Depreciation

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