1) Introduction, meaning and definition of depreciation
2) Need and causes of depreciation
3) Basic concepts to understood and calculated depreciation
4) Methods of depreciation
5) Fixed Installment Method
- Features, Merits and Demerits of Fixed Installment Method
6) Reducing Balance Method
- Features, Merits and Demerits of Reducing Balance Method
7) Difference between Fixed Installment Method and Reducing Balance Method
WHAT IS DEPRECIATION ?
Introduction -
Any business needs assets of two types - fixed assets like land, building, furniture, fixtures, plants, machinery, tools etc. And current assets like stock, debtors, bills receivables, bank balance, cash balance etc. The current assets are converted into cash in a short period of time viz. Normally less than one year. Thus, the life of a current assets is short. As against this, the fixed assets, as the name indicates, is fixed and remains with the business for pretty long period like 10 years, 15 years, etc. It is obvious that the usefulness or efficiency of these fixed assets will not be same for all the years of their lives. It will go on diminishing as the year pass. As the usefulness of the asset falls, so also it's market value is falls. In short because of lapse of time or wear and tear of the asset, it's value gets reduced. This reduction in the value of the fixed assets is permanent and also continuous. In business language, the fall in the value of assets is called as depreciation.
Depreciation is calculated on the value of the asset on estimated basis because no one can exactly work out the fall in the value of assets. Hence, it is called as a 'notional charge'. The reduction in the value of fixed asset is a loss of the business and hence deducted while finding the profit. Depreciation is merely a book entry of expenditure and it does not involve any cash outflow.
Meaning -
The word depreciation comes from the latin word 'depretium'. It means decrease in the value. In accounting the term depreciation generally used to indicate the decline or reduction in the value of fixed assets. The book value of the fixed assets like machinery, building, equipment etc. goes down as they are used in the business. In simple words depreciation means the reduction in the value of the fixed assets.
Definition of Depreciation -
"Depreciation may be defined as the permanent and continuing diminition in the quality or the value of an asset. "
- William Pickles
"Depreciation is the gradual and permanent decrease in the value of an asset from cause whatever"
- Carter
WHAT ARE THE NEEDS DEPRECIATION ?
Need of Depreciation :
The need of charging depreciation on fixed assets of the business organisation are stated as under.
1. To ascertain true profit or loss :
The charges of depreciation is very significant in accounting. the businessman is interested in a certain the true profit or loss of the business. he can arrive at the profit or loss only after recording the depreciation. it is impossible to know the net profit or loss without providing for depreciation. depreciation causes business loss. it surely affects the profit side. so depreciation must be provided and recorded to find profit or loss.
2. To present a true financial position -
Every businessman is also interested in knowing the net worth of the business. it is the difference between the Assets and liabilities. the balance sheet records Assets and liabilities. while preparing the balance sheet the true existing values of the assets are to be recorded. the balance sheet had to show the correct financial position of the business. So, the proper value must be shown in the balance sheet. This is possible only when the proper depreciation amount is deducted from the cost of the assets.
3. Replacement of Assets -
The fixed assets like machines and equipments are installed and used for a particular period for the business purpose. Because of their continuous use the assets become old, useless and defunct. Such unproductive assets must be replaced by new ones. A businessman has always to make provision equal to amount of depreciation of assets every year. These financial provisions later help him to purchase new asset when the existing one become old and and productive.
4. To compute correct tax liability -
The businessman has to pay income tax on the profit earned during the year. Correct tax liability cannot be computed on less correct profit is deducted or calculated. To ascertain or calculate correct profit, all business expenses and losses are charged to profit and loss account. Depreciation being a loss should be debited to profit and loss account so they a fixed rebate on Income Tax can be claimed by calculating the depreciation.
WHAT ARE THE CAUSES DEPRECIATION ?
Causes of Depreciation -
1) the value of the price of the fixed assets fall down due to the passage of time even though the assets are not used.
2) the constant use of the fixed assets for the production of the goods causes wear and tear, This wear and tear reduce the value of the assets.
3) Sometimes the market price of the assets goes down, this may bring down the value of the assets.
4) Some new invention or change in the machine may prove the existing assets less productive and obsolete.
5) Accidents such as fire, earthquake, breakage in the machinery may bring down the value of assets.
HOW TO CALCULATE DEPRECIATION ?
For charging depreciation the following four concepts need to be understood and calculated carefully :
1) Scrap Value :
It is the rasidual value of the assets which can be realized at the end of the effective life of the assets. The asset though become useless after a period, its market value was not become zero. It can fetch some amount at the time of discarding it.
For example, A machine costing rupees 5 lacs My fetch rupees 5000 only after 10 years of its use. This amount is called as scrap value.
The cost of the asset is recovered to the extent of scrap value. Hence, depreciation is charged on the net cost of the asset, which is the original cost minus the estimated scrap value of the asset.
When the asset is sold at scrap, cash comes in and the asset goes out. Hence, the journal entry pass is as under :
Cash / Bank A/c __________ Dr.
To Respective Fixed Asset A/c
2) Estimated life of asset :
Every asset is useful for a specific period only. For example a building may be useful for 25 years only. After 25 years replacement may be necessary. It is therefore, necessary that a provision should be made for making fund available for replacement of asset. The life of asset is determined by the experts in the respective fields. The asset may have a longer life in terms of years but for accounting purposes only. Those number of years are considered as life of the asset for which it is likely to be used. e. g. machine may have the life of 20 years but considering the technological upgradation of the machine may be actually estimated to be used for 10 years only.
Depreciation is calculated by dividing the net cost of the asset by the estimated life of the asset.
3) Installation Charges -
Some assets cannot be used without their installation. e. g. a machine may not be used unless it is fixed on the floor, is provided on electric connection and is fenced for security purpose. For this some expenditure if required to be incurred. For example wages, cost of material etc. These expenses are called as installation charges.
The installation charges are part and parcel of the total cost of the asset. Hence they are added to purchase price of the asset. In other words installation charges are not revenue expenses but are capital expenses. Installation charges are also known as erection charges.
The journal entry for installation charges paid is as under :
Respective fixed asset A/c _______ Dr.
To Cash / Bank A/c
4) Capitalised Expenditure -
The expenditure on assets which is non- recurring and which adds to the value of the asset and also makes the asset functionable is the capital expenditure for that asset. For example transport charges of the machine for bringing the machine to the factory, octroi paid on the machine, coolie charges, installation expenses etc.
The expenditure capitalised, is not debited to profit and loss account, but is added to the respective asset accounts.
The following entry is passed for incurring the expenditure which is capitalised.
Respective Fixed Asset A/c _______ Dr.
To Cash / Bank A/c
After considering the above for concept. calculation of depreciation will be more correct. It can be summed up as a under, cost of the asset + capital expenditure
Original cost of the asset +
installation charges -
scrap value.
Depreciation = ------------------------------------
Estimated life of asset.
WHAT ARE THE METHODS DEPRECIATION ?
Methods of Depreciation -
There are various methods for charging depreciation such as :
1) Fixed installment or straight line method.
2) Reducing balance method or diminishing balance Method.
3) sum of the digits method.
4) Annuity method
5) Depreciation fund method
6) Insurance policy method
7) Revaluation method
8) Depletion method
9) Machine hour rate method
10) Repairs provision method
out of these methods two methods are to be studied so they are explained below first Fixed installment method and second reducing balance method
1) Fixed Installment Method -
Fixed installment method is also called as straight line method or original cost method or equal installment method. This is the most popular method because it's very simple. Under this method fixed amount of depreciation is charged every year during the estimated life of the asset. Due to charging fixed amount of depreciation every year during the life time of the asset the book value of asset is reduced up to zero or to its residual value, at the end of its life. Every year depreciation is charged at the certain percentage on original cost of the asset.
Factors to be considered for calculating depreciation :
a) Cost of fixed assets ( purchase price + installment installation charges )
b) Scrap value
c) Estimated life of the asset.
Total cost of Fixed Asset - scrap value.
Depreciation = ----------------------------------------
Est. life of fixed asset.
Features of Fixed Installment Method -
1) In this method the rate of depreciation is fixed.
2) Depreciation is calculated as a fixed percentage on the original cost of the asset.
3) Every year the amount of depreciation remains the same during the economic life of the asset.
Merits / Advantages of Fixed Installment Method -
1) This method is simple to follow and easy to understand.
2) The calculation of amount of depreciation is also simple and calculation is not needed every year.
3) The cost of asset is reduced up to zero or to its received your value at the end of its estimated life.
4) If any additional to asset is made having the same life period calculation of depreciation is easy.
5) This method is suitable to patents, loose stools , short leases, furniture and fixtures etc.
6) This method is easy to suitable for such asset which includes small capital having short life and doesn't require much repair and renewals
Demerits / Disadvantages of Fixed Installment Method -
1) As per this method, the profit gets affected. Because depreciation amount of fixed asset remains the same while the expenditure on repairs and renewals go on increasing year after year.
2) As per this method, interest on investment for buying the asset is not taken into consideration.
3) The businessman has to make separate calculation if any additional asset is purchased of different working life.
2) Reducing Balance Method :
This method is also called as diminishing balance method or written down value method or reducing installment method.
The value or the cost of the asset goes on reducing every year because it becomes less and less productive. In this method the rate of depreciation does not change but the amount of depreciation changes. The depreciation is charged on the reduced value of the Asset and not on the original cost. The depreciation is calculated and charged on the diminished value of the asset at the beginning of every year. As the Asset becomes older than depreciation goes on reducing i. e lesser and lesser in every subsequent year. In this method the rate of depreciation is fixed and not the amount of depreciation.
Example :
A company purchased machinery for rupees 50,000. It is decided to depreciate it at 10% p.a. under reducing balance method the amount of depreciation will be calculated as under :
Rs.
First year. 50,000.
Less: dep 10% - 5000.
Second year. 45000.
Less: dep 10% -4,500.
Third year. 40,500.
Less: dep 10% -4,050
W.D.V. 36,450
Features of Reducing Balance Method -
1) Though the rate of depreciation is fixed.
2) The amount of depreciation changes every year.
3) The depreciation is calculated as a fixed rate. It is charged on the reducing value of the Asset.
4) As the utility of the asset falls, the annual depreciation also reduces.
Merits / advantages of Reducing Balance Method -
1)This method provides expenses for the use of an asset scientifically as on one hand the amount of depreciation decreases and on the other hand repairs and renewal charges go on increasing every year as the asset become old and older.
2) This method is simple to understand and apply.
3) This method of depreciation is accepted by business community as well as income tax authority.
Demerits / Disadvantages of Reducing Balance Method -
1) By charging depreciation and reducing balance method, the value of asset is not reduced up to zero even after its working life is over.
2) Under this method, interest on investment in the asset is not considered.
3) Under this method, it is difficult to determine the suitable rate of depreciation.
Difference between Fixed installment method and Reducing balance method :
|
No. |
Fixed installment method |
Reducing balance
method |
|
1 |
Depreciation is charged on the purchase price of the asset for all years. |
Depreciation is charged on
written value at the beginning of each year. |
|
2 |
Amount of depreciation
remain fixed thought out the life of the asset. |
Amount of depreciation
goes on reducing every year. |
|
3 |
After charging
depreciation the value of an asset is reduced up to zero at the end of its
working life. |
After charging
depreciation. The value of an asset is never reduced upto zero at the end of its working
life. |
|
4 |
This method is easy and
suitable for asset which includes small capital, short life, and does not
require much repairs and renewals. E.g. furniture and fixtures, short leases,
patent, Trademark etc. |
This method is proper for
the asset which have long life and require more and heavy repair expenses. E.g.
building, plant and machinery, motor car etc. |
|
5 |
This method is not
accepted for income tax purpose. |
This method is accepted
for income tax calculation. |
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