (depreciation plus repairs and renewals)

Total charge in later years is more as compared to that in earlier years since the amount of repairs and renewals goes on increasing as the asset grows older, whereas amount of depreciation remains constant year after year

Total charge remains almost uniform since in earlier years the amount of depreciation is more and the amount of repairs and renewals is less and vice versa

Book Value Book value becomes zero or equal to scrap value

The book value of the asset does not become zero

Calculation – depre. Rate Easy to calculate the rate Difficult to calculate rate

Important terms• Book value / WDV as on date = Original cost –

depreciation till that date • Book value as on date of sale = original cost –

total depreciation till date of sale• Profit = Sale proceeds – book value as on the

date of sale • Loss = Book value as on date of sale – Sale

proceeds