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The term depreciation refers to the reduction in or loss of quality or value of a fixed asset through wear or tear in or tear, in use, effusion of time, obsolescence through technology and market changes or from any other cause. Depreciation take place in case of all fixed assets with certain possible exceptions e.g. land and antiques etc., although the process may be invisible or gradual. Depreciation does take place irrespective of regular repairs and proper maintenance of assets. The word ‘depreciation’ is closely related to the concept of business income. Unless it is charged against revenues, we cannot say that the business income has been ascertained properly. This is because of the fact that the use of long term assets tend to consume their economic value and at some point of time these assets become useless. The economic value so consumed must be recovered from the revenue of the firm to have a proper measure of its income. Hence, the reader’s must understand that the process of charging depreciation is the technique used by accountants for recovering the cost of fixed assets over a period. The following definition will make the understanding of the concept of depreciation more convenient to the learner’s. According to IAS-4, “Depreciation is the allocation of the depreciable amount of an asset over its estimated useful life,”
According to AS-6, “depreciation is a measure of wearing out, consumption or other of value of a depreciable asset arising from use, effusion of time or obsolescence through technology and market changes. Depreciation is allocated so as to charge a fair proportion of the depreciable amount in each accounting period during the expected useful life of the assets. Depreciation includes amortisation of assets whose useful life is predetermined.” The American Institute of Certified Public Accountants (AICPA) employed the definition as given below:
“Depreciation Accounting is a system of accounting which aims to distribute the cost or other basic value of tangible capital assets, less salvage value (if any) over the estimated useful life of unit (which may be a group of assets) in a systematic and regional manner. It a process of allocation, not of valuation. Depreciation for the year is the portion of the total charge under such a system that is allocated to the year.”
From the above definitions it is clear that each accounting period must be charged with a fair proportion of the depreciable amount of the asset, during the expected useful life of the asset. Depreciable amount of an asset is its historical cost less the estimated residual value. Finally, it could be concluded that depreciation is a gradual reduction in the economic value of an asset from any cause.
The terms depreciation, depletion and amortisation are used often interchangeably. However, these different terms have been developed in accounting usage for describing this process for different types of assets. These terms have been described as follows:
Depreciation: Depreciation is concerned with charging the cost of manmade fixed assets to operation (and not with determination of asset value for the balance sheet). In other words, the term ‘depreciation’ is used when expired utility of physical asset (building, machinery, or equipment) is to be recorded.
Depletion: This term is applied to the process of removing an available but irreplaceable resource such as extracting coal from a coalminer or oil out of an oil well. Depletion differs from depreciation in that the former implies removal of a natural resource, while the latter implies a reduction in the service capacity of an asset.
Amortisation: The process of writing off intangible assets is termed as amortisation. The intangible assets like patents, copyrights, leaseholds and goodwill are recorded at cost in the books of account. Many of these assets have a limited useful life and are, therefore, written off.
Obsolescence: It refers to the decline in the useful life of an asset because of factors like (i) technological advancements, (ii) changes in the market demand of the product, (iii) legal or other restrictions, or (iv) improvement in production process.
The depreciation occurs because of the following:
1. Constant use: The constant use of assets results into their wear and tear, which in turn reduces their working capacity. Hence, a decrease in the value of assets may be seen due to reduced capacity. The value of assets like, machinery, furniture, etc., declines with the constant use of them.
2. Passage of Time: Many fixed assets lose their value with the passage of time. This holds true in case of intangible fixed assets such as patents, copy rights, lease hold properties, etc.The term “amortisation” is generally used to indicate the reduction in the value of such assets.
3. Depletion: Depletion also causes decline in the value of certain assets. This is true in case of wasting assets such as mines, oil wells and forest-stands. On account of continuous extraction of minerals or oils, these assets go on declining in their value and finally they gets completely exhausted.
4. Obsolescence: There may not be any physical deterioration in the asset itself. Despite of this there may be reduction in the utility of an asset that results from the development of a better method, machine or process. For example, an old machine which is still in good working condition may have to be replaced by a new machine because of the later being more economical as well as efficient. In fact, new inventions, developments in production processes, changes in demand for product or services, etc. make the asset out of date.
5. Accidents: An asset may get reduction in its value if it meets an accident.
6. Permanent Fall in the Market Value: Certain assets may get permanent fall in their value and this decline in their value is treated as depreciation. For example, a permanent decline in the market value of securities and investment may be assumed as 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 as its Reasonable Value: The assets get decrease in their value over a period of time on account of various 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 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 man. Thus, for calculating tax, depreciation should be deducted be from income similar to the other expenses.
In order to assess depreciation amount to be charged in respect of an asset in an accounting period the following three important factors should be considered:
1. Cost of the asset: The knowledge about the cost of the asset is very essential for determining the amount of depreciation to be charged to the profit and loss account. The cost of the asset includes the invoice price of the asset less any trade discount plus all costs essential to make the asset usable. Cost of transportation and transit insurance are included in acquisition cost. However, the financial charges such as interest on money borrowed for the purchase for the purchase of the asset should no be included in the cost of the asset.
2. Estimated life of the asset: Estimated life generally means that for how many years or hours an asset could be used in business with ordinary repairs for generating revenues. For estimating useful life of an asset one must begin with the consideration of its physical life and the modifications, if any, made, factors of obsolescence and experience with similar assets. In fact, the economic life of an asset is shorter than its physical life. The physical life is based mostly on internal policies such as intensity of use, repairs, maintenance and replacements. The economic life, on the other hand, is based mostly on external factors such as obsolescence from technological changes.
3. Scrap Value of the Asset: The salvage value of the asset is that value which is estimated to be realised on account of the sale of the asset at the end of its useful life. This value should be calculated after deducting the disposal costs from the sale value of the asset. If the scrap value is considered as insignificant, it is normally regarded as nil. With time, any asset tends to deteriorate and lose its original value to wear and tear. The acquired asset is thus known to be depreciated when the monetary value is reduced due to wear and tear, time, and daily usage.
While studying depreciation class 11, you will study two types of methods for calculating depreciation. As we are discussing the theory of depreciation, provisions and reserve, we will be looking briefly into the definition of the two methods of calculating depreciation. Students are advised to thoroughly practice the practical part of this section as it is one of the most important parts of the chapter. The two main methods that are used to calculate depreciation are:
1. Straight-line Method: Original cost of the asset is taken as the basis for the calculation of depreciation
2. Written Down Value Method:The reduced value or the book value is taken as the depreciation and is different for every year
This is also known as fixed instalment method. Under this method the depreciation is charged on the uniform basis year after year. When the amount of depreciation charged yearly under this method is plotted on a graph paper, we shall get a straight line. Thus, the straight line method assumes that depreciations is a function, of time rather than use in the sense that each accounting period received the same benefit from using the asset as every other period. The formula for calculating depreciation charge for each accounting period is:
Amount of annual Depreciation = Estimated Life in years
Original cost of the fixed assets – Residual value
For example, if an asset cost Rs. 50,000 and it will have a residual value of Rs. 2000 at the end of its useful life of 10 years, the amount of annual depreciation will be Rs. 4800 and it will be calculated as follow:
Depreciation = Rs. 4800
10 Years
Rs. 50,000 – 2000 = 48000
Depreciation = 48000/10
This method has many shortcomings. First, it does not take into consideration the reasonal fluctuations, booms and depression. The amount of depreciation is the same in that year in which the machine is used day and night to that in the another year in which it is used for some months. Second, it ignores the interest on the money spent on the acquisition of that asset. Third, the total charge for use of asset (i.e. depreciation and repairs) goes on increasing form year to year though the assets might have been use uniformly from year to year. For example, repairs cost together with depreciation charge in the beginning years is much less than what it is in the later year. Thus, each subsequent year is burdened with grater charge for the use of asset on account of increasing cost on repairs.
This is also known as Written down value method [WDV]. Under the diminishing balance method depreciation is charged at fixed rate on the reducing balance (i.e., cost less depreciation) every year. Thus, the amount of depreciation goes on decreasing every year. Under this method also the amount of depreciation is transferred to profit and loss account in each of the year and in the balance sheet the asset is shown at book value after reducing depreciation from it. For example, if an asset is purchased for Rs. 10,000 and depreciation is to be charged at 20% p.a. on reducing balance system then the depreciation for the first year will be Rs. 2000. In the second year, it will Rs. 1600 (i.e. 20% of 8000), in the third year Rs. 1280 (i.e. 20% of 6400) and so on. The rate of depreciation under this method can be computed by using the following formula:
Depreciation rate = –1
Acquisition cost
Net scrap value
For example, if the cost of an asset is 27000, scrap value Rs. 3375, economic life 3 year, the rate of depreciation would be:
Depreciation = 27000-3375 / 3
=7875
Depreciation rate = 7875/27000 *100
= 29.16666 %
29.17 %
1. It is very easy to understand and calculate the amount of depreciation despite the early variation in the book value after depreciation
2. This method put an equal burden for use of the asset oneach subsequent year since the amount of depreciation goes on decreasing for each subsequent year while the charge for repairs goes on increasing for each subsequent year.
3. This method has also been approved by the income tax act applicable in India
4. Asset is never reduced to zero because if the rate of depreciation is (say) 20%. Then even when asset is reduced to very small value, there must remain the 80% of that small value as on written off balance.
1. It ignores the interest on the capital committed to purchase that asset.
2. It does not provide adequately for replacing the asset at the end of its life.
3. The calculation of rate of depreciation is not so simple.
4. The formula for calculating the rate of depreciation can be applied only when there is some residual of the asset.
This method is suitable in those cases where the receipts are expected to decline as the asset gets older and, it is believed that the allocation of depreciation of depreciation ought to be related to the pattern of assets expected receipts.
Illustration 2: A company purchases Machinery on 1st April 1990 for Rs. 20,000. Prepare the machinery account for three years charging depreciation @ 25% p.a. according to the written down value method.
As you go on with the chapter and analyse what depreciation is, it is vital to understand its importance in Account keeping. After a due period of time, every form of organisation is required to evaluate the depreciated value of its product and goods. Mentioned below are the important points mentioned in depreciation explaining the importance of depreciation:
1. To provide an unbiased view of financial statements and not have inflated values reflected in financial statements. The assets’ value in the market decreases with time. So, not keeping a tab on that in the books as well would be necessary to provide an accurate picture of profits or losses.
2. For keeping money with the organization and not taking it away from the business. This is likely to happen when the profit is overestimated and is sent as dividends.
3. To even out the profit and reflect true value keeping in consideration the production cost that comes with the deterioration in the value of an asset. This would ensure that the original value of the asset is not counted as the only expense.
4. For replacing the old machinery with a new one by accumulating the charges for depreciation and using those when needed.
5. To avoid paying extra to the government in tax. The business will have to pay extra tax unnecessarily in lieu of the wrong calculation of profit if depreciation is not accounted for. Thus, it is important to ensure scope to avoid any additional tax.
As mentioned above, revising the profit and loss and calculating depreciation is necessary. But what are the factors that lead to the depreciation of a product? The below enlisted key points from depreciation will assist you in understanding the common causes of depreciation:
1. Wear and tear with regular use is likely to happen when you use an asset regularly. It will corrode with time and use or will become slower and, thus making it less productive and this would also reduce its value.
2. Many times, machinery is likely to go obsolete with time as newer inventions step in the market for better value and return. With a better bargain, these new machines will attract more business.
3. In accounting terms, an asset may also depreciate when it becomes useless after its full tenure is served, according to the legal expiry that it has. Its implications could be anywhere from having to make heavy repairs or disposing of the asset altogether.
4. An accident may also permanently reduce or damage the value of an asset completely.
As per the depreciation chapter for class 11, here are a few factors that affect the depreciation of an asset:
1. Cost of Asset: Depreciation is directly proportional.
2. Estimated Useful Life: Determines the division of depreciation proportionately.
3. Estimated Scrap Value: Identifies the net residual value and its direct correlation.
It is important to estimate and keep aside a certain amount when there is some expected expenditure for an asset or liability in the future. If the expenditure is recurring, you can use it as it is but you can keep a certain amount preserved for the future so that in case there is a need, you can prevent your profits from being disturbed and use the said amount instead. Hence, this is how depreciation class introduces these topics:
These are kept for an unforeseen circumstance that is likely to occur with a liability. Provision is an expense, according to GAAP. eg. Provision for Depreciation.
This is an amount set aside as a liability against the intention to buy an asset, pay bonuses, etc. These are often allocated for specific purposes and appear as shareholders equity.
Here are the key points of difference between Provisions and Reserves which you must know while studying Depreciation :
| Basis | Provision | Reserve |
| Meaning | Maintained for a known liability | Maintained for an unknown liability |
| Nature | It is charged against profit | Appropriation of profit |
| Creation | Debiting P&L Account | Debiting P&L Appropriation Account |
| Need for Creation | If there is almost no profit in the business | Only if the business is reaping profits |
| Purpose | Specific Liability | Fortification of Business |
| Dividend Payment | Not used for dividend payments | Can be utilized for dividend payments as well |
On the basis of the purpose that it is supposed to be solved, reserves can be general or specific. In the accountancy syllabus for depreciation, you will learn about how some reserves are kept for future use without defining the purpose of the same. Let us understand the vital differences between general and specific reserves.
| Basis | General Reserve | Specific Reserve |
| Meaning | Created without a specific purpose in mind | Created with a specific purpose in mind |
| Usage | Flexible with being utilized wherever the business deems necessary | For the specification that has been kept in mind during the creation |
| Example | Fund reserve | DRR (debenture redemption reserve) |
2. Prepare Machine account, Depreciation account and Provision for depreciation account (or accumulated depreciation account) for the first four years by providing depreciation using straight line method accounts are closed on March 31 every year.
Note: As per the solution, the closing balance of the machinery account at the end of the fourth year is Rs 1,88,000; whereas, the answer given in the book is Rs 1,28,000 .However, if we would have taken the purchase price of machine Rs 1,80,000 instead of Rs 2,80,000 then the closing balance would have been Rs 1,28,000.
Working notes: Calculation of annual depreciation
Depreciation (p.a.)= (Original cost – Scrap Value)/ Estimated Life of Asset (years)
Depreciation (p.a.) = (2,80,000 + 10,000 + 10,000 – 20,000)/ 10
= Rs 28,000 per annum
Machinery A/c
Provisional Depreciation
Depreciation A/c
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