INTRODUCTION

The concept of depreciation refers to allocation of the cost of fixed assets over their expected

period of useful life. The main purpose of depreciation is to charge it as an expense in order

to find out the cost of production. As a result, true profit/loss earned/suffered by the business

can be ascertained.

The following definitions will give a clear understanding of the term depreciation:

“Depreciation is the permanent decrease in the value of an asset due to use or the lapse of the

time.”
 CHARACTERISTICS OF DEPRECIATION

 Depreciation is a non-cash or non-monetary expense.

 Depreciation is charged in respect of fixed assets only.

 Depreciation may be physical or functional.

 Depreciation once charged cannot be recouped afterwards.

 Depreciation is continuous fall in the value of the asset till the entire cost is exhausted.
 CAUSES OF DEPRECIATION

1. Wear and tear: Assets get worn out because of constant use, passage of time. Such

thing happens with fixed assets like plant and machinery, furniture and fixtures,

building, etc.

2. Destruction: The physical destruction of an asset reduces its utility value. The causes

of depreciation may be due to accident like fire, flood or similar other calamities.

3. 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.

4. Depletion: In case of oil wells, mines, etc. the value is reduced with the extraction of

oil and (e) Exhaustion. Assets like plantations, animals etc. lose their value gradually

with the passage of time. They have their own age and exhaust in value after the

expiry of certain period of their age.

5. Obsolescence: Obsolescence is a process of becoming obsolete or out of date. Some

assets are discarded though they are in existence and working condition.

For example, a new asset has hit the market with more efficiency, low running and

Maintenance cost, etc. Use of the old asset becomes uneconomic. Running and

maintained cost will be increased. So the old asset is discarded and it is replaced by a

New asset.
 Need for Charging Depreciation

1. Correct calculation of profits: One of the objective of accounting is to

determine the true profits of business. This purpose is achieved when

depreciation is charged as expense to the Profit and Loss Account.

2. True and fair view in balance sheet: If depreciation is not provided in the

books of accounts, the fixed assets will be shown in the Balance Sheet at a

higher value than its real value i.e., it will be overvalued. 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: For the manufacture of goods the plants,

machinery, tools, equipments, etc., are required. Depreciation on these assets

is a factory overhead, which must be included to find out cost of production

accurately.

4. Replacement of assets: Assets used in the business need replacement after

the expiry of their useful life. Fresh funds are required to replace old assets.

Application of proper method of depreciation will make it convenient to make

arrangements for the replacement of asset after the expiry of its life.

5. Saving in income tax: When depreciation is debited to Profit and Loss

Account, the profits are reduced, consequently the tax liability on profit is also

reduced.
 Factors Determining the Amount of Depreciation

1. Cost of asset: The original cost of asset paid/payable on acquisition of asset, is

increased with the amount spent on installation, freight, loading and unloading

charges, transit insurance, octroi, import duty etc. The aggregate amount is called

"cost of asset'.

2. Estimated working life: 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 (unit & weight) or kilometres, etc.

3. Salvage/Residual/Scrap value: It refers to the estimated amount which will be

realised 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 asset.

4. Provision for repairs and renewals: Proper repairs and renewals undertaken at

regular intervals help in keeping the asset in good condition. Bad 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. Legal provisions: If there are some legal provisions for providing depreciation on

asset the same should be taken into consideration. Provisions of Companies Act,

1956 and Income Tax Act, 1961 are relevant in this regard.
 Methods of Charging Depreciation:

Different methods are used for the application of concept of depreciation to fixed assets.

1. Fixed instalment method (Straight line or original cost method):-

Under this method, a fixed proportion of original cost of the asset is written off

annually so that, by the time asset is worn out, its value in the books is reduced to zero

or residual value.

Depreciation= Original cost of fixed asset - Estimated scrap value

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Estimated life in years

2. Diminishing balance method

Under this method, a fixed rate or percentage of depreciation is charged each year on

the diminishing value of the asset till the amount is reduced to scrap value. Whereas,

the straight line method assumes that the net cost of an asset be allocated to

successive periods in uniform amounts, the diminishing balance method assumes that

the rate of allocation should be constant throughout time. Under this method, instead

of a fixed amount, a fixed rate on the reduced balance of the asset is charged

depreciation every year. Depreciation charged every year decreases over the life of the

asset. Though the percentage at which depreciation is charged remains fixed, the

amount of depreciation goes on decreasing year after year.