Back to Main Page

Web Notes

DEPRECIATION

Accountancy (Phase -I & II) Accounting standards

DEPRECIATION

ACCOUNTING FOR DEPRECIATION

Fixed assets (technically referred to as “depreciable assets”) tend to reduce their value once they are put to use. In general, the term “Depreciation” means decline in the value of a fixed assets due to use, passage of time or obsolescence. In other words, if a business enterprise procures a machine and uses it in production process then the value of machine declines with its usage.

Hence, depreciation is an expired cost or expense, charged against the revenue of a given accounting period.

According to Walter B. Meigs and others, "The concept of depreciation is closely linked to the concept of business income. Since part of the service potential of the depreciable asset is exhausted in the revenue getting process each period, the cost of these services must be deducted from revenue in measuring periodic income; the expired cost must be recovered before a business is considered as well off as at the beginning of the period. Depreciation is a measure of this cost."

From the above definition it is clear that depreciation refers to that part of the'cost of fixed asset which has expired on account of its usage and or the passage of time. It is thus the 'lost usefulness', 'expired utility', or 'reduction in the intrinsic value' of a fixed asset. Depreciation is charged on almost all fixed assets, possible exceptions being land, antiques, etc. Usually the value of lalld and antiques appreciates over a period of time, because they do not have finite economic life as in the case of machinery or furniture.

Depreciation & its related terms-

Depreciation and Depletion :

The term depletion is used in respect of the extraction of natural resources from wasting assets such, as quarries, mines, etc. and refers to the reduction in the available quantity of the material. As a matter of fact, depletion is regarded as a method of computing the depreciation on wasting assets. Thus, it has a limited application. Depreciation ,on the other hand, Is a wider term and refers to a reduction in the value of all kinds of fixed assets arising from their wear and tear.

Depreciation and Amortization :

The terms 'amortization' refers to writing off the proportionate value of the intangible assets such as copyrights, patents, goodwill, etc., while depreciation refers to the writing off the expired cost of the tangible assets like machinery, furniture, building etc.

Depreciation and Obsolescence:

Obsolescence refers to the decrease in usefulness arising on account of the external factors like change in technology, new inventions, change of style, etc. Thus, it is caused mainly on account of the asset becoming out of date, old fashioned. Depreciation on the other hand, is a functional loss generally arising on account of wear and tear. Obsolescence, in fact, is regarded as one of the causes of depreciation.

Depreciation and Fluctuation :

Fluctuation refers to an increase or decrease in the market price of an asset. Such a change is usually temporary. Depreciation differs from fluctuation in the following respects.

Depreciation is concerned with book value of asset while fluctuation is related to the market value.
Depreciation refers only to the decrease while fluctuation refers to either increase or decrease.
Depreciation reflects a permanent decrease while fluctuation is only a temporary phenomenon.

Causes of Depreciation

Wear and Tear due to Use or Passage of Time

Wear and tear means deterioration, and the consequent diminution in an assets value, 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 the physical deterioration. An asset deteriorates simply with the passage of time, even though they are not being put to any use. This happens especially when the assets are exposed to the rigours 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 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

Obsolescence is another factor leading to depreciation of fixed assets. In ordinary language, obsolescence means the fact of being “out-of-date”. Obsolescence implies to an existing asset becoming out-of-date on account of the availability of 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.

Abnormal Factors

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 which has been repaired after an accident will not fetch the same price in the market even if it has not been used

Depletion :

Some assets are of a wasting character. For example mines, quarries, oil wells etc. Due to continuous extraction of materials the natural resources get depleted. Depreciation, in case of such assets is often computed on the basis of actual depletion. For example, a coal mine has the coal deposits of 200 million tons. In the first year we extract 10 million tons of coal. The depreciation in the first five years shall amount to 10/200 of the cost of mine.

Need for Depreciation

The need for providing depreciation in accounting records arises from conceptual, legal, and practical business consideration. These considerations provide depreciation a particular significance as a business expense.

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 stationary, etc. It is a charge against the revenue of the corresponding period and must be deducted before arriving at 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 over valued 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 are certain specific legislations that indirectly compel some business organisations like corporate enterprises to provide depreciation on fixed assets.

Funds for replacement of assets :

Charging depreciation reduces the profits available for distribution. It enables-the concern to retain a part of its profit and thus - accumulate funds for the replacement of the assets as and when necessary.

Factors Affecting the Amount of Depreciation

The determination of depreciation depends on three parameters, viz. cost, estimated useful life and probable salvage value.

Cost of Asset

Cost (also known as original cost or historical cost) of an asset includes invoice price and other costs, which are necessary to put the asset in use or working condition. Besides the purchase price, it includes freight and transportation cost, transit insurance, installation cost, registration cost, commission paid on purchase of asset add items such as software, etc. In case of purchase of a second hand asset it includes initial repair cost to put the asset in workable condition.

Estimated Net Residual Value

Net Residual value (also known as scrap value or salvage value for accounting purpose) is the estimated net realisable 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 expected to have a useful life of 10 years. At the end of 10th year it is expected to have a sale value of Rs. 6,000 but expenses related to 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).

Depreciable Cost

Depreciable cost of an asset is equal to its cost less net residual value . Hence, in the above example, the depreciable cost of machine is Rs. 45,000 (i.e., Rs. 50,000 – Rs. 5,000.) It is 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 total amount of depreciation charged over the useful life of the asset must be equal to the depreciable cost. If total amount of depreciation charged is less than the depreciable cost then the capital expenditure is under recovered. It violates the principle of proper matching of revenue and expense.

Estimated Useful Life

Useful life of an asset is the estimated economic or commercial life 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.

Useful life depends upon the following factors :

• Pre-determined by legal or contractual limits, e.g., in case of leasehold asset, the useful life is the period of lease.

• The number of shifts for which asset is to be used.

• Repair and maintenance policy of the business organisation.

• Technological obsolescence.

• Innovation/improvement in production method.

• Legal or other restrictions.

Methods of Recording Depreciation

In the books of account, there are two types of arrangements for recording depreciation on fixed assets: • Charging depreciation to asset account or

• Creating Provision for depreciation/Accumulated depreciation account.

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 profit and loss account. Journal entries under this recording method are as follows:

For recording purchase of asset (only in the year of purchase)

Asset A/c Dr. (with the cost of asset including installation, freight, etc.)

To Bank/Vendor A/c 2.

Following two entries are recorded at the end of every year

For deducting depreciation amount from the cost of the asset.

Depreciation A/c Dr. (with the amount of depreciation)

To Asset A/c

For charging depreciation to profit and loss account.

Profit & Loss A/c Dr. (with the amount of depreciation)

To Depreciation A/c

Balance Sheet Treatment

When this method is used, the fixed asset appears

- at its net book value (i.e. cost less depreciation charged till date) on the asset side of the balance sheet

- not at its original cost (also known as historical cost).

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 ‘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 are 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.

The following journal entries are recorded under this method:
1.For recording purchase of asset (only in the year of purchase)
Asset A/c Dr. (with the cost of asset including installation, expenses etc.)
To Bank/Vendor A/c (cash/credit purchase)
2.Following two journal entries are recorded at the end of each year:
(a) For crediting depreciation amount to provision for depreciation account
Depreciation A/c Dr. (with the amount of depreciation)
To Provision for depreciation A/c

(b) For charging depreciation to profit and loss account
Profit & Loss A/c Dr. (with the amount of depreciation)
To Depreciation A/c

3. Balance sheet treatment in the balance sheet, the fixed asset continues to appear at its original cost on the asset side.
The depreciation charged till that date appears in the provision for depreciation account, which is shown either on the “liabilities side” of the balance sheet or by way of deduction from the original cost of the asset concerned on the asset side of the balance sheet.

Of the above eight methods used for providing depreciation, the first two viz., Fixed Instalment Method and Diminishing Balance Method are the most commonly used methods.

Straight Line Method-

This is the earliest and one of the widely used methods of providing depreciation.

It is also called fixed installment method because the amount of depreciation remains constant from year to year over the useful life of the asset. According to this method, a fixed and an equal amount is charged as depreciation in every accounting period during the lifetime of an asset. The amount annually charged as depreciation is such that it reduces the original cost of the asset to its scrap value, at the end of its useful life. This method is also known as fixed percentage on original cost method because same percentage of the original cost (infact 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 asset - Estimated net residential value

Estimated useful life of the asset

Rate of depreciation under 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. Rate of depreciation is calculated as follows:

Rate of Depreciation =Annual Depreciation x100

Acquisition Cost

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 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

Acqusition cost of asset – Estimated net residential value

Estimated life of asset

i.e. = Rs. 50,000Rs. 2,50,000

=Rs. 20,000

Rate of Depreciation =Annual Depreciation x100

Acquisition Cost

=20000 x 100 =8%

2,50,000

Advantages of Straight Line Method

Straight Line method has certain advantages which are stated below:

•Simplicity-

• Distribution of full depreciable cost over useful life of the asset

•Easy comparison –

• Consistent from year to year

Limitations of Straight Line Method

Although straight line method is simple and easy to apply it suffers from certain limitations which are given below.

• Faulty assumption-

This method is based on the faulty assumption of same amount of the utility of an asset in different accounting years;

• No Uniformity-

With the passage of time, 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 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 ‘reducing balance method’.

It is also known as Diminishing value 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, so as 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 is charged @ 10% p.a. at written down value, then the amount of depreciation will be computed as follows:

(i) Depreciation (I year) = Rs. 20,00,000× 10 /100 = Rs. 20,000

(ii) Written down value = Rs. 2,00,000 – 20,000 = Rs.1,80,000 (at the end of the year)

(iii) Depreciation (II year) = Rs. 1,80,000 × 10 /100 = 18,000 Rs.

(iv) Written down value = Rs. 1,80,000 – Rs.18,000 = 1,62,000 (at the end of the II year)

(v) Depreciation (III year) = Rs. 1,62,000 × 10/100

(vi) Written down value = Rs. 1,62,000 – Rs. 16,200 = Rs. 1,45,800 (at the end of III year)

As evident from the example, the amount of depreciation goes on reducing year after year. For this reason, it is also known ‘reducing installment’ or ‘diminishing value’ method. This method is based upon the assumption that the benefit accruing to business from assets keeps on diminishing as the asset becomes old.

This is due to the reason that a predetermined percentage is applied to a gradually shrinking balance on the asset account every year. Thus, large amount is recovered depreciation charge in the earlier years than in later years

Advantages of Written Down Value Method

Written down value method has the following advantages:

• More realistic assumption

This method is based on a more realistic assumption that the benefits from asset go on diminishing (reducing) with the passage of time. Hence, it calls for proper allocation of cost because higher depreciation is charged in earlier years when asset’s utility is higher as compared to later years when it becomes less effective.

• Equal burden of depreciation

It results into almost equal burden of depreciation and repair expenses taken together every year on profit and loss account;

• Tax purposes

Income Tax Act accept this method for tax purposes;

• Loss due to obsolescence

As a large portion of cost is written-off in earlier years, loss due to obsolescence gets reduced;

• Suitable for fixed assets

This method is suitable for fixed assets which last for long and which require increased repair and maintenance expenses with passage of time. It can also be used where obsolescence rate is high.

Limitations of Written Down Value Method

Although this method is based upon a more realistic assumption it suffers from the following limitations.

• Asset can never be zero

As depreciation is calculated at fixed percentage of written down value, depreciable cost of the asset cannot be fully written-off. The value of the asset can never be zero;

•Difficult-

It is difficult to ascertain a suitable rate of depreciation

Basis of Difference	Straight Line Method	Written Down Value Method
Basis of charging depreciation	Original cost	- Book Value (i.e. original cost less depreciation charged till date)
Annual depreciation charge	Fixed (Constant) year	Declines year after year
Total charge against profit and loss account in respect of depreciation and repairs	Unequal year after year. It increases in later years	Almost equal every year
Recognition by income tax law	Not recognised	Recognised
Suitablity	It is suitable for assets in which repair charges are less, the possibility of and obsolescence is low scrap value depends the time period involved. time.	It is suitable for assets, which are affected by technological changes and require more repair upon expenses with passage of

Change of method –

Sometimes a firm may decide to change the method of depreciation it had adopted i.e,, it may change the method of depreciation from fixed instalment lncthod to reducing instalment method or vice versa. If it decides to implement the change with prospective effect, there is no problem because no adjustment is necessary in respect of depreciation charged in earlier years. All that is necessary is to charge depreciation from that year onwards according to the new method decided, ' However, when it is decided to change the method with retrospective effect i.e., with effect from a prior date (usually from the date of acquisition ol' an asset) it would be necessary to adjust the depreciation charged till date. Suppose a firm was depreciating its machinery under the fixed instalment method during the past three years. It has now decided to change the method to written down value method with retrospective effect.

In such a case it would be necessary to take the following steps :

1 Calculate the amount of depreciation already charged till the date of change according to old method.

2 Calculate the amount of depreciation that would have been charged under the new method now proposed to be adopted.

3 If the amount of depreciation under the new method is more than what was charged under the old method, such difference should be credited to the asset account in current year and debited to the Profit and Loss Account.

4 If, on the other hand, the amount of depreciation under the new method is less than what was charged under the old method such a difference should be debited to the asset account in current year and credited to the Profit and Loss Account.

5 As the difference in depreciation amount is adjusted to the current value of asset in the asset account, the asset account will appear at its new value, from the date of change and depreciation will be charged according to the new method in subsequent years.

Annuity Method –

The amount invested in an asset has an opportunity cost i.e., if that amount had been invested in some other form it would have earned some interest. The fixed instalment and the diminishing balance methods ignore such cost. In case of lease we have to pay a lump sum amount at the initial stage and then a nominal amount as rent every year, The amount paid at the initial stage is a sort of advance , payment of rent. It is treated as the cost of lease and written off during the lease , period by way of providing depreciation.

In such a situation, the loss of interest on advance payment must also be treated as a part of the cost of using the asset: The method by which the interest is also included in the amount of depreciation-is known, as Annuity Method. This method is usually employed for providing depreciation on leasehold property. But it can also be used for other fixed assets provided it is decided to account for the toss of interest on the account invested in the asset.

Under this method the interest is calculated on the opening balance of the asset each year and debited to the asset account, credit being given to interest Account. As depreciation is to be inclusive of interest, the amount of depreciation charged every year is higher than what it would have been under any other method. Although the amount of interest varies from year to year (it goes on decreasing) the instalment of depreciation is uniform which is computed with reference to the annuity table.

Depreciation is debited to the Profit and Loss Account. When you prepare thc Interest Account, the amount of interest debited to the asset account will be credited to this account. This will ultimately be transferred to the Profit and Loss Account. Thus each year the Profit and Loss Account will have debit in respect of depreciation and credit in respect of interest. This will, ill effect, reduce the net charge (debit) to the Profit and Loss Account to the level of depreciation based on original cost.

The net charge to Profit and Loss Account increases year after year even though the depreciation is a fixed sum. This is because of the interest amount decreases year after year, However, the total net charge to Profit and Loss Account is equal to the cost of lease.

Merits and Demerits

The annuity method has the merit of considering the amount ivested in the purchase of an asset as an investment capital of earning some interest. However, when additions are made to the asset, fresh computations have to be made and the calculation becomes difficult. Another limitation of this method arises on account of debiting the asset account with interest, 'This increases the book value of asset particularly in the initial years. As stated earlier, this method is generally used for leases in respect of which a lumpsum payment is made in advance.

Depreciation fund method-

. Under this method a fixed amount as calculated above is charged every year as depreciation by debiting it to the Profit and Loss Account and crediting it to the Depreciation Fund Account. You should note that [he asset account is not credited with the amount of depreciation as in the case of other methods. The asset account appears at its original edst till the last year of its useful life. Every ,year an amount equal to depreciation is invested in some outside securities. These investments accumulate at compound interest and make available adequate funds for replacement of the worn out asset. In the last year of the life of the asset the balance in Depreciation fund Account is transferred to asset account and thus the accounts will be closed (after due adjustment in respect of profit or loss on sale of investment).

The following points are to be in this regard.

1 At the end of every year the debit balance on Depreciation Account xeprtsrntiq total amount of depreciation charged on all fixed assets will be transferred to Profit and Loss Account with the help of the following entry

Profit and Loss A/c To Depreciation A/c

Dr.

2 Usually the annual charge of depreciation and interest received are rounded off .to the nearest rupee with a view to simplify the calculations,.

3 Sometimes, the interest is received half yearly. In such a situation, the entries for receipt of interest on investments and investing the amount of interest in securities, will have to be passed twice a year.

The main advantages of this method is that it provides the firm with necessary funds required for replacing the asset. If the amounts were not invested outside the business and accumulated, the withdrawal of funds from regular business operations would have crippled the normal financial working of business. The depreciation however, is that the combined charge of depreciation and repairs will not be uniform throughout the life of an asset.

Insurance policy method

The Depreciation Fund Method involves the investment of funds in outside securities. This requires an expert knowledge of the investment market arid risk of loss due to price fluctuations in the market. Moreover the specific securities may not always be available in the market. To avoid such uncertainties, the firm instead of investing the money in purchasing securities; may take an insurance policy from it general insurance company for the sum required for replacement of the asset. For this it wilI have to pay certain amount as premium every year. In return the insurance company promises to pay agreed policy amount at the end of the, specified period i.e, useful life of the asset which will be utilized for replacement of the asset. The money received from insurance company is usually a little higher than the amount insured because of bonus. Thus, there is certainty about receiving an anticipated amount. From the accounting point of view, this method is very similar to Depreciation Fund Method. In fact, it is also called Depreciation fund Policy Method.

Depletion Method

This method is suitable for mines and quarries where all estimate is made of the output to be available from the mines and quarries. Depreciation is calculated per tonne of output. Supposing, a mine is procured for Rs. 50,00,000 and the estimated output is 5,00,000 tomes, the depreciation comes to Rs. I0 per tonne. If the output in the first year is 25,000 tonnes, then the depreciation to be charged off is Rs, 2,50,000. Similarly, if the second year output is 35,000 tonnes, depreciation will be Rs. 3,50,000 and so on.

Machine Hour Rate Method

This method takes into account remaining time of the asset (particularly machineries). This is worked out as under :

Depreciation =Original Cost - Scrap Value

Life of the Asset in Hours

The rate obtained is for per hour working of the machine. If the machine has run for 900 hours in a year, the depreciation will be 900 x (per hour rate).

Revaluation Method

Under this method, a valuation (by experts) is made about the effective value of the asset a1 the end of the year. The difference between the value at the beginning and the value at end is charged off as depreciation.

Sum of the Years Digit Method

This method is on the pattern of written down value method. In this method, the depreciation for each year is worked out as under : -

=Remaining life of the Asset (including current year)- x Cost of Asset

Sum of all the digits of the life of the Assets

For example, Cost of Asset = Rs. 10,000

Expected life = 5 years

Depreciation in 1 st year = 5 x 10000

1+2+3+4+5

= Rs. 3,333

Depreciation in 2nd year =4 x 10000

1+2+3+4+5

= Rs. 2,667