DEPRECIATION

MEANING OF DEPRECIATION 

The word "description" comes from the Latin word "depretium" meaning decrease in price. In accounting depreciation means gradual diminution in the economic value of a fix asset. Fixed are acquired by the business with the object of earning revenue. In the process of using such fixed assets, the useful life of the assets decreases. It may be mentioned here that all fixed assets excepting land have a limited useful life. However useful life of the land is considered to be unlimited. The loss in the value in the fixed assets over its useful life because of use, wear and tear or passage of time is termed as description It is one of the consideration while arriving at the profit or loss or the financial position of the business.

In description accounting the cost of the fixed assets is recovered over its useful life. Thus description accounting is the systematic procedure for allocating the cost of the fixed asset over its useful life. The description charge is considered as the cost using the fixed assets or an expense of earning revenue during a particular period. Description is provided on all fixed assets expecting land by changing a portion of the cost of the fixed assets against the revenue of the period.

DEFINITION OF DEPRECIATION

According to International Accounting Standard committee " Depreciation is the allocation of the depreciable  amount of asset over its estimated life. Depreciation for the accounting period is charged to income either directly or indirectly.

According to the Institution of Charted Accountant of India "Depreciation is 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 allocation so as to charge a fair portion of the depreciable amount in each accounting period during the expected useful life on the asset. Depreciation includes amortization of assets whose useful is predetermined.

CHARACTERISTICS OF DEPRECIATION   

1. Depreciation is the decrease in the value of a fixed assets.
2. It is a continuous, regular, gradual and permanent decline in the utility value of an assets.
3. Depreciation is not always physical deterioration but deterioration of usefulness.
4. It is the process of spreading the cost of the fixed assets over their useful life.
5. Depreciation is treated as business expenses.
6. Depreciation does not result on outflow of cash.
7. Depreciation occurs even if the assets is not in use.
8. It may be charged even through the asset appreciates in money value.

NEED FOR DEPRECIATION    

In Accounting the need of charging depreciation arises because of the following reason. 

To find out the true profit or loss :

The entire cost of fixed assets should be spread over its useful life and the profit and loss Account of each year should bear proportionate amount. If no charge is made for the depreciation the profit of the concern will be more to the that extent.

To show correct financial position :

The purpose of the balance sheet is to show the true and correct financial position of the concern. If depreciation is not provided the value of the fixed assets will be overstated in the balance sheet than the real ones.

To facilitate replacement :

If the depreciation is not charged in the entire profit distributed among the shareholders in the form of dividend. When the assets becomes useless and it is necessary to purchase a new one, the concern has borrow money for replacing the old asset. If depreciation is deducted from profit and keep in a fund which goes on accumulating, the firm can be able to replace the asset when necessary without disturbing the financial health of the business.

To facilitate fixation of prices of products : 

Selling price fixation depends upon the cost of production. True cost of production can be found out only if depreciation is taken into consideration.

To comply with legal requirements :

As per section 205 of Indian Companies Act, 1956, depreciation must be provided before the declaration of dividend to the shareholder.Though there is no such law for sole trading and partnership firms depreciation should be provided from sound financial point of view. Further, depreciation is a necessity to comply to the accounting standards.

CAUSE OF DEPRECIATION 

The main cause of depreciation are:-

Use - The value of assets decreases because of its constant use. The more an asset is used, the more is the wear and tear and decrease in its value.

Efflux of time - Sometimes sheer passage of time causes the value of an assets to decrease with the expiry of time the value of assets such as lease, copyright, patent etc. decrease even if they are not used in business operations. In this case depreciation is known as "amortization" .

Obsolescence -  Due to the technological improvement and new inventions the value of an existing assets may decrease. A businessman like to have a new machinery which produces more qualitative products more qualitative products in large quantities at low cost and discards the old and outdated one. Discarding of outdated machinery will cause some loss to the business and such loss to the business and such loss is called depreciation on account of obsolescence.

Depletion -  The exhaustion of a natural resource is known as depletion. Wasting assets like mines, oil wells, etc, get exhausted due to continuous extraction of mineral of the value of such assets gradually falls. Annually decreases in value is termed as depreciation.

Accidents - An asset may lose some of its value due to an accident.

Natural causes - The natural causes such as the effect of weather, sunshine, rain, wind, evaporation etc, reduces the value  of fixed assets.

FACTORS DETERMINING THE AMOUNT OF DEPRECATION 

It is almost impossible to calculate the actual and accurate amount of deprecation. However, depreciation should be estimated very cautiously and with vary much accuracy because that will effect the profit or loss of the business. To estimate the amount of depreciation following factor is considered.

1. Cost of the asset - The cost of the asset means the price paid at the time of purchase and sll additional expenses incurred till the assets is put to use such as freight, carriage, installation charges etc. However, the interest on money borrowed to purchase the asset is not taken into consideration.
2. Useful  life - The estimated working life of the asset is to determined. It may be predicted in number of years, or hours of work or units of output etc.
3. Scrap or Residual value - The sale price of an asset when it becomes useless is known as residual value or scrap value. To estimate the amount of depreciation the scrap value is to be deducted from the cost of the asset.
4. Other factors - While computing the amount of depreciation, in addition to asset, sale of asset etc , are to be considered.

Methods of recording depreciation :-

There are two methods to record depreciation in the books of account.

1. Direct Method 
2. Indirect Method

Direct Method :- Under this method depreciation is directly charged against the assets.In this case following entries are made.

• When asset id purchased for cash.

           Asset A/c                           Dr

          To Cash/Bank A/c                  

• When depreciation is provided at the end of the year.

          Depreciation A/c               Dr

          To Asset A/c

• When Depreciation is transferred to profit loss A/c.

          At the end of the accounting year, depreciation is transferred to profit and loss account.

          

          Profit and loss A/c              Dr 

          To Depreciation A/c 

The above two entries are passed every year till the asset become a scrap.

• When asset sold as a scrap.

          Cash/Bank A/c                    Dr   (Amount Received)

          Profit and Loss A/c             Dr   (If Loss)

          To Asset A/c                               (Book Value of Asset)

          To Profit and Loss A/c                (If Profit)

Indirect Method :- Under this method amount of depreciation is not charged to Assets Account directly but credited to provision for depreciation account or Accumulated depreciation account.In this case following journal entries are passed.

• When assets are purchased for cash.

          Asset A/c                            Dr
          To Cash/Bank A/c         

• When annual depreciation is charged 

          Depreciation A/c                Dr
          To Provision for Depreciation A/c
          To Accumulated Depreciation A/c

• When depreciation is transferred to profit and loss A/c.

           At the end of accounting year, depreciation is transferred to Profit and loss Account.
     
          Profit and Loss A/c              Dr
          To Depreciation  A/c 

The above two entries are passed every year till the asset become a scrap. Provision for Depreciation Account goes accumulating in the liabilities side of balance sheet and the asset appears in the asset side of Balance sheet at its original value till the date of sale.

• When asset is sold as a scrap, the following two entries are passed.

          1. For transferring the balance of provision for Depreciation Account to Asset Account in order to know the book value of the asset.

          Provision for Depreciation A/c                Dr

          To Asset A/c

          2. For the sale of Asset.

          Cash/Bank A/c                                         Dr

          Profit and Loss A/c                                  Dr  (If Loss)

          To Asset A/c                                                   (Book value of asset)

          To Profit and Loss A/c                                    (If Profit)

Methods of Calculating Depreciation :-

       There are numerous methods of apportioning the cost of a fixed asset over years of its use. Some of the main methods of calculating depreciation are given below.

• Fixed Installment Method / Straight Line Method 

          Under this method, a fixed percentage of the original cost of the fixed asset minus scrap value is written off every year till the end of its estimated life by way of depreciation. This method is also known as straight line method. because it is assumed that cost of the asset expaires at a steady (straight line ) function of time.The amount of depreciation remains constant for each and every year till the end of its useful life.

         Formula :   D = C - S / N

                            

                            Where D = Amount of Depreciation

                                        C = Original Cost of Asset

                                        S = Scrap Value

                                        N = Life in number of years

                           Percentage of Depreciation = Depreciation / Cost of Asset * 100.

                      

                         

Advantages :-

• This method is very simple and easy to calculate depreciation.
• This method is suitable when life of an asset can be accurately estimated such as patents, leasehold property, trademarks etc.
• In this method the book value of asset can be reduced to zero i.e, written fully.

Disadvantages :-

• It is an illogical method. With the expiry of time efficiency of time efficiency of an asset decreases but the amount of depreciation remains the same.
• When additional assets are purchased calculation of depreciation creates problem.
• It does not make any provision for the interest on capital invested in fixed assets.
• This method is not recognized by Income Tax Authorities.