Depreciation

What us depreciation? What are the methods of depreciation? What factors to be taken into account while determining the amount of depreciation?

Matching principle requires that the revenue of a given period is matched against the expenses for the same period. This ensures ascertainment of the correct amount of profit or loss. If some cost is incurred whose benefits extend for more than one accounting period then it is not justified to charge the entire cost as expense in the year in which it is incurred. Rather such a cost must be spread over the periods in which it provides benefits. Depreciation, which is the main subject matter of the present chapter, deals with such a situation.

Further, it may not always be possible to ascertain with certainty the amount of some particular expense. Recall that the principle of conservatism (prudence) requires that instead of ignoring such items of expenses, adequate provision must be made and charged against profits of the current period. Moreover, a part of profit may be retained in the business in the form of reserves to provide for growth, expansion or meeting certain specific needs of the business in future. Fixed assets are the assets which are used in business for more than one accounting year. 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. Even if the machine is not used in production process, we can not expect it to realise the same sales price due to the passage of time or arrival of a new model (obsolescence). It implies that fixed assets are subject to decline in value and this decline is technically referred to as depreciation. As an accounting term, depreciation is that part of the cost of a fixed asset which has expired on account of its usage and/or lapse of time. Hence, depreciation is an expired cost or expense, charged against the revenue of a given accounting period. For example, a machine is purchased for Rs.1,00,000 on April 01, 2005. The useful life of the machine is estimated to be 10 years. It implies that the machine can be used in the production process for next 10 years till March 31, 2015. You understand that by its very nature, Rs. 1,00,000 is a capital expenditure during the year 2005. However, when income statement (Profit and Loss account) is prepared, the entire amount of Rs.1,00,000 can not be charged against the revenue for the year 2005, because of the reason that the capital expenditure amounting to Rs.1,00,000 is expected to derive benefits (or revenue) for 10 years and not one year. Therefore, it is logical to charge only a part of the total cost say Rs.10,000 (one tenth of Rs. 1,00,000) against the revenue for the year 2005. This part represents, the expired cost or loss in the value of machine on account of its use or passage of time and is referred to as ‘Depreciation’. The amount of depreciation, being a charge against profit, is debited to the profit and loss account Depreciation may be described as a permanent, continuing and gradual shrinkage in the book value of fixed assets. It is based on the cost of assets consumed in a business and not on its market value.

According to Institute of Cost and Management Accounting, London (ICMA) terminology “ The depreciation is the diminution in intrinsic value of the asset due to use and/or lapse of time.” Accounting Standard-6 issued by The Institute of Chartered Accountants of India (ICAI) defines depreciation as “a measure of the wearing out, consumption or other loss of value of depreciable asset arising from use, effluxion of time or obsolescence through technology and market-change. Depreciation is allocated so as to charge fair proportion of depreciable amount in each accounting period during the expected useful life of the asset. Depreciation includes amortization of assets whose useful life is pre-determined”. Depreciation has a significant effect in determining and presenting the financial position and results of operations of an enterprise. Depreciation is charged in each accounting period by reference to the extent of the depreciable

amount. It should be noted that the subject matter of depreciation, or its base, are ‘depreciable’ assets which:

• “are expected to be used during more than one accounting period;

• have a limited useful life; and

• are held by an enterprise for use in production or supply of goods and

services, for rental to others, or for administrative purposes and not for the purpose of sale in the ordinary course of business.” Examples of depreciable assets are machines, plants, furnitures, buildings, computers, trucks, vans, equipments, etc. Moreover, depreciation is the

allocation of ‘depreciable amount’, which is the “historical cost”, or other amount substituted for historical cost less estimated salvage value. Another point in the allocation of depreciable amount is the ‘expected useful life’ of an asset. It has been described as “either

(i)                 the period over which a depreciable asset is expected to the used by the enterprise,

(ii)               the number of production of similar units expected to be obtained from the use of the

asset by the enterprise.”

Features of Depreciation

Above mentioned discussion on depreciation highlights the following features of depreciation:

1. It is decline in the book value of fixed assets.

2. It includes loss of value due to effluxion of time, usage or obsolescence.

For example, a business firm buys a machine for Rs. 1,00,000 on April 01, 2000. In the year 2002, a new version of the machine arrives in the market. As a result, the machine bought by the business firm becomes outdated. The resultant decline in the value of old machine is caused by obsolescence.

3. It is a continuing process.

4. It is an expired cost and hence must be deducted before calculating taxable profits. For example, if profit before depreciation and tax is Rs. 50,000, and depreciation is Rs. 10,000; profit before tax will be: (Rs.)Profit before depreciation & tax 50,000 (-) Depreciation (10,000)

Profit before tax 40,000

5. It is a non-cash expense. It does not involve any cash outflow. It is the process of writing-off the capital expenditure already incurred.

Causes of Depreciation

These have been very clearly spelt out as part of the definition of depreciation in the Accounting Standard 6 and are being elaborated here

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.

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.

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:

1. 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

(a) For deducting depreciation amount from the cost of the asset.

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

To Asset 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

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 and 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 ‘depreciation provision’ or ‘accumulated depreciation’. Such accumulation of depreciation enables that 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, which 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 into 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.

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. According to Accounting Standand-6 of ICAI, cost of a fixed asset is “the total cost spent in connection with its acquisition, installation and commissioning as well as for addition or improvement of the depreciable asset”.

For example, a photocopy machine is purchased for Rs. 50,000 and Rs. 5,000 is spent on its transportation and installation. In this case the original cost of the machine is Rs. 55,000 (i.e. Rs. 50,000 + Rs.5,000 ) which will be written off as depreciation over the useful life of the machine.

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 Depreciation, Provisions and Reserves 235 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. For example, a machine is purchased and it is estimated that it can be used in production process for 5 years. After 5 years the machine may still be in good physical condition but can’t be used for production profitably, i.e., if it is still used the cost of production may be very high. Therefore, the useful life of the machine is considered as 5 years irrespective of its physical life. Estimation of useful life of an asset is difficult as it depends upon several factors such as usage level of asset, maintenance of the asset, technological changes, market changes, etc. As per Accounting Standard – 6 useful life of an asset is normally the “period over which it is expected to be used by the enterprise”. Normally, useful life is shorter than the physical life. The useful life of an asset is expressed in number of years but it can also be expressed in other units, e.g., number of units of output (as in case of mines) or number of working hours. 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 Calculating Depreciation Amount

The depreciation amount to be charged for during an accounting year depends up on depreciable amount and the method of allocation. For this, two methods are mandated by law and enforced by professional accounting practice in India. These methods are straight line method and written down value method. Besides these two main methods there are other methods such as – annuity method, depreciation fund method, insurance policy method, sum of years digit method, double declining method, etc. which may be used  for determining the amount of depreciation. The selection of an appropriate method depends upon the following :

• Type of the asset;

• Nature of the use of such asset;

• Circumstances prevailing in the business;

As per Accounting Standard-6, the selected depreciation method should be applied consistently from period to period. Change in depreciation method may be allowed only under specific circumstances.

Straight Line Method

This is the earliest and one of the widely used methods of providing depreciation. This method is based on the assumption of equal usage of the asset over its entire useful life. It is called straight line for a reason that if the amount of depreciation and corresponding time period is plotted on a graph, it will result in a straight line .

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:

Estimated useful life of the asset

Cost of asset Estimated  - net residential value

 Depreciation − 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:

Acquisition cost/Annual depreciation amount

Rate of Depreciation

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

Estimated life of asset

Acquisition cost of asset − Estimated net residential value

Rs. (2,50,000 - Rs. 50,000)/10

Rs. 20,000

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. 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:

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. Under written down value method, the rate of depreciation is computed by using the following formula 

What is diminishing balance method of charging depreciation? Discuss its merits and demerits ? How does it differ from fixed installment system?

Matching principle requires that the revenue of a given period is matched against the expenses for the same period. This ensures ascertainment of the correct amount of profit or loss. If some cost is incurred whose benefits extend for more than one accounting period then it is not justified to charge the entire cost as expense in the year in which it is incurred. Rather such a cost must be spread over the periods in which it provides benefits. Depreciation, which is the main subject matter of the present chapter, deals with such a situation.

Further, it may not always be possible to ascertain with certainty the amount of some particular expense. Recall that the principle of conservatism (prudence) requires that instead of ignoring such items of expenses, adequate provision must be made and charged against profits of the current period. Moreover, a part of profit may be retained in the business in the form of reserves to provide for growth, expansion or meeting certain specific needs of the business in future. Fixed assets are the assets which are used in business for more than one accounting year. 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. Even if the machine is not used in production process, we can not expect it to realise the same sales price due to the passage of time or arrival of a new model (obsolescence). It implies that fixed assets are subject to decline in value and this decline is technically referred to as depreciation. As an accounting term, depreciation is that part of the cost of a fixed asset which has expired on account of its usage and/or lapse of time. Hence, depreciation is an expired cost or expense, charged against the revenue of a given accounting period. For example, a machine is purchased for Rs.1,00,000 on April 01, 2005. The useful life of the machine is estimated to be 10 years. It implies that the machine can be used in the production process for next 10 years till March 31, 2015. You understand that by its very nature, Rs. 1,00,000 is a capital expenditure during the year 2005. However, when income statement (Profit and Loss account) is prepared, the entire amount of Rs.1,00,000 can not be charged against the revenue for the year 2005, because of the reason that the capital expenditure amounting to Rs.1,00,000 is expected to derive benefits (or revenue) for 10 years and not one year. Therefore, it is logical to charge only a part of the total cost say Rs.10,000 (one tenth of Rs. 1,00,000) against the revenue for the year 2005. This part represents, the expired cost or loss in the value of machine on account of its use or passage of time and is referred to as ‘Depreciation’. The amount of depreciation, being a charge against profit, is debited to the profit and loss account Depreciation may be described as a permanent, continuing and gradual shrinkage in the book value of fixed assets. It is based on the cost of assets consumed in a business and not on its market value.

According to Institute of Cost and Management Accounting, London (ICMA) terminology “ The depreciation is the diminution in intrinsic value of the asset due to use and/or lapse of time.” Accounting Standard-6 issued by The Institute of Chartered Accountants of India (ICAI) defines depreciation as “a measure of the wearing out, consumption or other loss of value of depreciable asset arising from use, effluxion of time or obsolescence through technology and market-change. Depreciation is allocated so as to charge fair proportion of depreciable amount in each accounting period during the expected useful life of the asset. Depreciation includes amortization of assets whose useful life is pre-determined”. Depreciation has a significant effect in determining and presenting the financial position and results of operations of an enterprise. Depreciation is charged in each accounting period by reference to the extent of the depreciable

amount. It should be noted that the subject matter of depreciation, or its base, are ‘depreciable’ assets which:

• “are expected to be used during more than one accounting period;

• have a limited useful life; and

• are held by an enterprise for use in production or supply of goods and

services, for rental to others, or for administrative purposes and not for the purpose of sale in the ordinary course of business.” Examples of depreciable assets are machines, plants, furnitures, buildings, computers, trucks, vans, equipments, etc. Moreover, depreciation is the

allocation of ‘depreciable amount’, which is the “historical cost”, or other amount substituted for historical cost less estimated salvage value. Another point in the allocation of depreciable amount is the ‘expected useful life’ of an asset. It has been described as “either

(i)                 the period over which a depreciable asset is expected to the used by the enterprise,

(ii)               the number of production of similar units expected to be obtained from the use of the

asset by the enterprise.”

Diminishing balance 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. 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:

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. Under written down value method, the rate of depreciation is computed by using the following formula

Advantages of Written Down Value Method

Written down value method has the following advantages:

• This method is based on a more realistic assumption that the benefits from asset go on diminishing 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 more as compared to later years when it becomes less useful;

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

 • Income Tax Act accept this method for tax purposes;

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

• This method is suitable for fixed assets, which lasts 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.

• 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;

• It is difficult to ascertain a suitable rate of depreciation.

Straight Line Method and Written Down Method: A Comparative Analysis

Straight line and written down value methods are generally used for calculating depreciation amount in practice. Following are the points of differences between these two methods.

Basis of Charging Depreciation

In straight line method, depreciation is charged on the basis of original cost or  (historical cost). Whereas in written down value method, the basis of charging depreciation is net book value (i.e., original cost less depreciation till date) of the asset, in the beginning of the year.

Annual Charge of Depreciation

The annual amount of depreciation charged every year remains fixed or constant under straight line method. Whereas in written down value method the annual amount of depreciation is highest in the first year and subsequently declines in later years. The reason for this difference, is the difference in the basis of charging depreciation under both methods. Under straight line method depreciation is calculated on original cost while under written down value method it is calculated on written down value.

Total Charge Against Profit and Loss Account on Account of Depreciation and Repair Expenses

It is a well-accepted phenomenon that repair and maintenance expenses increase in later years of the useful life of the asset. Hence, total charge against profit and loss account in respect of depreciation and repair expenses increases in later years under straight line method. This happens because annual depreciation charge remains fixed while repair expenses increase. On the other hand, under written down value method, depreciation charge declines in later years, therefore total of depreciation and repair charge remains similar or equal year after year. Recognition by Income Tax Law

Straight line method is not recognised by Income Tax Law while written down value method is recognised by the Income Tax Law.

 Suitability

Straight line method is suitable for assets in which repair charges are less,the possibility of obsolescence is less and scrap value depends upon the time period involved. Such as freehold land and buildings, patents, trade marks, etc. Written down value method is suitable for assets, which are affected by technological changes and require more repair expenses with passage of time such as plant and machinery, vehicles, etc.