Depreciation and Provision for Depreciation
➢ Depreciation:
Depreciation is the gradual and permanent decrease in the value of an asset from any cause.
Depreciation is a business expense to be charged to the profit & loss account at the end of every
year.
➢ Reasons / causes for depreciation:
1. Wear and tear: The regular usages of fixed asset in the business that causes decrease in value.
• Erosion, rust and decay: Erosion is subjected to assets like land, rust to plant and
machinery, decay to the elements of nature and the lack of proper attention.
2. Obsolescence: A fall in the value of an asset as a result of its age or usefulness.
3. Depletion: The using up of an asset like oil wells, mines etc.
4. Time factor: The passage of time, reducing the value of assets.
➢ Residual/salvage/scrap value:
This is the value that the business will get from the sale of an asset at the end of its useful life time.
➢ Methods of calculating depreciation:
1. Straight line method/depreciation on cost price/equal installment method/fixed
installment method:
Under this method fixed percentage on original cost is written off the asset throughout its economic
life. In this method the cost of the asset (minus net residual value if any) is divided by the expected
number of years of use of the asset.
Depreciation = cost – salvage/residual/scrap/disposal value
Estimated life of the asset/Number of years of use
➢ Advantages of Straight line method:
i. It is easier to calculate.
ii. The same figure is deducted from the asset every year.
iii. The residual value can be included in the calculation.
iv. The final balance of the asset comes to zero.
➢ Disadvantages of Straight line method:
i. This method assumes that the fixed assets will give the same amount of service annually
throughout their lifetime which in fact the service given may not be uniform, but instead may
vary from year to year.
ii. This may not lead to the enterprises setting aside enough resources to replace the asset at the
end of its useful life.
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2. Reducing Balance Method/Diminishing Balance Method/Depreciation on Book
Value:
A specific percentage of depreciation is charged upon the basic value of the asset at every year end.
Thus, the depreciation per year falls as the net book value decreases and hence the impact upon
profit is not constant but increasing.
➢ Advantages of Reducing balance method:
i. It does not write the asset down to zero and this reflects its residual value.
ii. It deducts more depreciation in the early years and better reflects market value.
iii. It allows the total asset cost to balance out.
➢ Disadvantages of Reducing balance method:
i. The asset is never fully depreciated.
ii. The method lacks simplicity.
iii. The method cannot be applied for assets with a very short life.
Straight line method Reducing balance method
1 A fixed amount of depreciation is 1 A fixed rate of depreciation is charged.
charged.
2 The asset may or may not have scrap 2 The asset must have a significant scrap
value. value.
3 The amount of depreciation per year is 3 The amount of depreciation goes on
same. reducing.
4 At the end of life the book value of assets 4 The book value of assets never reduces to
becomes zero. zero.
3. Revaluation Method:
Under this method, the depreciation is calculated by comparing the opening and closing values of
the asset. The difference is treated as depreciation. This method is suitable for the assets like small
tools, screwdrivers etc. The formula of calculating depreciation under revaluation method is as
follows:
Depreciation = Value of assets at the beginning + Purchase of Assets during the period – Value of
assets at the end.
➢ Provision for depreciation:
It means saving a part of the profit for the replacement of the asset. In other words this is the
provision created to cover the expense of depreciation on fixed assets.
➢ Importance of including depreciation in the profit & loss account and balance
sheet:
Depreciation is an expense of the business therefore it must be shown in the profit & loss account to
produce an accurate net profit.
Depreciation represents a fall in the value of the relevant asset. So it must be shown in the balance
sheet as a deduction from the asset to reflect that fall in value. Since the net profit is shown in the
balance sheet accounting for depreciation will show a true and fair balance sheet.
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