Depreciation

 

Image by - shutterstock.com

Depreciation

 

Meaning of Depreciation

 

The word depreciation is derived from the Latin word ‘Depretium’ which means reduction. Every business concern acquires some fixed assets which are used in the business for its trading activity. These assets are purchased for business with an intention of permanent use and not for resale.

 

Working life of all fixed assets, except Land, decreases with the passage of time. The value of these assets decrease every year. So, reduction in the value of fixed assets due to its Wear and Tear or actual use is called as ‘Depreciation’.

 

“Depreciation is defined as shrinkage in the value of an asset due to wear and tear, passage of time or obsolescence.”

 

Unless depreciation is charged to the revenues, the true income of the business cannot be ascertained properly, and we cannot make provision for their replacement. Purchase of an asset is a capital expenditure and not a recurring expenditure.

 

Accounting Related Articles

👆 Financial Accounting
👆 Types of Accounting
👆 Cost Accounting
👆 Types of Cost Accounting
👆 Methods and Techniques of Costing
👆 Cost Sheet
👆 Cost Management
👆 Cost Control and Reduction
👆 Cost Accounting System
👆 Difference between Cost Accounting and Financial Accounting
👆 Management Accounting
👆 Materials Control
👆 Bookkeeping
👆 Accounting methods
👆 Accounting Terminologies
👆 Double Entry System
👆 Classification of Accounts
👆 Journal in Accounting
👆 Ledger
👆 Trial Balance
👆 Bank Reconciliation Statement

Definition of Depreciation

 

“Depreciation is the gradual decrease in the value of an asset from any cause.” -R.N.Carter.

 

“Depreciation may be defined as a gradual deterioration in the value due to use.” -R.G.Williams.

 

“Depreciation may be defined as permanent and continuing diminution in the quality,quantity or the value of an asset.” -William Pickles.

 

“A measure of the wearing out,consumption or other loss of a value of a depreciable asset arising from use, effluxion of time or obsolescence through technology and market changes.” -The Institute of Chartered Accountants of India.(ICAI)

 

“Depreciation is the allocation of the depreciable amount of an asset over its estimated useful life. Depreciation for the accounting period is charged to income either directly of indirectly.” -The International Accounting Standard Committee.(ICAC)

 “Continuous, gradual and permanent reduction in the value of assets is called depreciation.”

Need and Importance OF Depreciation

 

Depreciation is charged to Profit and Loss A/c as it is an element of Cost. It is also essential to arrive at true value of the asset and also net Profit or Loss during a particular accounting period. Even if an asset is not in use, its value is reduced due to passage of time. Depreciation is Cost/Loss to the business. It is a non – cash expenditure. It is a Nominal Account.

 

If depreciation is not provided and deducted from the value of assets, the assets will be overvalued and we cannot find out true and fair financial position of the business.

 

Depreciation is necessary to make provision for replacement of old assets. If provision for depreciation is not made, the business may not have sufficient funds to replace them.

 

It enables the business to compute and pay correct amount of tax to the Government.

 

Depreciation must be calculated and equivalent funds should be provided for every year, so that at the end of its life, the assets may be easily replaced.

Factors to be Considered While Charging Depreciation

 

While deciding the amount of depreciation to be charged every year, the following basic factors should be taken into consideration.

 

Cost of Asset

 

The cost of asset is an important factor while computation of depreciation. Historical cost of the assets represents the money spent in connection with its acquisition, installation or improvement thereof.

 

In short Original Cost of the Assets = Purchasing Price of Assets + its Installation or Incidental charges i.e. cost of transportation, transit insurance, custom duty, unloading charges, brokerage, wages for fixation , amount spent for repairs on second hand assets or reconditioning, etc.

 

Useful or Estimated Economic Life of Assets

 

The useful life of an asset is generally taken to be in terms of years or working life of the assets expected utility to the business concern.

 

In other words it means the business should use the assets till the business gets useful services from the asset and earns Profit from its use.

 

Estimated Terminal or Scrap or Residual Value

 

Scrap Value is the Realisable (net) value of the asset at the end of its economic life. This value should be calculated after deducting the disposal and removal costs from the sale value of the asset.

 

Stock Market Related Articles

👆Option Trading in India
👆Option Trading Greeks
👆How to calculate option price (Options Pricing)
👆Options Trading Strategies India
👆Options Trading Strategies Long Call
👆Options Trading Strategies Long Put
👆Options Trading Strategies Short Call
👆Options Trading Strategies Short Put
👆Options Trading Strategies Collar
👆Options Trading Strategies Bull Call Spread
👆Options Trading Strategies Bull Put Spread
👆Options Trading Strategies Bear Call Spread
👆Options Trading Strategies Bear Put Spread

Methods of Depreciation

 

There are different methods of charging depreciation according to the nature of asset, use of asset and necessity. Following are the various methods for providing depreciation.

 

Fixed Instalment or Straight Line or Original Cost Method.

Diminishing or Reducing Balance or Written Down Value Method.

Annuity Method.

Depreciation Fund Method.

Revaluation Method.

Insurance Policy Method.

Machine Hour Rate Method, etc.

Fixed Instalment or Straight Line or Original Cost Method

 

Under this method depreciation is charged at a specific percentage on the Original Cost of the asset every year, so as to reduce the asset account to nil or to its Scrap value at the end of the estimated life of the asset.

 

To ascertain the annual charge under this method, all that is necessary is to divide the original value of the asset (minus its residual value, if any) by the number of years of its estimated life.

 

Depreciation is calculated by following formula-

 

Depreciation (p.a.) = Original cost – Scrap Value/ Estimated life of the asset (in years)

Original cost of Asset = Purchasing price of an Asset + Incidential Charges etc.

Example

 

A machine costing 15,000 is purchased and installation charges of 3000 are paid. Estimated life of the asset is 10 years and the Scrap Value is estimated to be 2,000 at the end of its life. The amount of depreciation would be,

 

Depreciation (p.a.) = (15000+3000)-2000/10

 

                            = 16000/10

 

                            = 1,600 p.a.

 

Depreciation is also charged when the rate of depreciation is given. It is calculated by using following formula

 

Depreciation (p.a.) = Cost of the Asset x Rate of depreciation/100

 

Example

 

The Original cost of an asset is 80,000, and the depreciation is charged @ 10% p.a. at Fixed Instalment Method, then the amount of depreciation will be computed as follows.

 

Depreciation p.a. (1st year) = 80,000 x 10/100 = 8,000 p.a.

WDV= 80,000 – 8,000 = 72,000 (at the end of the 1st year)

 

Depreciation p.a. (2nd year) = 80,000 x 10/100 = 8,000 p.a.

WDV= 72,000 – 8,000 = 64,000 (at the end of the 2nd year)

 

Depreciation p.a. (3rd year) = 80,000 x 10/100 = 8,000 p.a.

WDV= 64000 – 8,000 = 56,000 (at the end of the 3rd year)

 

Depreciation p.a. (4th year) = 80,000 x 10/100 = 8,000 p.a.

WDV= 56,000 – 8,000 = 48000 (at the end of the 4th year)

Note: In this method depreciation is charged every year on Original Cost of the asset.

Diminishing or Reducing Balance or Written Down Value Method

 

Under this method, depreciation is calculated at a certain percentage each year on the balance of the asset which is brought forward from the previous year. In other words, under this method depreciation is calculated at a specific percentage on the value of that asset which stands in the books of accounts on the opening date of each year.

 

The amount of depreciation charged per year is not fixed but it goes on decreasing gradually as the opening balance of the asset will decrease in each year. The charges depreciation in initial periods are higher than those in the later periods.

 

Example

 

The Original Cost of an asset is 80,000,and the depreciation is charged @ 10% p.a. under Written Down Value Method, then the amount of depreciation will be computed as follows:

 

Depreciation p.a. (1st year) =80,000 X 10/100 = 8,000 p.a.

WDV= 80,000 – 8,000 = 72,000 (at the end of the 1st year)

 

Depreciation p.a. (2nd year) =72,000 X 10/100 = 7,200 p.a.

WDV= 72,000 – 7,200 = 64,800 (at the end of the 2nd year)

 

Depreciation p.a. (3rd year) =64,800 X 10/100 = 6,480 p.a.

WDV= 64,800 – 6,480 = 58,320 (at the end of the 3rd year)

 

Depreciation p.a. (4th year) =58,320 X 10/100 = 5,832 p.a.

WDV= 58,320 – 5,832 = 52,488 (at the end of the 4th year)

 

Note: In this method depreciation is charged on original cost in first year and from the next year it is charged on Written Down Value (WDV)of an asset. It is charged on opening balance of every year.