Unit-3 Depreciation

The monetary values of all tangible assets tend to reduce gradually over time
due to factors like wear and tear. The meaning of depreciation, in very simple
words, is the rate at which this value drops. Hence, it compares an asset’s
current value with its original cost at the time of acquisition or purchase.
For example, let us consider a cloth manufacturing company that purchased a
truck in 2010 for Rs. 50 lakhs for the purpose of transportation of finished
goods to its dealers. The truck’s value will decrease each year with regular use
over time. In order to determine the true reduced value of its truck every year,
the company will deduct, say, 10% of its worth. This is the meaning of
depreciation.
Depreciation applies to all tangible and generally fixed assets whose values
decrease with time. These include buildings, vehicles, machinery, office
equipment, furniture, etc. Land, however, does not come under this list because
the value of land usually only increases; it reduces only during adverse
economic downturns.
Introduction to Depreciation
• Concept: Depreciation is an essential accounting concept that ensures the
accurate reflection of an asset’s value in financial statements. Instead of
recording the entire cost of an asset as an expense in the year of purchase,
depreciation spreads this cost over its useful life.
• Purpose: It helps businesses allocate expenses correctly, maintain
financial accuracy, and comply with accounting and tax regulations.
• Legal Requirement: Most accounting standards and tax laws mandate
depreciation to reflect the true financial position of a company.
• Example: A machine purchased for $10,000 with a 10-year lifespan
depreciates annually, ensuring the company’s financial records reflect its
reduced value over time.
The Causes of Depreciation
Depreciation can be easily defined as a reduction in the carrying amount of a
fixed asset. Depreciation is equated with a value of consumption of the asset for
a specific period. Over the span of an asset, over which it is considered usable,
depreciation brings down the value of the asset to a salvage value.
This salvage value is the sum of money that is expected to accrue to the owner
if he makes a sale of the asset. Or it can be said to be the scrap value that he gets
on disposal of the asset. Following are the causes of depreciation:
Wear and Tear of the Asset
Every machinery or tool is bound to undergo wear over a period of time. There
will be parts that may need replacing or repairing. Usually, such assets have a
fixed span of life, after which, they need to be scrapped. This wear and tear of
the asset must be accounted for in financial terms, hence depreciation.
Perishability of Inventory
Items such as raw material and inventory, undergone deterioration over a quick
span of time. This is faster in relation to a fixed asset, which normally lasts for a
few years at least. This perishability of assets is a point of consideration for
depreciation accounting.
Usage Right Expiration
Some assets such as software and licenses have a typical span over which it can
be used. As soon as this time span finishes, the owner has to give up using the
asset. So the depreciation of this asset must be done over time, it cannot just be
written off on the day of expiration.
Obsolescence
Another cause of depreciation is the obsolute nature of certain assets. Over a
period of time, every asset loses its novel value. A new alternative can always
be developed for replacing the asset and its functions.
NEED FOR PROVIDING DEPRECIATION
The need for providing depreciation arises on account of the following points:
1. To Ascertain the Profits or Losses: The true profits or losses could be
ascertained when all costs of earning revenues have been properly charged
against them. Fixed assets like building, plant and machinery, furniture, motor
vehicles etc are important tool in earning business income. But the cost of the
fixed asset is not charged to profit and loss of the accounting period in which
the asset is purchased. Therefore, the cost of the fixed asset less its salvage
value must be allocated rationally to the periods that receive benefit from the
use of the asset. Thus, depreciation is an item of business expense and must be
provided for a proper matching of costs with the revenue.
2. To show the Asset at its Reasonable Value: The assets decrease in their
value over a period of time on account of various reasons such as passage of
time, constant use, accidents, etc. Therefore, if the depreciation is not charged
then the asset will appear in the balance sheet at the over stated value. This
practice is unfair as the balance sheet would fail to present the true financial
position.
3. Replacement of assets: Business assets become useless at the expiry of their
life and, therefore, need replacement. The cash resources of the concern are
saved from being distributed by way of dividend by providing for depreciation.
The resources so saved, if set aside in each year, may be adequate to replace it
at the end of life of the asset.
4. To Reduce Income Tax: If tax is paid on the business income without
providing for depreciation, then it will be in excess to the actual income tax.
This is a loss to the business. Thus, for calculating tax, depreciation should be
deducted from income similar to the other expenses as depreciation is a
chargeable expense and results in tax benefit.

Methods of Depreciation
(a) Straight-Line Method (SLM)
 • Explanation:
o In this method, depreciation is charged evenly over the useful life
of the asset.
o The same amount is deducted as an expense every year.
o It is simple and commonly used for assets with a predictable useful
life.
Cost of Asset-Scrap Value
• Formula: Annual Depreciation = Useful Life

• Example: If a machine costs $10,000, has a salvage value of $1,000, and a

useful life of 5 years:

• Advantages: Easy to calculate, consistent depreciation amount.

• Disadvantages: Does not consider higher usage in early years.

(b) Reducing Balance Method (RBM) or Diminishing Balance

Method
• Explanation:
o A fixed percentage of depreciation is charged on the book value of
the asset.
o Depreciation amount decreases over time.
o Suitable for assets that lose value faster in initial years, like
machinery and vehicles.
o Formula:

• Example: If a machine costs $10,000 and the depreciation rate is 20%:

• Advantages: Higher depreciation in early years matches higher utility.

 • Disadvantages: Complex calculation, asset never fully depreciates.
(c) Units of Production Method
• Explanation:
o Depreciation is based on actual usage rather than time.
o Useful for manufacturing or mining assets.
• Formula:

• Example: If a machine costs $10,000, has a scrap value of $1,000, and is

expected to produce 10,000 units: per unit.

• Advantages: Accurate depreciation based on actual use.

• Disadvantages: Difficult to estimate total production accurately.
(d) Sum of Years' Digits Method
• Explanation:
o Accelerated depreciation method where higher depreciation is
charged in earlier years.
o The sum of the years of the asset's useful life is calculated.
• Formula:

• Example: If an asset has a useful life of 5 years, the sum of years’ digits =
5+4+3+2+1 = 15.
• Advantages: Matches higher utility in earlier years.
• Disadvantages: Complex calculations.
(e) Double Declining Balance Method
 • Explanation:
o A higher depreciation rate is applied than the reducing balance
method.
o It uses twice the straight-line depreciation rate.
• Formula:

• Example: If a machine costs $10,000 with a 5-year life, straight-line rate

is 20%, so double declining rate = 40%.
• Advantages: Accelerated depreciation benefits tax savings.
• Disadvantages: Depreciation amount reduces significantly in later years.

Accounting Treatment

Revised AS-6 and Practical Problems

Revised AS-6 (Depreciation Accounting)
 • The revised AS-6 specifies the recognition, measurement, and disclosure
requirements for depreciation.
• It requires systematic allocation of depreciable assets over their useful
lives.
• Depreciation is recognized in the Profit & Loss Account, ensuring true
financial representation.

Practical Problem Using SLM and RBM (Where Provision for Depreciation
Account is Not Maintained)
Problem Statement:
XYZ Ltd. purchased machinery for $50,000 on April 1, 2020. The estimated
useful life is 5 years, and the expected residual value is $5,000. The
depreciation rate under the Reducing Balance Method is 20% per annum. The
company does not maintain a Provision for Depreciation Account. Prepare
depreciation calculations for the first two years using both the SLM and RBM
methods.
Solution:
Accounting Treatment