Depreciation

Depreciation

What Is Depreciation?

Depreciation is the decrease in book value of a fixed asset. It is a permanent and continuous decrease in the book value of a fixed asset due to various causes like physical wear and tear because of use, passage of time, change in economic environment, expiration of legal rights, etc. Depreciation is the non-cash expense of the company. Depreciation expense is spread or allocated over the useful life of an asset as it is regarded as the cost of the fixed asset which is used for generation of revenue. Depreciation expense is charged or matched against the revenue generated through the use of the asset.

Need Of Allocating Depreciation:-

  • To ascertain the true profit or loss made by the company.
  • To show the true valuation of fixed assets.
  • To ascertain the true cost of production.
  • To make provision for replacement of assets.
  • To comply with the legal requirements.

Factors Considered For Determining The Amount Of Depreciation:-

There are three main factors which are considered for determining the amount of depreciation:-

(1) The original cost of the asset and the costs that are incurred on its installation, addition and improvements which are of capital nature.

(2) The expected useful life of the asset i.e. the number of years the asset is expected to last or the number of production or similar units expected to be obtained from the use of the asset. The useful life of the asset is usually shorter than its physical life.

(3) The estimated scrap value or residual value or salvage value of the asset at the end of its life. It is the value which the asset would fetch when discarded as useless and sold.

Methods Of Allocating/Calculating
Depreciation:-

There are many methods of allocating depreciation over the useful life of the asset. But the two most commonly used methods are:-
(1) Straight line method or Fixed installment method
(2) Written down value method or Declining balance method

(1) Straight Line Method:-

Straight line method is the most popular and simple method of calculating depreciation. Under this method, depreciation is charged equally every accounting period over the expected useful life of the asset. So the amount of depreciation is the same each accounting period. The amount of depreciation may reduce the book value to its residual value or even zero, as the case maybe, at the end of asset’s life. Straight line method is appropriate in cases where the benefit to be gained from the asset is likely to have an even spread over its useful life.
The amount of depreciation for each accounting period under the Straight line method is calculated as under:-
Cost of asset – estimated scrap value
        Expected useful life of asset

The rate of depreciation under the straight line method is calculated as under:-
Amount of depreciation ÷ cost of asset × 100

Example of Straight line method:-

Purchase price of machine = Rs 475000
Installation charges of machine = Rs 25000
Expected useful life of machine = 5 years
Estimated scrap value of machine = Rs 50000

Calculate the amount of depreciation per year and rate of depreciation.

Solution:-

Amount of depreciation = 500000 – 50000
                                                             5

                                                    = 450000
                                                             5

                                                    =  90000

Rate of depreciation = 90000 ÷ 500000 × 100

                                                    = 18%

So the amount of depreciation to be allocated each accounting period is Rs 90000 and the rate of depreciation is 18%.

(2) Written Down Value Method:-

Under the Written down value method, depreciation is charged unequally every accounting period over the expected useful life of the asset. So the amount of depreciation is not the same each accounting period though the rate of depreciation is the same. Under Written down value method, a fixed percentage of depreciation is calculated on the original cost of the asset in the first accounting period and on the written down value (original cost – depreciation) in the subsequent accounting periods over the expected useful life of the asset. So the amount of depreciation goes on decreasing each accounting period. Written down value method is appropriate in cases where the benefit to be gained from the asset is likely to be more in its earlier years of use.

Example of Written down value method:-

Purchase price of machine = Rs 475000
Installation charges of machine = Rs 25000
Expected useful life of machine = 5 years
Estimated scrap value of machine = Rs 50000
Rate of depreciation = 18%

Calculate the amount of depreciation for each accounting year.

Solution:-

Amount of depreciation:-

For first year = 18% of 500000 = 90000

For second year = 18% of 410000 (500000 – 90000) = 73800

For third year = 18% of 336200 (410000 – 73800) = 60516

For fourth year = 18% of 275684 (336200 – 60516) = 49623

For fifth year = 18% of 226061 (275684 – 49623) = 40691

So the amount of depreciation to be allocated for the first, second, third , fourth and fifth year is Rs 90000, Rs 73800, Rs 60516, Rs 49623 and Rs 40691 respectively.

Methods Of Recording Depreciation:-

There are two methods of recording depreciation in the books of accounts:-
(1) Creating provision for depreciation or accumulated depreciation account
(2) Without creating provision for depreciation

(1) Creating Provision For Depreciation:-

Under this method, depreciation is not directly charged to the respective asset account. It is credited to the provision for depreciation account and depreciation account is closed by transferring it to the profit and loss account. In the balance sheet, asset appears at its original cost and the accumulated depreciation is shown as a deduction from the asset account. So from the balance sheet, the original cost of the asset and the total depreciation charged to-date on that asset can be known. As the years pass, the balance of accumulated depreciation goes on increasing as depreciation from the earlier years get added to the accumulated depreciation account.

Journal entries under this method:-

For providing depreciation:-

Depreciation a/c…..Dr
 To provision for depreciation a/c

For closing depreciation account and transferring to profit and loss account:-

Profit and loss a/c…..Dr
 To depreciation a/c

(2) Without Creating Provision For
Depreciation:-

Under this method, depreciation is directly charged to the respective asset account. It is credited to the respective asset account and depreciation account is closed by transferring it to the profit and loss account. In the balance sheet, asset appears at its written down value i.e. original cost minus depreciation charged to-date. So from the balance sheet, the original cost of the asset and the total depreciation charged to-date on that asset cannot be known.

Journal entries under this method:-

For providing depreciation:-

Depreciation a/c…..Dr
 To respective asset a/c

For closing depreciation account and transferring to profit and loss account:-

Profit and loss a/c…..Dr
 To depreciation a/c

What Is Amortization?

Amortization is the decrease in the value of intangible assets such as patents, copyright, trademarks, etc. Amortization is the non-cash expense of the company. Amortization expense is spread or allocated over the useful life of the asset.

What Is Depletion?

Depletion is the physical reduction due to the exhaustion of natural resources like oil, coal, timber, minerals, etc. Depletion is the non-cash expense of the company.

 

                 
                                                  

 

 

 

 

 

 

 

 

 

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