- What is a Depreciation?
- Meaning of Depreciation
- Features of Depreciation
- Causes of Depreciation
- Need for Depreciation
- Factors Affecting the Amount of Depreciation
- Advantages of the Straight Line Method
- Limitations of the Straight Line Method
- Written Down Value Method
- Advantages of the Written Down Value Method
- Limitations of the Written Down Value Method
- Straight Line Method and Written Down Method: A Comparative Analysis
- Methods of Recording Depreciation
What is a Depreciation?
Depreciation meaning- The decline in the value of a fixed asset due to use, the passage of time, or obsolescence. if a business enterprise procures a machine and uses it in a production process then the value of the machine declines with its usage. Even if the machine is not used in the production process, we can not expect it to realize the same sales price due to the passage of time or arrival of a new model (obsolescence). It implies that fixed assets are subject to a decline in value and this decline is technically referred to as depreciation.
As an accounting term, depreciation is that part of the cost of a fixed asset that has expired on account of its usage and/or lapse of time. Hence, depreciation is an expired cost or expense, charged against the revenue of a given accounting period.
For example, a machine is purchased for Rs.2,00,000 on April 01, 2017. The useful life of the machine is estimated to be 10 years. It implies that the machine can be used in the production process for the next 10 years till March 31, 2016. You know that by its very nature, Rs. 2,00,000 is a capital expenditure during the year 2017-18.
However, when an income statement (Statement of Profit and Loss) is prepared, the entire amount of Rs.2,00,000 can not be charged against the revenue for the year 2017-18, because of the reason that the capital expenditure amounting to Rs.2,00,000 is expected to derive benefits (or revenue) for 10 years and not one year. Therefore, it is logical to charge only a part of the total cost say Rs.20,000 (one-tenth of Rs. 2,00,000) against the revenue for the year 2017-18.
This part represents the expired cost or loss in the value of the machine on account of its use or passage of time and is referred to as ‘Depreciation’. The amount of depreciation, being a charge against profit, is debited to the Income Statement (Statement of Profit and Loss).
Depreciation may be described as a permanent, continuing, and gradual shrinkage in the book value of fixed assets. It is based on the cost of assets consumed in a business and not on its market value.
Examples of depreciable assets are machines, plants, furniture, buildings, computers, trucks, vans, types of equipment, etc. Moreover, depreciation is the allocation of a ‘depreciable amount’, which is the “historical cost”, or other amount substituted for a historical cost less estimated salvage value.
Another point in the allocation of the depreciable amount is the ‘expected useful life of an asset. It has been described as “either (i) the period over which a depreciable asset is expected to the used by the enterprise, or (ii) the number of production of similar units expected to be obtained from the use of the asset by the enterprise.”
Features of Depreciation
- It is a decline in the book value of fixed assets.
- It includes loss of value due to effluxion of time, usage, or obsolescence. For example, a business firm buys a machine for Rs. 2,00,000 on April 01, 2017. In the year 2017, a new version of the machine arrives on the market. As a result, the machine bought by the business firm becomes outdated. The resultant decline in the value of the old machine is caused by obsolescence.
- It is a continuing process.
- It is an expired cost and hence must be deducted before calculating taxable profits. For example, if profit before depreciation and tax is Rs. 50,000, and depreciation is Rs. 10,000; profit before tax will be:
- It is a non-cash expense. It does not involve any cash outflow. It is the process of writing off the capital expenditure already incurred.
Profit before depreciation & tax Rs. 50,000
(-) Depreciation (10,000)
Profit before tax 40,000
Causes of Depreciation
Wear and Tear due to Use or Passage of Time:
Wear and tear means deterioration, and the consequent diminution in the value of an asset, arising from its use in business operations for earning revenue. It reduces the asset’s technical capacities to serve the purpose for, which it has been meant. Another aspect of wear and tear is physical deterioration. An asset deteriorates simply over time, even though it is not being put to any use. This happens especially when the assets are exposed to the rigors of nature like weather, winds, rains, etc.
Expiration of Legal Rights:
Certain categories of assets lose their value after the agreement governing their use in business comes to an end after the expiry of the pre-determined period. Examples of such assets are patents, copyrights, leases, etc. whose utility to business is extinguished immediately upon the removal of legal backing to them.
Obsolescence is another factor leading to the depreciation of fixed assets. In ordinary language, obsolescence means the fact of being “out-of-date”. Obsolescence implies an existing asset becoming out-of-date on account of the availability of a better type of asset. It arises from such factors as:
• Technological changes;
• Improvements in production methods;
• Change in market demand for the product or service output of the asset;
• Legal or other description.
The decline in the usefulness of the asset may be caused by abnormal factors such as accidents due to fire, earthquake, floods, etc. Accidental loss is permanent but not continuing or gradual. For example, a car that has been repaired after an accident will not fetch the same price in the market even if it has not been used.
Need for Depreciation
Matching of Costs and Revenue
The rationale of the acquisition of fixed assets in business operations is that these are used in the earning of revenue. Every asset is bound to undergo some wear and tear, and hence lose value, once it is put to use in business. Therefore, depreciation is as much the cost as any other expense incurred in the normal course of business like salary, carriage, postage, and stationery, etc. It is a charge against the revenue of the corresponding period and must be deducted before arriving at a net profit according to ‘Generally Accepted Accounting Principles.
Consideration of Tax:
Depreciation is a deductible cost for tax purposes. However, tax rules for the calculation of depreciation amount need not necessarily be similar to current business practices.
True and Fair Financial Position:
If depreciation on assets is not provided for, then the assets will be overvalued and the balance sheet will not depict the correct financial position of the business. Also, this is not permitted either by established accounting practices or by specific provisions of law.
Compliance with Law:
Apart from tax regulations, there is certain specific legislation that indirectly compels some business organizations like corporate enterprises to provide depreciation on fixed assets.
Factors Affecting the Amount of Depreciation
Cost of Asset:
Cost (also referred to as original cost or historical cost) of an asset includes invoice price and other costs, which are necessary to place the asset in use or working condition. Besides the acquisition price, it includes freight and transportation cost, transit insurance, installation cost, registration cost, commission paid on the acquisition of asset add items like software, etc.
In the case of the purchase of a second-hand asset, it includes the initial repair cost to place the asset in workable condition. According to Accounting Standard-6 of ICAI, the cost of a fixed asset is “the total cost spent in connection with its acquisition, installation and commissioning as well as for addition or improvement of the depreciable asset”.
For example, a Xerox is purchased for Rs. 70,000 and Rs. 5,000 is spent on its transportation and installation. In this case, the first cost of the machine is Rs. 75,000 (i.e. Rs. 70,000 + Rs.5,000 ) which will be written off as depreciation over the useful life of the machine.
Estimated Net Residual Value:
Net Residual value (also known as scrap value or salvage value for accounting purposes) is the estimated net realizable value (or sale value) of the asset at the end of its useful life. The net residual value is calculated after deducting the expenses necessary for the disposal of the asset.
For example, a machine is purchased for Rs. 50,000 and is predicted to possess a useful lifetime of 10 years. At the end of the 10th year, it is expected to have a sale value of Rs. 6,000 but expenses associated with its disposal are estimated at Rs. 1,000. Then its net residual value shall be Rs. 5,000 (i.e. Rs. 6,000 – Rs. 1,000).
The depreciable cost of an asset is equal to its cost less net residual value Hence, in the above example, the depreciable cost of the machine is Rs. 45,000 (i.e., Rs. 50,000 – Rs. 5,000.) it’s the depreciable cost, which is distributed and charged as depreciation expense over the estimated useful life of the asset.
In the above example, Rs. 45,000 shall be charged as depreciation over a period of 10 years. It is important to mention here that the total amount of depreciation charged over the useful life of the asset must be equal to the depreciable cost. If the entire amount of depreciation charged is a smaller amount than the depreciable cost then the cost is under recovered. It violates the principle of proper matching of revenue and expense.
Estimated Useful Life:
The useful lifetime of an asset is the estimated economic or commercial lifetime of the asset. Physical life is not important for this purpose because an asset may still exist physically but may not be capable of commercially viable production.
For example, a machine is purchased and it is estimated that it can be used in the production process for 5 years. After 5 years the machine should be in good fitness but can’t be used for production profitably, i.e., if it’s still used the value of production may be very high. Therefore, the useful lifetime of the machine is taken into account like 5 years regardless of its physical life. Estimation of the useful life of an asset is difficult as it depends upon several factors such as usage level of an asset, maintenance of the asset, technological changes, market changes, etc.
As per accounting principle – the 6 useful lifetime of an asset is generally the “period over which it’s expected to be employed by the enterprise”. Normally, useful life is shorter than physical life. The useful life of an asset is expressed in several years but it can also be expressed in other units, e.g., number of units of output (as in case of mines) or number of working hours. Useful life depends on the following factors :
- Pre-determined by legal or contractual limits, e.g., in the case of leasehold assets, the useful life is the period of the lease.
- The number of shifts for which asset is to be used.
- Repair and maintenance policy of the business organization.
- Technological obsolescence.
- Innovation/improvement in the production method.
- Legal or other restrictions.
Methods of Calculating Depreciation Amount:
The depreciation amount to be charged during an accounting year depends upon the depreciable amount and the method of allocation. For this, two methods are mandated by law and enforced by professional accounting practice in India. These methods are a straight-line method and a written down value method. Besides these two main methods, there are other methods such as – annuity method, depreciation fund method, insurance policy method, the sum of years digit method, double declining method, etc. which may be used for determining the amount of depreciation. The selection of an appropriate method depends upon the following :
- Type of the asset;
- Nature of the use of such asset;
- Circumstances prevailing in the business;
Straight Line Method:
This is the earliest and one among the widely used methods of providing depreciation. This method is predicated on the idea of equal usage of the asset over its entire useful life. It is called a line for a reason that if the quantity of depreciation and the corresponding period of time is plotted on a graph, it’ll end in a straight line. It is also called a hard and fast installment method because the quantity of depreciation remains constant from year to year over the useful lifetime of the asset.
According to this method, a fixed and equal amount is charged as depreciation in every accounting period during the lifetime of an asset. The amount annually charged as depreciation is such it reduces the first cost of the asset to its scrap value, at the top of its useful life. This method is also known as a fixed percentage on the original cost method because the same percentage of the original cost (in fact depreciable cost) is written off as depreciation from year to year.
The depreciation amount to be provided under this method is computed by using the following formula:
Depreciation =Cost of an asset – Estimated net residential value/ Estimated useful life of the asset
The rate of depreciation under the straight-line method is the percentage of the total cost of the asset to be charged as deprecation during the useful lifetime of the asset. The rate of depreciation is calculated as follows:
Rate of Depreciation = Annual depreciation amount/ Acquisition cost × 100
Consider the following example, the original cost of the asset is Rs. 2,50,000. The useful life of the asset is 10 years and the net residual value is estimated to be Rs. 50,000. Now, the amount of depreciation to be charged every year will be computed as given below:
Annual Depreciation Amount= Acquisition cost of the asset – Estimated net residential value/ Estimated life of an asset
=Rs. 2,50,000 Rs. – 50,000/10 = Rs. 20000
The rate of depreciation will be calculated as :
Rate of Depreciation= Annual depreciation amount/ Acquisition cost x 100
From this point, the annual depreciation amounts to Rs. 20,000.
Thus, the rate of depreciation will be =Rs. 20,000/ Rs. 2,50,000 x 100= 8%
Advantages of the Straight Line Method
- It is very simple, easy to understand, and apply. Simplicity makes it a popular method in practice;
- An asset can be depreciated up to the net scrap value or zero value. Therefore, this method makes it possible to distribute the full depreciable cost over the useful life of the asset;
- Every year, the same amount is charged as depreciation in the profit and loss account. This makes the comparison of profits for different years easy;
- This method is suitable for those assets whose useful life can be estimated accurately and where the use of the asset is consistent from year to year such as leasehold buildings.
Limitations of the Straight Line Method
- This method is based on the faulty assumption of the same amount of the utility of an asset in different accounting years;
- With time, the work efficiency of the asset decreases, and repair and maintenance expense increases. Hence, under this method, the total amount charged against profit on account of depreciation and repair have taken together, will not be uniform throughout the life of the asset, rather it will keep on increasing from year to year.
Written Down Value Method
Under this method, depreciation is charged on the book value of the asset. Since book value keeps on reducing by the annual charge of depreciation, it is also known as the ‘reducing balance method’. This method involves the application of a pre-determined proportion/percentage of the book value of the asset at the beginning of every accounting period, to calculate the amount of depreciation. The amount of depreciation reduces year after year.
For example, the original cost of the asset is Rs. 2,00,000 and depreciation are charged @ 10% p.a. at written down value, then the amount of depreciation will be computed as follows:
- Depreciation ( 1 year) =Rs. 20,00,000 x 10/100 = Rs. 20,000
- Written down value (at the year-end of the 1st year) = Rs. 2,00,000 – 20,000= Rs, 1,80,000
- Depreciation ( 2nd year) = Rs. 1,80,000 x 10/100 = Rs. 18,000
- Written down value (at the year-end of the 2nd year)= Rs. 1,80,000- Rs.18,000= Rs, 1,62,000
- Depreciation ( 3rd year) = Rs. 1,62,000 x 10/100= Rs. 16,200
- Written down value (at the year-end of the 3rd year) = Rs. 1,62,000- Rs. 16,200 = Rs. 1,45,800
As evident from the instance, the quantity of depreciation goes on reducing year after year. For this reason, it is also known as the ‘reducing installment’ or ‘diminishing value method. This method is predicated upon the idea that the benefit accruing to business from assets keeps on diminishing because the asset becomes old. This is thanks to the rationale that a predetermined percentage is applied to a gradually shrinking balance on the asset account per annum. Thus, the large amount is recovered depreciation charge in the earlier years than in later years.
Advantages of the Written Down Value Method
- This method is based on a more realistic assumption that the benefits from assets go on diminishing (reducing) with time. Hence, it calls for proper allocation of cost because higher depreciation is charged in earlier years when the asset’s utility is higher as compared to later years when it becomes less effective.
- It results in the almost equal burden of depreciation and repair expenses taken together every year on profit and loss account;
- Income Tax Act accept this method for tax purposes;
- As a large portion of the cost is written-off in earlier years, loss due to obsolescence gets reduced;
- This method is suitable for fixed assets which last for long and which require increased repair and maintenance expenses with time. It can also be used where the obsolescence rate is high.
Limitations of the Written Down Value Method
- As depreciation is calculated at a fixed percentage of written down value, the depreciable cost of the asset cannot be fully written off. The value of the asset can never be zero;
- It is difficult to ascertain a suitable rate of depreciation.
Straight Line Method and Written Down Method: A Comparative Analysis
Straight line and written down value methods are generally used for calculating depreciation amount in practice. Following are the points of difference between these two methods.
Basis of Charging Depreciation:
In the straight-line method of depreciation, depreciation is charged supported original cost or (historical cost). Whereas in the written down value method, the basis of charging depreciation is the net book value (i.e., original cost less depreciation till date) of the asset, at the beginning of the year.
Annual Charge of Depreciation:
The annual amount of depreciation charged every year remains fixed or constant under the straight-line method. Whereas in the written down value method the annual amount of depreciation is highest in the first year and subsequently declines in later years. The reason for this difference is the difference in the basis of charging depreciation under both methods. Under the straight-line method, depreciation is calculated on the original cost while underwritten down value method is calculated on written down value.
Total Charge Against Profit and Loss Account on Account of Depreciation and Repair Expenses:
It is a well-accepted phenomenon that repair and maintenance expenses increase in later years of the useful life of the asset. Hence, the total charge against profit and loss account in respect of depreciation and repair expenses increases in later years under the straight-line method. This happens because the annual depreciation charge remains fixed while repair expenses increase.
On the other hand, underwritten down value method, depreciation charge declines in later years, therefore a total of depreciation and repair charge remains similar or equal year after year.
Recognition by Income Tax Law:
The straight-line method is not recognized by Income Tax Law while the written down value method is recognized by the Income Tax Law.
The straight-line method is suitable for assets in which repair charges are low the possibility of obsolescence is low and scrap value depends upon the time period involved, such as freehold land and buildings, patents, trademarks, etc. The written down value method is suitable for assets that are affected by technological changes and require more repair expenses with time such as plant and machinery, vehicles, etc.
Methods of Recording Depreciation
Charging Depreciation to Asset account:-
According to this arrangement, depreciation is deducted from the depreciable cost of the asset (credited to the asset account) and charged (or debited) to the profit and loss account.
Creating Provision for Depreciation Account/Accumulated Depreciation Account:
This method is designed to accumulate the depreciation provided on an asset in a separate account generally called the ‘Provision for Depreciation’ or ‘Accumulated Depreciation’ account. By such accumulation of depreciation, the asset account need not be disturbed in any way and it continues to be shown at its original cost over the successive years of its useful life. There is some basic characteristic of this method of recording depreciation. These are given below:
- Asset account continues to appear at its original cost year after year over its entire life;
- Depreciation is accumulated on a separate account instead of being adjusted in the asset account at the end of each accounting period
Disposal of Asset
Disposal of an asset can take place either (a) at the end of its useful life or (b) during its useful life (due to obsolescence or any other abnormal factor). If it is sold at the end of its useful life, the amount realized on account of the sale of asset as scrap should be credited to the asset account and the balance is transferred to a profit and loss account.
Use of Asset Disposal Account:
Asset disposal account is designed to provide a complete and clear view of all the transactions involved in the sale of an asset under one account head. The concerned variables are the original cost of the asset, depreciation accumulated on the asset up to date, the sale price of the asset, the value of the parts of the asset retained for use if any, and the resultant profit or loss on disposal. The balance of this amount is transferred to the profit and loss account.
This method is generally used when a part of the asset is sold and a provision for a depreciation account exists.
Under this method, a new account titled Asset Disposal Account is opened. The original cost of the asset being sold is debited to the asset disposal account and accumulated depreciation amount appearing in provision for depreciation account relating to that asset till the date of disposal is credited to the asset disposal account. The net amount realized from the sale of the asset is also credited to this account. The balance of the asset disposal account shows profit or loss which is transferred to the profit and loss account. The advantage of this method is that it gives a full picture of all the transactions related to asset disposal in one place.
Effect of any Addition or Extension to the Existing Asset
An existing asset may require some additions or extensions for being suitable for operations. Such additions/extensions may or may not become an integral part of the asset. The amount incurred on such additions/extensions is capitalized and written off as depreciation over the life of the asset. It is important to mention here that the amount so incurred is in addition to usual repair and maintenance expenses.
- Any addition or extension, which becomes an integral part of the existing asset should be depreciated over the useful life of that asset;
- The depreciation on such addition or extension may also be provided at the rate applied to the existing asset;
- Where an addition or extension retains a separate identity and is capable of being used after the existing asset is disposed of, depreciation should be provided independently based on its own useful life.