अवमल्

ू यन
Definitions :-
1. "Depreciation is the gradual and permanent decrease in the value of an asset
from any cause.“ - R.N. Carter

2. "Depreciation may be defined as the permanent and continuing diminution in

the quality, quantity or the value of an asset.“ - William Pickles

3 .- "Depreciation is the measure of the exhaustion of the effective life of an asset

from any cause during a given period.“ - Spicer & Peglar

4. "It is a matter of common knowledge that all fixed assets such as plant,
machinery, building, furniture etc. gradually diminish in value as they get older
and become worn out by constant use in the business.“ - J.R. Batliboi
Special features or Characteristics of Depreciation :-

1. Depreciation is decline in the value of fixed assets (except land).

2. Such fall is of a permanent nature. Once the value of an asset is

reduced due to depreciation, it cannot be restored to its original cost.

3. Depreciation is a gradual and continuing process because the value

of the asset will decline either by their constant use or obsolescence
due to expiry of time.
4. Depreciation is not the process of valuation of asset but process
of allocation of the cost of an asset to its effective span of life.

5. It decreases only the book value of the asset, not the market
value,

6. The term depreciation is used only in respect of tangible fixed

assets.

7. It is a non-cash expense. It does not involve any cash outflow.

Causes of Depreciation
(1) By Constant Use :- Due to the constant use of fixed assets in business
operations wear and tear arise in them which results in the reduction of their
values.

(2) By Expiry of Time :- The value of majority of assets decreases with the
passage of time even if they are not being put to use in the business. Natural forces
such as rain, winds, weather etc, contribute to the deterioration of their values.

(3) By Expiry of Legal Rights : There are certain assets which have a definite
span of life such as Lease. For example, if a lease has been obtained for 20 years for
₹5,00,000, it will lose 1/20th, i.e ., ₹25,000 of its value each year whether utilised or
not, so that at the end of 20th year its value is reduced to zero.
(4) By Obsolescence : Quite often, due to new inventions and improved
techniques the old assets become obsolete and may have to be discarded even if they
can be put to use physically.

(5) By Accident :- Sometimes a machine may be destroyed due to fire,

earthquake, flood etc, or a vehicle may be damaged due to accident.

(6) By Depletion :- Depletion is the decrease in the value of wasting assets such
as mines, oil-wells etc. due to their constant working.

(7) By Permanent fall in Market Price : - Though, the fluctuations in the

market value of fixed assets are not recorded because such assets are not meant for
resale but for use in the business, sometimes the fall in the value of certain fixed
assets is treated as depreciation such as permanent fall in the value of investments.
 Need, Importance or Objects of Providing Depreciation

1) For ascertaining the true profit or loss :- The true profit of a business can
be ascertained only when all costs incurred for the purpose of earning
revenues have been debited to the Profit and Loss Account. As the Assets are
used in earning revenues, the depreciation in the value of an asset is as much
an expense as any other, such as wages, salary, rent etc.

(2) For showing the 'true and fair view' of the financial position :- If the
depreciation is not charged, the assets will be shown in the Balance Sheet at an
amount which is in excess of their true values. As such, the Balance Sheet will
not present the true and fair view' of the financial position of a business.
(3) To provide funds for replacement of assets :- Depreciation though
debited to Profit & Loss Account, is not paid in cash like other expenses.
Hence, the amount of depreciation is retained in the business and is used for
the replacement of fixed assets after the expiry of their estimated span of
life.

(4) To prevent the distribution of profits out of capital : If the depreciation is

not charged, the profit shown by the Profit and Loss Account will be in excess of the
actual profits, Such an excess profit may be wholly withdrawn by the proprietor or may be
distributed among the shareholders as dividend. Hence, the amount of dividend
distributed will also include the amount of depreciation which is actually a part of Capital
(5) For avoiding over payment of Income Tax : Depreciation is a deductible
expense for tax purposes. If depreciation is not debited to Profit and Loss
Account, the net profit shown by it will be in excess of actual profits,
Hence, we will also have to pay more income tax.

(6) Other Objectives : If the depreciation is not charged, the net profit
shown by Profit & Loss Account will exceed the actual profits and as a
result:
(1) Employees may demand an increase in wages and bonus,
(Il) It may also result in extravagance.
(III) It may lead to increase in competition in that type of business.
Factors determining the amount of Depreciation
(1) Total Cost of the Asset :- The cost of a fixed asset is determined after adding
all expenses incurred for bringing the asset to usable condition, such as
freight, transit insurance and installation costs etc.

(2) Estimated Useful Life of Asset :- Useful life of an asset is estimated in terms
of number of years, it can be effectively used for business operations. For
example, if a machine can work for 25 years but is likely to become obsolete
in 15 years on account of availability of a better type of machine due to
improved technology, its useful life will be considered as only 15 years.

(3) Estimated Scrap Value : - It is the estimated sale value of the asset at the
end of its useful life. It is also known as residual value or break-up value
Methods of Providing or Allocating Depreciation

1. Straight Line Method

2. Written Down Value Method
3. Annuity Method
4. Depreciation Fund Method
5. Insurance Policy Method
6. Revaluation Method
7. Depletion Method
8. Machine Hour Rate Method
(1)Straight Line Method

▪ This method is also termed as 'Original Cost Method' because under this
method depreciation is charged at a fixed percentage on the original cost
of the asset .

▪ The amount of depreciation remains equal from year to year and as such
the method is also known as 'Equal Instalment Method' or 'Fixed
Instalment Method’.

▪ Under -method, the amount of depreciation is calculated by deducting

the scrap value from the original cost of the asset and then by dividing
the remaining balance by the number of years of its estimated life.
Merits of Straight Line Method :-

(1) Simplicity :- Calculation of depreciation under this method is very simple and as such the
method is widely popular.

(2) Equality of Depreciation Burden :- Under this method, equal amount of depreciation is
debited to the Profit and Loss Account of each year. Hence, the burden of depreciation on each
year's net profit is equal.

(3) Assets can be completely written off :- Under this method, the book value of an asset can be
reduced to net scrap value or zero value, which is not possible under some other methods.

(4) Knowledge of Original Cost and Up-to-date depreciation : Under this method, the original cost
of the asset is shown in the Balance Sheet and the up-to-date depreciation is shown as a direct
deduction from it. As such, the information of Original Cost of the asset and its up-to-date
depreciation is available at any time. Various assets also maintain their separate identity under
this method.
Demerits :
(1) Difficulty in Computation :- When there are different machines having different life-spans, the
computation of depreciation becomes complicated because the depreciation on each machine will
have to be calculated separately.

(2) Unequal charge against income :- Repair charges go on increasing year by year as the asset
becomes older but as the equal depreciation is charged under this method each year. the total burden
charged to Profit and Loss Account in respect of depreciation and repairs put together will not be
equal each year. The total burden will be lighter in earlier years and heavier during the later years.

(3) Undue pressure in later years :- It is a well-known fact that the efficiency and usefulness of a
machine is more in the earlier years in comparison to later years. As such, more depreciation should
be charged in earlier years in comparison to the later years, whereas, depreciation remains constant
from year to year under this
method.
Demerits :
(1) Difficulty in Computation :- When there are different machines having different life-spans, the
computation of depreciation becomes complicated because the depreciation on each machine will
have to be calculated separately.

(2) Unequal charge against income :- Repair charges go on increasing year by year as the asset
becomes older but as the equal depreciation is charged under this method each year. the total burden
charged to Profit and Loss Account in respect of depreciation and repairs put together will not be equal
each year. The total burden will be lighter in earlier years and heavier during the later years.

(3) Undue pressure in later years :- It is a well-known fact that the efficiency and usefulness of a
machine is more in the earlier years in comparison to later years. As such, more depreciation should be
charged in earlier years in comparison to the later years, whereas, depreciation remains constant from
year to year under this
method.
Advantages of WDV Method:

1.Realistic Depreciation: It matches the usage pattern of many assets

where they lose more value in the earlier years.

2.Tax Benefits: Many tax authorities allow businesses to adopt this method
for computing tax deductions.

3.Higher Depreciation in Early Years: It provides a higher tax shield earlier,

which could benefit cash flow.
Disadvantages of WDV Method:

1.Complex Calculations: As the WDV decreases, the amount of depreciation needs to

be recalculated each year.

2.No Asset Fully Depreciated: In theory, the asset never becomes fully depreciated
because each year a percentage is subtracted from the declining value.

Usage:

•The WDV method is commonly used by businesses where assets lose value rapidly in
the first few years and then more gradually. It is often used for machinery,
equipment, vehicles, and computers.
Annuity Method:
Depreciation is calculated based on the principle that the asset earns
interest during its useful life. This method considers both the cost of the
asset and interest on capital invested. Depreciation charges are higher in
the earlier years and decrease over time.

Depreciation Fund Method (Sinking Fund Method):

A fixed sum is set aside each year in a depreciation fund. The amount is
invested, and at the end of the asset's life, the total fund (principal +
interest) is used to replace the asset. It ensures that sufficient funds are
available when the asset is to be replaced.
Insurance Policy Method:
•A business takes out an insurance policy to cover the eventual replacement
of the asset. Annual premiums are paid, and at the end of the asset's life, the
insurance proceeds are used to replace it. This method provides a similar
outcome to the depreciation fund method but uses insurance instead of
investment.

Revaluation Method:
•Assets are revalued at the end of each period, and the difference between
the old and new value is considered depreciation. This method is often used
for assets like livestock or loose tools where usage is irregular and frequent.
Depletion Method:
Used primarily for natural resources (like mines or oil wells), where
depreciation is based on the quantity of resources extracted during a
specific period. The cost of the asset is allocated based on the total
estimated extraction over its useful life.

Machine Hour Rate Method:

Depreciation is calculated based on the number of hours a machine is
used. The total life of the machine, in terms of hours, is estimated, and
depreciation is charged based on the hours it operates each period. This
method is suitable for machinery with varied usage patterns.
Accounting Standard:
Depreciation is governed by specific accounting standards (e.g., IAS 16 or AS 10) which
dictate how and when depreciation should be recorded.

Impact on Financial Statements:

Income Statement: Depreciation is recorded as an expense, reducing the net profit.
Balance Sheet: The value of the asset is reduced by the accumulated depreciation each
year, showing the asset at its book value (cost minus accumulated depreciation).

Tax Impact:
Depreciation reduces taxable income. The method of depreciation chosen (SLM vs. WDV)
can affect the timing of tax benefits.

Accelerated Depreciation:
Some methods, like WDV and Double Declining Balance, allow for higher depreciation in the
early years of an asset's life, providing larger tax benefits upfront.
Depreciation vs. Amortization:
Depreciation applies to tangible assets (e.g., buildings, machinery), while
amortization is used for intangible assets (e.g., patents, goodwill).

Impairment:
Depreciation is different from impairment. Impairment occurs when the
market value of an asset falls significantly below its book value, requiring an
additional write-down.

Revaluation:
In some cases, businesses may revalue their assets. When an asset is
revalued, its depreciation charge may change to reflect its updated value.
Impact of Depreciation on Cash Flow:
Since depreciation is a non-cash expense, it does not affect cash
flow directly. However, by reducing taxable income, it indirectly
improves cash flow by reducing tax payments.

Depreciation and Capital Expenditure:

Depreciation spreads the cost of a capital expenditure (CAPEX)
over several years, smoothing out the expense recognition rather
than recognizing it all in the year of purchase.
1. Depreciation is charged on which type of asset?

(A) Current Assets

(B) Fixed Assets
(C) Intangible Assets
(D) Liquid Assets
2.In which of the following methods does the
amount of depreciation remain constant
throughout the useful life of the asset?

(A) Written Down Value Method

(B) Reducing Balance Method
(C) Double Declining Method
(D) Straight Line Method
3. What is the main objective of providing
depreciation?

(A) To reduce profit

(B) To comply with tax regulations
(C) To allocate the cost of the asset over its
useful life
(D) To improve cash flow
4.Depreciation is considered as:

(A) A cash expense

(B) A non-cash expense
(C) A deferred expense
(D) A liability