We know that a sole proprietor commences business with capital in the form of various assets and liabilities. The assets can be in form of fixed assets (or long-term assets) and current assets. Both the type of assets are acquired to carry out various business activities. Fixed assets are used for the production of various goods and services whereas, current assets are consumed for the production of various goods and services of a business. Fixed assets are used continuously in daily business operations. Therefore, with the passage of time and their consistent use in the business their value may decrease due to normal wear and tear. This decrease or fall in the value of the fixed assets is termed Depreciation. In this lesson, our basic focus will be on the reduction in the value of fixed assets and their various causes.
Meaning of Depreciation
Reduction in the value of fixed assets associated with their continuous use in the business is regarded as Depreciation. Depreciation is a permanent decrease in the value of the fixed asset. All the fixed assets, except land, have a specific useful life in the business. Generally, the total cost of an asset is spread over its useful life in the business and this allocation of cost is regarded as Depreciation. Thus, it can be said that depreciation is an allocation of the cost of an asset over its useful life and is not a valuation process of the asset.
It should be noted that generally no depreciation is provided on land. This is because the land is assumed to have an infinite life in the business. According to William Pickles, ‘Depreciation is the permanent and continuing diminution in the quality, quantity or value of an asset’. In the words of J.R. Batliboi, ‘It is a matter of common knowledge that all fixed assets such as plant, machinery, building, furniture, etc. gradually diminish in value as they get older and become worn out by constant use in the business’.
According to the Matching Concept, Depreciation is considered as an expense only to the extent of the decrease in the value of the asset during an accounting period. In other words, it refers to the value of fixed assets consumed in the production process during an accounting period.
As depreciation is a reduction or loss in the value of fixed assets, therefore, it is charged from the revenues earned by a business. It is charged by recording it on the Debit side of the Profit and Loss Account.
Features of Depreciation
The following are the various features of depreciation.
- It is a fall in the book value of fixed assets.
- It occurs due to normal wear and tear or obsolescence of technology during its use in the business.
- It does not affect the market value of the fixed assets. It only reduces the book value of the asset.
- The decrease in the value of the fixed assets is permanent in nature.
- It is an allocation of the cost of an asset over its effective life.
- It is charged only on the Tangible fixed assets. Tangible fixed assets are those which can be seen or touched such as buildings, Machinery, Furniture, etc.
- It is a non-cash expense of a business that does not involve any outflow of cash.
Causes of Depreciation
Given below are the various causes of depreciation.
Continuous Use: The continuous use of the fixed assets in the business operations leads to a reduction in their value due to natural factors such as sunlight, rain, gas, etc. Therefore, it can be said that depreciation occurs due to the normal wear and tear and constant use of the fixed assets in the business.
Expiry of Useful Life: All the fixed assets (except land) has only some specific life for which they are useful in the business. With the passage of time, there is always a fall in the value of fixed assets irrespective of the fact whether they are used or not. This fall in the value can be due to natural forces such as rain, weather, etc.
Obsolescence: Due to the fast technological innovations and inventions, the existing assets may get outdated. In such cases, the old assets are needed to be replaced by new technologically sophisticated assets. This leads to the obsolescence of fixed assets which need to be replaced even if their useful life has not expired.
Expiration of Legal Rights: If an asset is acquired for a specific period of time, then, whether the asset is put to use or not, its value becomes zero at the end of its useful life. For example, if a building is acquired at a cost of Rs 1,00,000 for 10 years on the lease, then each year its value depreciates by 1/10th of its gross value and at the end of the 10th year, the value of the building will be zero in the books.
Accidents: An asset may lose its value or get damaged due to some mishaps such as fire, accident, theft, or a natural calamity. Loss due to an accident is permanent in nature, in the sense, that such assets cannot be used further in the business as they have been permanently destroyed by the accident.
Permanent Reduction in the Market Value: Generally, the fluctuations in the market price of the fixed assets are not recorded in the Books of accounts. However, if the fall in market price is permanent, then it is recorded in the books because it leads to a fall in the value of fixed assets.
Need for Providing Depreciation
The following are the various reasons due to which there arises a need for providing depreciation.
To Determine True Net Profit or Net Loss: Correct profit or loss can be ascertained only when all the expenses and losses incurred during an accounting period for earning revenues are charged to the Profit and Loss Account. Assets are used in various business operations for earning revenues and therefore, its cost should be charged in the form of depreciation from the Profit and Loss Account. Therefore, if depreciation is not charged, then the net result shown by the Profit and Loss Account would not reveal the true profit or loss.
To Reveal True and Fair View of Financial Position: If depreciation is not charged in the books, then assets would be shown at a higher value than their actual value in the Balance Sheet. Consequently, the Balance Sheet fails to reflect the true and fair view of the Financial Position of a business at the end of an accounting period.
To Determine Cost of Production: Depreciation on Plant and Machinery and on other assets, which are engaged in production, is included in the cost of production. Cost of production is a basis for determining the selling price of products in the market. Therefore, if depreciation is not provided, then the cost of production is underestimated, which will lead to the low sale price in the market and thus leads to lower profits.
Distribution of Dividend Out of Profit: In case depreciation is not charged from the revenues, the profit shown by the Profit and Loss Account will be more than actual. This may lead to the distribution of more profits as dividends out of capital instead of retaining the profit in the business. This will in turn lead to the flight of scarce capital out of the business.
For Replacement of Assets: Unlike other expenses, depreciation is not a cash expense, rather it is a non-cash transaction. So, the amount of depreciation charged will be retained in the business. This amount, in the future, can be used for the replacement of fixed assets after their useful life.
Consideration of Tax: When depreciation is charged, the Profit and Loss Account will disclose lesser profit as compared to when depreciation is not charged. This depicts the reduced profits and thus the business will be liable for a lesser tax amount.
Other Terminologies related to Depreciation Depletion: This term refers to the reduction in the availability of natural resources due to extraction, mining, and quarrying. It helps to ascertain the reduction in product reserves of natural resources. In other words, it refers to the number of natural resources used or consumed during an accounting period.
Obsolescence: This term refers to the loss in the capital value of the existing fixed assets that are not physically worn out. This reduction in the value takes place due to the advancement and appreciation of technology, scientific innovations, and inventions, change in fashion, adoption of cost-efficient production techniques, etc.
Amortization: This term refers to the reduction in the value of intangible assets over their useful life. Intangible assets are those assets that do not have physical existence such as, Goodwill, Copyrights, Patents, etc. It measures the number of intangible assets used during an accounting period.
Determinants of Depreciation
We know depreciation is the fall in the value of fixed assets that are used in business operations. The calculation of the exact amount of depreciation is a troublesome process. It is generally based on estimations. However, efforts are made that estimated depreciation calculated is precise and exact. The given below are some factors that help in determining the actual amount of depreciation.
Cost of Asset: For the purpose of calculating the amount of depreciation, the total cost of the asset should be considered. All the expenses incurred in relation to acquiring, installing, and constructing an asset and bringing the asset into the usable condition are included in the total cost of the asset. Some of the examples of such costs are freight, installation cost, transit insurance cost, etc. An important point to be noted here is that the cost of assets never includes the financial charges such as interest on loans taken to purchase the fixed assets, etc.
Estimated Useful Life of Asset: Another factor determining the amount of depreciation is the estimated useful life of the asset. The useful life of assets may be in terms of a number of months, years, hours, units, etc. Every asset has its useful life other than its physical life. An asset may have a physical existence but may not be able to perform its functions. For instance, if machinery is purchased for carrying out business operations whose useful life is 10 years. But, it is expected to last only for 6 years. In such a case, the estimated useful life of the machinery will be considered only for 6 years and not 10 years.
Estimated Scrap Value: Scrap value is the residual value or salvage value that is expected to be realized from the sale of the asset at the end of its expected useful life. Before providing the depreciation, the scrap value should be deducted from the cost of the asset. This net value of the assets i.e. difference of the cost of assets and scrap value is considered as a base for charging depreciation. Algebraically, it can be written as Amount to be Written-off = Cost of Asset – Scrap Value For example, Furniture is acquired at a cost of Rs 2,00,000 with its effective life of 10 years. After 10 years, furniture is expected to realize Rs 20,000.
In this case, the cost of assets that should be considered for charging depreciation is Rs 1,80,000 (2,00,000 – 20,000). That is the cost after deducting its scrap value.
Methods of Depreciation
There are various methods of calculating depreciation on fixed assets. Once the method for charging depreciation is selected and adopted, then, it should be followed consistently every year. The given below are the various methods for charging depreciation.
- Straight Line Method
- Written Down Value Method
- Depreciation Fund Method
- Replacement Method
- Annuity Method
- Insurance Policy Method
- Machine Hour Rate Method
- Sum of Years Digit Method
- Depletion Method
- Revaluation Method
Straight Line Method
It is one of the most popular and easy methods of charging depreciation on fixed assets. Under this method, depreciation is charged on the original cost of the asset every year, at a fixed rate of percentage. Therefore, in this case, the amount of depreciation remains the same for each of the years. This method of depreciation is also known as the Original Cost Method or Equal /Fixed Instalment Method.
Under this method, the amount to be written off each year as depreciation is calculated by dividing the cost of the asset by its estimated useful life. It should be noted that the scrap value of the asset is to be deducted from the original cost
before calculating depreciation. The given below is the formula for calculating depreciation under this method.
For example, the cost of machinery purchased is Rs 4,70,000, and the installation cost is Rs 30,000. The scrap value at the end of its estimated life of 10 years is expected to be Rs 50,000. In this case, the amount to be written off each year as depreciation is calculated as follows
Advantages of Straight Line Method
The given below are the various advantages of the Straight Line Method of depreciation.
- It is a simple and easy method of calculating depreciation.
- Under this method, assets can be completely written-off. That is, an asset can be depreciated to its net scrap value or zero value.
- As under this method, the same or equal amount of depreciation is charged from the Profit and Loss Account each year, so, the burden of depreciation on the net profit remains the same.
- It is suitable for those assets that have low repairs and maintenance costs and are used continuously in the business over a period of time.
Disadvantages of Straight Line Method
The disadvantages of the Straight Line Method of depreciation are given below.
- When the assets have been in use for a long time, it demands frequent repairs and maintenance. Thus, with the passage of time, the burden of depreciation on profit and loss accounts increases along with the repairs and maintenance costs of the asset.
- Under this method, the value of the asset becomes zero in the books even if the asset is still in usable condition by the business.
- The estimation of the scrap value of the asset after a long period of say, 10 or 15 years, is a difficult task.
- This method is not suitable for all kinds of fixed assets.
Written Down Value Method
This is another method of charging depreciation on fixed assets. Under this method, depreciation is not charged on the original cost of the asset. It is charged at a fixed rate on the diminished or reduced value of the asset, i.e. the cost after deducting previously charged depreciation. As a result of this, with the decline in the value of assets year after year, the amount of depreciation also decreases from one year to another. This method of charging depreciation is also known as Diminishing Balance Method or Reducing Instalment Method.
For example, the cost of machinery purchased is Rs 2,00,000, and the rate of depreciation is 10% p.a. In this case, depreciation for the first year would be Rs 20,000 (i.e. 2,00,000 × 10%).
For the second year, depreciation will be computed on the written down value of Rs 1,80,000 (i.e. 2,00,000 − 20,000). So, the amount of depreciation for the second year would be Rs 18,000 (i.e. 1,80,000 × 10%). In a similar manner, depreciation for the subsequent years can be computed by considering the written-down value of machinery.
Advantages of Written Down Value Method
The following are the advantages of the written down value method of depreciation.
- It is based on the logical assumption that asset is used more in the earlier years, so, more cost is charged in earlier years in the form of depreciation.
- It is suitable for those assets that have high repairs and maintenance costs.
- This method is accepted by the income tax authorities.
- As more depreciation is charged in the earlier years, so the loss of the asset due to obsolescence of technology is reduced.
Disadvantages of Written Down Value Method
Given below are the disadvantages of the written down value method of depreciation.
- It is difficult and a time-consuming process to calculate the rate of depreciation under this method.
- The value of an asset under this method cannot be zero, thus, the asset cannot be completely written-off in the books.
- Under this method, there arises a shortage of funds for the replacement of an asset. This happens due to the fact that the amount of depreciation is retained and used in the business. Consequently, at the end of the useful life of an old asset, a business finds it difficult to arrange funds for its replacement.
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