What is Depreciation Accounting? Definition, Characteristics, Methods, Causes

  • Post last modified:20 January 2022
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What is Depreciation Accounting?

What is Depreciation Accounting?-Investoinfo.com
What is Depreciation Accounting?

Depreciation is a measure of wearing out consumption or loss in value of assets that are depreciable due to use, time period or obsolescence due to new technology and market changes.

Depreciation is allocated in order to charge a some amount of money as depreciation amount in each accounting period during the expected useful life of the assets.


Definition of Depreciation

There Some definition of Depreciation are:

Depreciation is a measure of wearing out consumption or loss in value of assets that are depreciable due to use, time period or obsolescence due to new technology and market changes. Depreciation is allocated in order to charge a some amount of money as depreciation amount in each accounting period during the expected useful life of the assets.Institute of Chartered Accountants of India
Depreciation is the allocation of the depreciable amount of an asset over its estimated life.International Accounting Standard Committee

We can summarize that depreciation as a process of allocation of the cost of depreciable asset, over it use full if inarational and systematic manner.


Characteristics of Depreciation

The important characteristics of depreciation are noted below:

  • Depreciation is charged on fixed and tangible assets only.

  • Depreciation refers to a permanent / gradual and continuous decrease in the utility value of a fixed asset and it continues till the end of the useful life of the asset.

  • Depreciation is a charge against profit for a particular accounting period.

  • Depreciation is always computed in a systematic and rational manner since it is not a sudden loss.

  • Depreciation is a process of allocation of expired cost and not of valuation of fixed assets.

  • Depreciation represents only an estimate and not the exact amount.

  • Depreciation may be physical and functional.

  • Total depreciation cannot exceed the cost of the depreciable asset.
  • It is non-cash charge and hence does not involve outflow of cash.

  • The basis of charging depreciation is economic life of the asset and the cost thereof. Market value has no relevance for calculating depreciation.

  • Depreciation is different and distinct from Amortization, Depletion Obsolescence, Dilapidation and Fluctuation.

Causes of Deprecation

The depreciation may broadly be divided into two Causes are :

  • Internal causes

  • External causes.

In detail :

Internal causes

Depreciation that is a result of certain inherent normal causes is known as internal depreciation. The causes of internal depreciation are:

Wear and Tear

The life of an asset reduces due to its continued use as for e.g. the life of building, plant, machinery, etc. such decline and the quantum depends of use of an asset and in the event of double- shift depreciation on plant and machinery will be doubled.

It is very obvious that such loss is unavoidable. A time will come when the asset will become unfit for repairs, when it will no longer be suitable.

Depletion

Some assets decline in value proportionate to the quantum of production or use as for example mines, quarry, etc. As we extract coal, etc. from coal mine, the total deposit in the mine reduces gradually and after some time it will be fully exhausted. Then its value will be nil.

External

Whenever depreciation is caused by some external factors then it is called external depreciation.

Obsolescence

Some of the assets, though still new and still having their life left that too in proper condition can result in becoming obsolete. For example with the advent of new technology and modern machinery, an old machine can become obsolete unable to bear the brunt of invasion of new technologies.

This is also possible because new and modern machinery bring in higher productivity, better quality and lower cost of production. Thus it becomes necessary to install new machinery in a competitive environment.

Passage of time

Certain assets which have not been used also lose their value in course of time, for example lease hold property, patent rights, copy rights, etc.

Accidents

Disasters such as floods, earthquakes cause major destruction of assets reducing its usage. In such cases the assets are described as loss and new asset can be purchased.


Objectives of Providing Depreciation

Following are the objectives of providing depreciation in any business:

  • In order to keep the owners capital intact the recovery of cost incurred on fixed assets is made over their useful life.

  • In the event of retirement of original assets the cope up with the replacement cost.

  • To determine the actual cost of production by considering depreciation as also one of the component of cost.

  • To determine the actual profit for the year.

  • To find out the actual financial position through balance sheet.

Computation of Depreciation

Calculation of depreciation is a complex process. Several factors are to be kept in mind while calculating depreciation. These factors are as under:

Cost of the depreciable asset

Cost of the asset plays is the most important factor in determining depreciation. Here, cost implies to historical cost of the assets. This idea is also supported by cost concept which maintains that the fixed assets should be recorded at cost and not market price. Thus, Cost includes price (less discount if any), freight or handling charges, legal charges, installation charges or transfer charges, sales tax, insurance in transit, etc.

which assist in acquisition and putting the asset onto working condition. When a used asset is bought, the preliminary cost of putting the asset in working condition such as expenditure for new parts, repairs/renovation, etc. are added to the cost of assets.

It is to be remembered that the interest on loan to purchase an asset does not form part of cost of asset. Instead interest paid on a loan during construction period will be treated part of cost of an asset.

Useful life of the Depreciable asset

As per accounting standard 6(7) the useful life of an asset that is depreciating is less than its physical life and is:

  • Is calculated much earlier before commencing the usage based on legal and contractual limits like the expiry date of the lease periods.
  • Very often it is governed by consumption and extraction.
  • The usage and physical deterioration due to wear and tear and operational entities such as how long it has been used in different shifts,
  • repair and maintenance and the policy of the company determines the depreciation.

Obsolescence can be due to the following:-

  • Change in Technology

  • Any change in production process

  • Change in market demand of product or service

  • Legal or other restrictions

Residual value

The amount that is likely to receive when asset is sold as scrap or asset is discarded. Nevertheless, the amount of expenses incurred on sale or disposal is to be deducted from the sale proceeds of asset discarded. According to AS-6, computation of residual value of an asset is generally considered a difficult task..

In such cases the value is considered as nil as it is termed irrelevant. In case the residual value is important then the calculation of the value is made at the time of purchase or instalment during revaluation of the asset.

The residual value of the asset is calculated by its realizable value of the asset which is similar in nature and is completely used completing its useful life and has been operated similarly as the asset. Therefore, calculation of depreciation consists of three variables – the cost of asset, useful or economic life of the depreciating asset and the residual value thereof.


Methods of Charging Depreciation

The difference in the nature of fixed assets is so wide that the same method of depreciation cannot be applied to each other. Let us discuss few of the widely used methods of depreciation.

  • Straight line also known as Original cost method or fixed instalment method.

  • Written down value method or Diminishing Balance Method also known as Reducing Instalment method.

  • Annuity Method.

  • Sinking fund amortization fund method or Depreciation fund method.

  • Insurance policy method.

  • Revaluation method.

Straight line method

Straight line method or fixed instalment method which is also known as or original cost method. In this method the expected life of the asset is the calculated. The total cost of the asset i.e. cost incurred in bringing the asset to its working condition is taken and scrap value at the end of its expected life is deducted from it and then the balance amount is divided by the number of years of its expected life, the result we get is the amount of depreciation that would be charged per year.

Here the amount of depreciation remains same from year to year. This method is known as straight line method because if a graph of annual depreciation is drawn, it would be a straight line.

The formula or equation used to calculate depreciation under Straight line method is as follows

Annual Depreciation = [(Cost of Assets – Scrap Value)/Estimated Life of assets.

The journal entries under this method are very simple. The journal entries will be as under:

Depreciation account A/c Dr.
To Asset account
(Being the depreciation charged)
Profit and loss account A/c Dr.
To Depreciation account
(Being the amount of depreciation transferred to P& L a/c)

The above entries are passed at the end of each year as long as the asset is with us in working condition and in the last year, the scrap will be sold and with the amount that realised by the sale the following entry will be passed:

Cash account
To Asset account
(Being the cash realised on the sale of scrap.)

Advantages

  • Straight line method of depreciation is the most simple and easy method to work out.

  • Under this method the book value of the asset can even be reduced to zero.

Disadvantages

  • In spite being the simplest method, it is not a popular method here the approach is not very logical to charge depreciation each year’s in equal amount, the charge for repairs and renewals goes on increasing as the asset becomes older.

  • Some of the methods of depreciation consider the interest payment on money which is locked up in purchase of assets but unlike the other methods this method does not consider the interest factor.

  • In straight line method there is no provision made for the replacement of the asset.

  • Sometimes even a little difficulty is faced in calculation of depreciation on account of additions during the year.

    So, from the above discussion it is clear that straight line method is more suitable for assets having small investments and on whom there is no repair and renewals expenses for example copyright, patents, short leases, etc.

Written Down Value 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.

Advantages

  • It is the most popular method adopted as the total burden of profit and loss due to depreciation and repairs remains almost equal year after year because the amount of depreciation goes on decreasing and with the passage of time the amount on repairs goes on increasing.

  • Separate calculations for additions and extensions of new assets are not required.

Disadvantages

  • Like the first method even this method ignores the interest on capital investment and the replacement of the asset.

  • This method does not reduce the book value to zero as is in the case of the straight line method.

  • To write an asset value to residual value takes a long time therefore high depreciation rate is required.

Generally this is one of the most popular method which has been adopted in our country even our Income tax act prefers this method. This method is considered to be most suitable for plant and machinery where additions and extensions take place quite often.

However this method does not suit the case of lease, whose value has to be reduced to zero.

Annuity method

The asset in question is considered as an investment of capital, earning interest at certain rate. Thus the cost of the asset and also interest there on are written down annually by equal installments unless and until the book value of the asset comes to nil.

With the help of annuity table the annual charge of depreciation is found out. In the books of accounts the annual charge for depreciation will be credited to asset account and debited to depreciation account, while the interest will be debited to asset account and credited to interest account. In this method the journal entries are a little different.

The entries are to be made in respect of interest and depreciation. As far as calculation of interest is concerned it is to be calculated on the debit balance of the asset account at the commencement of the period, at the given rate.

The journal entry will be:

Particular Asset account Dr.

To Interest account (Being interest on capital sunk in asset)

After finding the depreciation amount from the depreciation annuity table, the following entry is passed: Depreciation account Dr.

To Particular Asset account (Being the depreciation of asset)

It should also be kept in mind that the interest is charged on the diminishing balance of the asset account, the amount of interest goes on declining year after year. But the amount of depreciation remains the same during the life time of the asset.

Advantages

This method is technically more sound and scientific as it takes interest on capital invested in the asset into consideration. 2. Of the several method of depreciation it is regarded as one of the most exact and precise from the point of view of calculations and so considered to be most scientific.

Disadvantages

  • This system is one of the most complicated.

  • With the passage of time there is a consistent increase in profit and loss account with the charge on depreciation remaining constant and there is a diminishing rate of interest every year. Hence the net profit and loss becomes heavier each year.

  • When the asset requires frequent additions and extensions, the calculation have to be changed frequently, which is very inconvenient. This method is suitable for those assets that require considerable investment and where there are no frequent additions e.g., long lease.

Sinking fund method

Sinking fund method is also known as depreciation fund method or amortization fund method. In this method, a fund know as sinking fund is created and every year and the profit and loss account is debited and the fund account credited with A certain sum.

which is so calculated that the annual sum credited to the fund account and accumulating throughout the life of the asset may be equal to the amount which would be required to replace the old asset. The main logic behind this method is to ensure the availability of the funds at the time of replacement of the asset.

For this purpose an amount equal to that credited to the fund account is invested outside the business, generally in some securities. The asset appears in the balance sheet year after year at its original cost while depreciation fund account appears on the liability side.

Revaluation Method

Here in this method as the name suggests under revaluation method, the valuation of assets done at the end of each period so as to calculate the difference between the old value and the new value and this difference is the actual depreciation which is charged to the profit and loss account.

This method is most accepted method in case of assets like bottles, horses, packages, loose tools, casks etc. Sometimes rarely during the process of revaluing the asset is increased it will be temporary and will not be taken into account.


Change of Method of Charging Depreciation

It should be kept in mind that once a method of depreciation has been adopted then it should be applied consistently to ensure comparison over the years. Accounting standard AS-6 says that “to provide comparisons from time to time of the enterprise a consistency is maintained to the method of applying depreciation.

If an alternate method of calculating depreciation is applied, it should be done as per the statute or compliance of the accounting standards. This is adopted only if it is seen that it is more appropriate in preparing financial statements of the enterprise.

When such change in the method of depreciation is made, the un-amortized depreciable amount of the asset is charged to revenue over the remaining useful life by applying the new method”.

Hence it quite clear that a business enterprise may change the method either:

  • To comply with statutory requirements or

  • To enhance or improve quality of preparation or presentation of financial statements.

There are two ways to change the method of the depreciation:

  • A Change made effective from the current year only – When a change is made effective form the current year only, the unexpired cost of the asset should be charged to Profit & Loss account over the remaining useful life of the asset by applying the new method of depreciation. Such a change is treated as a change in accounting policy and as such it is disclosed in the financial statements.

  • A change in method with retrospective effect – When a change in method of depreciation is made with retrospective effect then following steps must be taken.
  • Find out the book value / cost of the assets in the beginning of year, from that date change is to be made effective. For example if on 31st March 2021 it is decided to change the method with effect from 1stApril 2018, then the book value of the assets on 1stApril 2018 has to be worked out. And similarly if the change is to be made from the date of acquiring of such assets then cost of the assets has to be found out.

  • Find out total depreciation charged on the assets till date on the basis of old rate i.e. depreciation already provided.

  • Calculate the depreciation on the basis of new method with retrospective effect up to the end of previous year.

  • Find out the difference between (ii) and (iii) above.

  • Debit or Credit the asset account by adjusting the difference. If there is excess of old accumulated depreciation over the total depreciation calculated in accordance with the new rate, assets account will be debited with the difference. And if it is otherwise, asset account will be credited with the differential figure.

  • Charge depreciation according to new method for the current year.

Salient features of AS-6: Depreciation Accounting

Following is the synopsis of Depreciation policy as per accounting standards:

  • Standard does not apply to depreciation in respect of forests, plantations and similar regenerative natural resources, wasting assets including expenditure on exploration and extraction of minerals, oils, natural gas and similar non- regenerative resources, expenditure on research and development, goodwill and livestock. Special considerations apply to these assets

  • Allocate depreciable amount of a depreciable asset on systematic basis to each accounting year over useful life of asset.

  • Useful life may be reviewed periodically after taking into consideration the expected physical wear and tear, obsolescence and legal or other limits on the use of the asset.

  • Basis for providing depreciation must be consistently followed and disclosed. Any change to be quantified and disclosed.

  • A change in method of depreciation should be made only in that case where it is required by statute, for any kind of compliance with an accounting standard or for any of the appropriate presentation of the financial statements and such a revision in method of depreciation should be made from date of use. Such a change in method of depreciation should be considered a change in accounting policy and it should be quantified and disclosed to users of accounting information.

  • cIf there is any addition or extension which becomes an important part of the existing asset depreciation to be provided on adjusted figure prospectively over the residual useful life or at the rate that is applicable.

  • If there is a change in cost due to fluctuation in exchange rate or price adjustment, etc. then the depreciation on the revised unamortized amount should be given for the balance useful life of the asset.

  • On revaluation of asset depreciation should be based on re-valued amount over balance useful life. Material impact on depreciation should be disclosed.

  • Deficiency or surplus in case of disposal, destruction, and demolition etc.be disclosed separately, if material.

  • Historical cost, amount substituted for historical cost, depreciation for the year and accumulated depreciation should be disclosed.

    Depreciation method used should be disclosed. If rates applied are different from the rates specified in the governing statute then the rates and the useful life are also disclosed.

What is Depreciation?

Depreciation is a measure of wearing out consumption or loss in value of assets that are depreciable due to use, time period or obsolescence due to new technology and market changes. Depreciation is allocated in order to charge a some amount of money as depreciation amount in each accounting period during the expected useful life of the assets.

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