The term Depreciation means Loss or Diminution or decrease or decline in the value of fixed assets. The decline in the value of an asset occurs due to wear and tear, obsolescence and permanent fall in market value.
The word Depreciation has been derived from the Latin word ‘Depretum’. ‘De’ means decline and precum means price. Therefore, Depretum means a decline in price.
In every business, there are certain assets of a fixed nature which are required for the purpose of business operations.
Example of such assets is Building, plant and machinery, furniture, motor vehicles, office equipment such as a computer, typewriter, photocopier machine, etc. These assets have a definite span of life.
In accounting, depreciation is the process of allocating the net cost of fixed assets over it’s estimated useful life. The net cost of fixed assets means cost priceless scrap value or residual value.
Features Of Depreciation:
Following are the special features of Depreciation:
1. It refers to a permanent, gradual and continuous decrease in the value of fixed assets and it continues till the end of the useful life of the assets.
2. It is a charge against profit for a particular accounting period.
3. It is always computed in a systematic and regional manner since it is not a sudden loss.
4. It is a process of allocation of expired cost and not of valuation of fixed assets.
5. Whatever method for calculating depreciation is followed, the exact amount can never be ascertained.
6. It decreases only the book value of the assets.
7. It has no relation to the market value.
8. The term Depreciation is used only in respect of tangible fixed assets.
9. It has no relation with the amount spent on repairs and maintenance of particular assets.
10. The total amount of depreciation charged cannot exceed the book value of the assets.
Caution Of Depreciation:
The causes are discussed are under:
1. Constant Use: Due to the constant use of an asset, wear and tear are caused and as a result, their value decreases.
For example, the use of a machine in a factory. As on account of constant use, the value of the machine decreases, it will not fetch the same price at which it was purchased.
2. Expiry of Time: The value of the majority of assets decreases with the passage of time even if they are not being put to use in the business.
Natural forces such as rain, winds, weather etc. contribute to the deterioration of their values. Again, after purchasing assets such as machinery, motor car, Furniture, etc.
3. Expiry of legal Rights: There are certain assets over which legal rights to use them are acquired for a fixed period.
For example, Lease of land, Mines, Quarry, patent right etc. The right to use such assets is generally acquired for a fixed period by making lump sum payment.
4. Obsolescence: Due to new inventions and improvement in existing technologies, the old assets become obsolete and may have to be discarded even if the assets can be used.
For example, Computers of older versions become obsolete as and when new versions are invented.
5. Accident: Sometimes, assets may be damaged or destroyed on account of abnormal reason such as accident, flood, earthquake, fire, etc.
For example, a machine may be damaged or destroyed due to fire, flood, earthquake, etc. or a vehicle may be damaged due to accident.
6. Depletion: Depletion means a decrease in the existing quantity. The decrease in the value of wasting assets such as mines, oil-wells etc. occurs due to their constant extraction.
Importance of Providing Depreciation:
Following are the importance of Depreciation:
A) To ascertain the true profit or loss: The true profit of a business can be ascertained only when all costs incurred for the purpose of earning revenue have been charged against revenue.
B) To show the true and fair view of the financial position: If the depreciation is not charged, the assets will be shown in the balance sheet at an amount which is in excess of their value.
As such, the balance sheet will not present the true and fair view of the financial position of a business.
C) To ascertain the accurate cost of production: As depreciation is also an item of expenses, the correct cost of production cannot be calculated unless it is also taken into account.
D) To provide funds for replacement of assets: Depreciation through debited to profit & loss account is not paid in cash like other expenses.
Hence, the amount of cash equivalent of depreciation is retained in the business and is used to provide fund for the replacement of fixed assets after the expiry of their estimated useful life.
E) To reduce income-tax liability: Depreciation is an allowable expenditure under the income-tax law.
If the depreciation is not charged, the net profit is shown by profit & loss account the actual profits, as a result, the income tax liability will be more than what it should have actually been.
Methods of Charging Depreciation:
1. A straight-line method or fixed instalment methods.
2. Diminishing Balance Method.
3. Annuity Method.
4. Depreciation fund method.
5. Insurance policy method.
6. Revaluation Method.
7. Depletion Method.
8. Machine Hour rate method.
Factors to be considered for determining the amount of Depreciation:
The main factors are discussed below:
1. The cost of the assets: The cost of a fixed asset is determined after adding all expenses incurred for bringing the assets to a usable condition.
Expenses such as freight, transit insurance and installation cost, etc. incurred for particular assets are examples of expenses which are incurred for bringing the assets to a usable condition.
2. The estimated useful life of the asset: Useful life of an asset is estimated in terms of a number of years for which the assets can be effectively used for business operations.
3. Estimated Scrap value: Scrap value means the amount which can be realised from the sale of the asset after the expiry of its useful life.
In other words, it is the estimated sale value of the assets at the end of their useful life. It is also known as residual value or Break-up value.