DEPRECIATION
Depreciation is the gradual and permanent decrease in
the value of an asset from any cause. In the business we need some fixed assets for the conduct of business
operations. For example, plant & machinery, motor vehicles, office
equipments, furniture, building etc. These assets have a limited life after
that they lose their usefulness. Due to their constant use and expiry of time,
there is a fall in their value and utility. It is termed as depreciation. We
can say that the process of allocation
of the cost of a fixed asset over its useful life is known as depreciation.
Main
features:
·
Depreciation is
decrease in the value of fixed assets (except land).
·
It is a gradual
and continuing process because the value will decline due to their constant use
or obsolescence or expiry of time.
·
It decreases only
the book value of the asset and not the market value.
·
Such fall is of a
permanent nature. Once the value of an asset is reduced due to depreciation, it
cannot be restored to its original cost.
·
It is not the
process of valuation of assets. It is the process of allocation of the cost of
an asset to its effective span of life.
·
It is a non-cash
expense because it does not involve any cash outflow.
·
It is used only
for tangible fixed assets and not for the wasting assets such as mines,
oil-wells etc.
Need of providing depreciation
1.
For ascertaining
true profit or loss of the business because depreciation in the value of an
asset is treated as expense like other expenses.
2.
For showing the
true and fair view of the financial position because if the depreciation is not
charged the assets will not show their exact value.
3.
To know the
accurate cost of production because if depreciation is not included in cost of
production the sale price will be fixed at lower rates and this will lead to reduced
profits.
4.
To provide funds
for replacement of assets because the amount of depreciation is retained in the
business and is used for replacement of fixed assets after the expiry of their
life.
5.
To prevent the
distribution of profits out of capital because the amount of dividend
distributed among the shareholders will also include the amount of depreciation
which is actually a part of capital.
6.
For avoiding over
payment of income tax because if depreciation is not debited to Profit &
Loss A/c, it will show excess profit and we have to pay more income tax.
7.
If depreciation
is not charged, the Profit & Loss A/c will show excess profit and Employees
may demand an increase in wages & bonus.
8.
If extra profit
is shown by Profit & Loss A/c, it may result in extravagance. Also it may
lead to increase in competition.
Factors
determining the amount of depreciation
Total cost of asset:- It can be determined after adding all expenses
incurred for bringing asset to usable condition. For example, freight,
installation expenses, transit insurance etc.
Estimated useful life of asset:- It is estimated in no. of years for which the asset
can be used for business effectively.
Estimated Scrap Value:- It is the residual value of the asset at the end of
its useful life.
CAUSES OF DEPRECIATION
Ø Due to constant use of assets, wear and tear arises in
them. Hence, result in the reduction of their value.
Ø Due to passage of time the value of assets decreases.
Ø Natural forces such as rain, winds, weather etc. also
contribute to the deterioration of the values of the fixed assets.
Ø Certain assets have a definite span of life such as
lease. After that period their value reduced to zero.
Ø Due to new inventions and improved techniques, the old
assets become obsolete and may have to be discarded.
Ø Due to accidents such as fire, earthquakes, floods
etc. assets may be destroyed.
Ø Depletion may be a cause of reduction in the value of
assets. It may be in case of mines, oil-wells etc. (known as wasting assets). Due
to their constant use of working their value decreases.
Ø Fluctuations in the market value is treated
(sometimes) depreciation if value decreases permanently.
Methods of allocating depreciation
Various methods have been used for providing depreciation
according to the suitability depending upon the nature and type of the asset. Some
are:
1.
Straight Line Method
2.
Written Down
Value Method
3.
Annuity Method
4.
Depreciation Fund
Method
5.
Insurance Policy
Method
6.
Revaluation
Method
7.
Depletion Method
8.
Machine Hour Rate
Method