Accounting For Depreciation:

Learning Objectives:

1. Define and explain the term "depreciation".
2. Why does depreciation calculated and charged?
3. What are the different methods for providing depreciation?

Definition, Explanation and Characteristics of "Depreciation" or "Accounting Depreciation":

Learning Objectives:

1. Define and explain the terms "depreciation" or "accounting depreciation".

The value of assets gradually reduces on account of use. Such reduction in value is known as depreciation. Different authors have given different definitions of depreciation, such as:

"Depreciation may be defined as the permanent continuous diminution in the quality, quantity or value on an asset." (By Pickles)

"Depreciation is the gradual permanent decrease in the value of an asset from any cause." (By Carter)

"Depreciation may be defined as a measure of the exhaustion of the effective life of an asset from any cause during a given period." (By Spicer & Pegler)

Depreciation is the diminution in intrinsic value of an asset due to use and/or the lapse of time." (By Institute of Cost and Management Accountants, England)

"Depreciation is the reduction in the value of a fixed asset occasioned by physical wear and tear, obsolescence or the passage of time." (Northcott & Forsyth)

"Depreciation is the diminution in the value of assets owing to wear and tear, effluscion of time, obsolescence or similar causes." (Cropper)

From the above definitions, it follows that an asset gradually declines on account of use and passage of time and this causes permanent reduction in the value and utility of asset. Such reduction in the value or utility of asset is called depreciation. In other words, expired cost or utility of asset is depreciation.

Characteristics of Depreciation:

Depreciation has the following characteristics:

1. Depreciation is charged in case of fixed assets only. e.g., building, plant and machinery, furniture etc. There is no question of depreciation in case of current assets - such as stock, debtors, bills receivable etc.
2. Depreciation causes perpetual, gradual and continual fall in the value of assets.
3. Depreciation occurs till the last day of the estimated working life of the asset.
4. Depreciation occurs on account of use of asset. In certain cases, however, depreciation may occur even if the assets are not used, e.g., leasehold, property, patent, copyright etc.
5. Depreciation is a charge against revenue of an accounting period.
6. Depreciation does not depend on fluctuations in market value of assets (see difference between depreciation and fluctuation page).
7. The amount of depreciation of an accounting year cannot be determined precisely - it has to be estimated. In certain cases, however, it may be ascertained exactly, e.g., leasehold property, patent right, copyright etc.
8. Total depreciation of an asset cannot exceed its depreciable value (cost less scrap value).

Causes of Depreciation:

Learning Objectives:

1. What are the causes of definition?

The main causes of depreciation may be divided into two categories, namely:

1. Internal Cause and
2. External Causes

Internal Causes:

Depreciation which occurs for certain inherent normal causes, is known as internal depreciation. The main causes of internal depreciation are:

Wear and Tear:

Some assets physically deteriorate due to wear and tear in use. More and more use of an asset, the greater would be the wear and tear. Physical deterioration of an asset is caused from movement, strain, friction, erasion etc. An obvious example of this is motor car which rapidly wears out. Other assets like this are building, plant, machinery, furniture, etc. The wear and tear is general but primary cause of depreciation.

Depletion:

Some assets declines in value proportionate to the quantum of production, e.g. mine, quarry etc. With the raising of coal from coal mine the total deposit reduces gradually and after sometime it will be fully exhausted. Then its value will be reduced to nil.

External Causes:

Depreciation caused by some external reasons is called external depreciation. The main external causes are as follows:

Obsolescence:

Some assets, although in proper working order, may become obsolete. For example, old machine becomes obsolete with the invention of more economical and sophisticated machine whose productive capacity is generally larger and cost of production is therefore less. In order to survive in the competitive market the manufacturers must must install new machines replacing the old ones. Again, it may happen that the articles produced by old machine are no longer saleable in the market on account of change of habit and taste of the people. In such a case the old machine, although in good working condition, must be discarded and the new one purchased.

Efflux of Time:

Some assets diminish in value on account of sheer passage of time, even though they are not used e.g., leasehold property, patent right, copyright etc. Suppose we take a lease of a house for 10 years for $10,000. Its annual depreciation will be $1,000 (10,000/10), irrespective of the the whether the house has been used or not. Because with the end of lease after 10 years, the house will go out of possession.

Accident:

Assets may be destroyed by abnormal reasons such as fire, earthquake, flood etc. In such a case the destroyed asset must be written off as loss and a new one purchased.

Need for Depreciation:

Learning Objectives:

1. Why does the need for calculating and charging depreciation arise.

The Need for depreciation arises for the following reasons:

Ascertainment of True Profit or Loss:

Depreciation is a loss. So Unless it is considered like all other expenses and losses, true profit or loss cannot be ascertained. In other words, depreciation must be considered in order to into out true profit or loss of a business.

Ascertainment of True Cost of Production:

Goods are produced with the help of plant and machinery which incurs depreciation in the process of production. This depreciation must be considered as a part of the cost of production of goods. Otherwise, the cost f production would be shown less than the true cost. Sales price is fixed normally on the basis of cost of production. So, if the cost of production is shown less by ignoring depreciation, the sale price will also be fixed at low level resulting in a loss to the business.

True Valuation of Assets:

Value of assets gradually decreases on account of depreciation, if depreciation is not taken into account, the value of asset will be shown in the books at a figure higher than its true value and hence the true financial position of the business will not be disclosed through balance sheet.

Replacement of Assets:

After sometime an asset will be completely exhausted on account of use. A new asset must then be purchased requiring a large sum of money. If the whole amount of profit is withdrawal from business each year without considering the loss on account of depreciation, necessary sum may not be available for buying the new asset. In such a case the required money is to be collected by introducing fresh capital or by obtaining loan or by selling some other assets. This is contrary to sound commerce policy.

Keeping Capital Intact:

Capital invested in buying an asset, gradually diminishes on account of depreciation. If loss on account of depreciation is not considered in determining profit or loss at the year end, profit will be shown more. If the excess profit is withdrawal, the working capital will gradually reduce, the business will become weak and its profit earning capacity will also fall

Depreciation, Depletion and Amortization:

Learning Objectives:

1. What is the difference among depreciation, depletion, and amortization.

Depreciation:

The term depreciation is used with reference to tangible fixed assets because the permanent continuing and gradual fall in book value is possible only in the case of fixed asset.

Depletion:

The term depletion is used for the depreciation of wasting assets such as mines, oil wells, timber trees etc.

Amortization

The term amortization is used in respect of intangible assets like patents, copyrights, leasehold and goodwill which are recorded at cost. Some intangible assets have limited useful life and are, therefore, written off.