MEANING
Depreciation is the permanent and gradual decrease in the value of the assets due to wear and tear, effluxion of time and expiration of legal rights etc.
ACCORDING TO R N CARTER
“Depreciation is the gradual decrease in the value of assets from any cause.”
ACCORDING TO J H BURTON
“Depreciation is the shrinkage in the value assets at a given date as compared with its value at previous date”.
Thus, Depreciation is the decline in the book value of the depreciable assets during the estimated useful life of the assets. It may be due to wear and tear of assets, passage of time, technology upgradation or depletion etc.
1. NATURE OF EXPENSE: It is a non-cash expense as there is no actual payment of cash when it occurs. It is just writing off the value of the asset.
2. MAY BE PHYSICAL OR ECONOMIC: It may be physical or economic. Physical depreciation refers to the decline in the productive or service ability of the capital asset due to the effects of environment and wear and tear.
Economic Depreciation refers to the decrease in the value of asset over time. This form of depreciation usually pertains to real estate, which can lose value due to indirect causes such as the addition of new construction in close proximity to the property, road additions or closures, a decline in the quality of the neighborhood, or other external factors.
3. AN ALLOCATION OF COST: It is a process of allocation of cost of the asset for a particular period of time. It is the time in which the asset fetches economic benefit. It is not a valuation of fixed asset.
4. GOVERNING STANDARD: Accounting Standard-6 issued by ICAI (Institute of Chartered Accountants of India) governs Depreciation Accounting. AS-6 states that-
“Depreciation is a measure of the wearing out, consumption or other loss of value of a depreciable asset arising from use, effluxion of time or obsolescence through technology and market changes. It is allocated so as to charge a fair proportion of the depreciation amount in each accounting period during the expected useful life of the assets. Depreciation includes amortization of assets whose useful life is pre-determined.”
5. ACCOUNTING TREATMENT: Depreciation is a charge against profit. The Debit side of Profit and Loss Account shows Depreciation as an Expense.
The Assets side of Balance Sheet shows amount of depreciation by deducting the amount from value of asset.
6. It does not depend upon the fluctuations in the market value of an asset.
7. Total depreciation of an asset cannot exceed its depreciable value.
8. Only fixed assets are chargeable to Depreciation.
9. It is a continuous fall in the utility of a fixed asset till the end of its useful life.
OBJECTIVES/ NEED/ IMPORTANCE
It is recorded in the books because of the following reasons:
1. ASCERTAINMENT OF TRUE PROFIT OF LOSS: One of the objectives of accounting is to determine the true profits of business. That’s why, profit and loss account shows the depreciation as an expense. In the absence of depreciation being charged, the profit would be overstated in the books.
2. TRUE AND FAIR VIEW OF ASSETS IN THE BALANCE SHEET: No treatment of depreciation leads to over valuation of assets in the balance sheet. As such, this overvaluation of fixed asset will not represent a true and fair view of the state of affairs of the business.
3. ACCURATE ASCERTAINMENT OF COST OF PRODUCTION: The manufacturing of goods requires plants, machinery and equipments. The cost of production must includes depreciation as a factory overhead for accurate calculation.
In case, cost of production excludes depreciation, there will be no recovery of depreciation at the time of sales of goods.
4. TO PREVENT DISTRIBUTION OF PROFIT OUT OF CAPITAL: Profits are divisible only after providing for depreciation as per Section 205 of the Indian Companies Act. Without charging depreciation the profit and loss account will show more profit than the actual profit. The shareholders get this excess profit as dividend. As such amount so distributed will actually be a part of capital.
Indian Companies Act 2013 prohibits distribution of profit out of capital. As a result, depreciation is provided for fixed assets only.
5. TO PREVENT FUNDS FOR REPLACEMENT OF ASSETS: The profits reduces by charging depreciation to profit and loss account. However, depreciation is non-cash expense. So, the amount of depreciation retains in the business and uses for the replacement of fixed assets when its life is over.
6. TO SAVE TAX: The charge of depreciation reduces the profits of the firm. This in turn reduces the tax liability of the firm or company.
7. TO MEET LEGAL REQUIREMENTS: In order to comply with the provisions of the Companies act and the Income Tax act, it is a legal necessity to charge Depreciation.
8. TO KEEP CAPITAL INTACT: If depreciation is not charged, the amount of profit will be inflated. If such profits are distributed among the owners, then it will amount to the distribution of fixed capital from the business. In the long run, it will affect the financial wealth of the business.
9. OTHER OBJECTIVES: Amount of depreciation reduces the amount of profit to that extent. If the depreciation is not provided it may have the following adverse affect on the business concern:-
- Employees may demand more salary, bonus and facilities.
- Other people may enter the similar type of business which may increase competition.
- Business may commit funds to wasteful activities, like donations for political purposes.
CAUSES OF DEPRECIATION
The causes of decline in the book value of fixed assets may be divided into categories:
PHYSICAL CAUSES
The physical causes of depreciation are as follows:
1. WEAR AND TEAR: Some assets physically deteriorate due to wear and tear in use. The constant use of asset , the greater would be wear and tear.Example: A machine used in two shifts would have more wear and tear as compared to a machine used for single shift.
2. DESTRUCTION: The physical destruction of an asset reduces its utility or value. The causes of destruction may be due to an accident like flood, fire and other similar havocs.
3. DECAY: It refers to lessening the utility of an asset by the effect of nature. Example: Rain, Moisture, Change in weather and other elements of nature.
ECONOMIC CAUSES
The economic causes of depreciation are as follows:
1. OBSOLESCENCE: Some assets are discarded before they are worn out because of changed conditions.Example: An old machine which is still workable may have to be replaced by a new machine because the new machine being more efficient and economical.
Such a loss on account of new inventions or changed fashion is termed as obsolescence.
2. INADEQUACY: It refers to the termination of the use of an asset due to increase in the volume of business activities. Although the asset is still usable, its inadequacy for present level of activity has cut short its service life.
3. EFFLUXION OF TIME: There are some assets which lose their value simply with the effluxion of time. Such assets become valueless after the expiry of period of their life. Thus, their cost is written off over their working life.Example: Lease, Patents, Licenses, Copyrights etc. are the assets that depreciate with effluxion of time.
4. DEPLETION: Depletion term is used for extraction of natural resources from mines, oil wells etc. Extraction of natural resources reduces their stock value. This reduction is termed as Depletion. Depletion is shown as an Expense at the Debit side of Profit and Loss Account.
5. EXHAUSTION: Some assets lose their value gradually with the passage of time. They have their own age and exhaust in value after the expiry of the certain period of their age.Example: Plantations, Animals etc.
6. FALL IN PRICE: Though fluctuation in the market price of an asset is not recorded in the books but if the fall in the price is permanent, we have to take it into account as loss on account of depreciation.
FACTORS AFFECTING DEPRECIATION
It is not possible to accurately determine the amount of depreciation. It can only be estimated by considering the following factors:
1. TOTAL COST OF AN ASSET: The actual cost of the asset is determined after including all expenses incurred such as:
- Freight
- Carriage
- Installation charges
- Cost of improvement etc.
However, financial charges such as interest on money borrowed to purchase the asset or installment paid should not be included in the cost of the asset.
Example: If a machinery is purchased for ₹ 75,000 and ₹4,000 are spent on its freight and ₹1,000 on installation, then the total cost of asset is:
75,000+4,000+1,000= ₹80,000
2. ESTIMATED WORKING LIFE OF AN ASSET: Technical expertise is required to estimate the working life of an asset conditions under which the asset is maintained and preserved affect the life of asset. The estimated working life of the asset may be measured in terms of years, months, days, hours, output, kilometers etc.
Example: Suppose the given machinery can work for 15 years. However, the machinery is likely to become obsolete after 10 years. In such a case, its useful life for the purpose of accounting should be considered as only 10 years. So, depreciation will be 70,000/10= ₹7,000 p.a.
3. ESTIMATED RESIDUAL VALUE: It refers to the estimated amount will be realized when asset is sold, discarded or exchanged for a new asset at the end of its working life. Cost of asset minus residual value is called the ‘Depreciable Amount’ which is charged over the working life of the asset.
Example: If the given machinery of ₹80,000 is estimated to have a residual value of ₹10,000, then the amount of ₹70,000 (80,000-10,000) is the ‘Depreciable Cost’ which is to be written off over the useful life of the machinery.
4. PROVISION FOR REPAIRS AND RENEWALS: Proper repairs and renewals undertaken at regular intervals help in keeping the asset in good condition. Both handling and careless approach adversely affect the life of the asset. Thus, before estimating the amount of depreciation, this factor must be taken into consideration.
5. DEPRECIATION IN CASE OF OBSOLESCENCE: If the asset is likely to be of nil value due to some new inventions, more amount of depreciation should be provided. Lesser the period, more will be the amount of depreciation and vice-versa.
Example: If the asset is expected to be obsolete within 6 years, the firm will have to split its value over 6 years. If it will obsolete in 5 years, the value will be split over 5 years.
It means the amount of depreciation charged over every year, will increase with more quick obsolescence.
6. LEGAL PROVISIONS: If there are some legal provisions for providing depreciation on asset, the same should be taken into the consideration. Provisions of Companies Act (Amendment), 2013 and Income Tax Act, 1962 are relevant in this regard.
7. ADDITION TO ASSETS: Any capital expenditure incurred on extension and addition to old machinery will be subject to depreciation in the in which addition is made to the asset.
8. SALE OF ASSET: The amount of depreciation also gets affected by the sale of an asset. In case of sale of asset, the amount of depreciation gets reduced by the amount of asset sold.
CONCLUSION
Depreciation is charged only in respect of tangible fixed assets. If depreciation is not provided for, the Profit and Loss Account and the Balance Sheet will not show a true and fair view of the business and thus:-
- Periodic expenses will be understated.
- Profits will be overstated.
- Asset valuation will be overstated.
- Capital depletion will be inappropriate.
- Net worth will be overstated.
