MEANING OF DEPRECIATION

Depreciation is the reduction in the value of assets due to wear and tear. It is a method of allocation of the cost of the asset over its useful life. Every asset is subject to wear and tear in the normal course of its use and also over time. The cost of the asset is allocated over time and considered as an expense.

Depreciation is a method of reallocating the cost of a tangible asset over its useful life span of it being in motion. In accounting terms, depreciation is defined as the reduction of the recorded cost of a fixed asset in a systematic manner until the value of the asset becomes zero or negligible.

Generally, the cost is allocated, as depreciation expense, among the periods in which the asset is expected to be used. An example of fixed assets are buildings, furniture, office equipment, machinery, etc.. The land is the only exception that cannot be depreciated as the value of land generally appreciates with time.

 CAUSES OF DEPRECIATION

Depreciation is a value reduction in the carrying amount of a fixed asset. Depreciation is intended to roughly reflect the actual consumption of the underlying asset so that the carrying amount of the asset has been greatly reduced to its salvage value by the time its useful life is over.

The term depreciation represents loss or diminution in the value of an asset consequent upon wear and tear, obsolescence, effluxion of time, or permanent fall in market value. The causes of depreciation are:

1. Wear and Tear: Some assets physically deteriorate due to wear and tear in use. When an asset is constantly used for production, the asset wears out. 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, erosion etc. For instance, building, machineries, furniture, vehicles, plant etc. The wear and tear is general but pri­mary cause of depreciation.
2. Lapse of Time: There are certain assets like leasehold property, patents, copy-right etc. that are acquired for a particular period. After the expiry of the period, they are rendered useless i.e. their value ceases to exist. Thus, their cost is written off over their legal life.
3. Obsolescence: A new and improved machine performs the same function more quickly and cheaply than the existing ma­chine. As such, existing machine may become out of date or outmoded or obsolete. The new inventions, change in fashions and taste, market condition etc. are the causes to discard the value of an asset.
4. Exhaustion: Some assets are of wasting nature. For instance, quarries, mines, oil-well etc. It is the reduction in the value of natural deposits as resources have been extracted year after year. As such these assets are known as wasting assets. The coalmine or oil well gets physically exhausted by the removal of its contents.
5. Maintenance:A good maintenance of machine will naturally increase its life. When there is no maintenance, there is more depreciated value. When there is good maintenance, there is longer life to the machines. The long life of machine depends upon good and skilled maintenance.

When there is damage to or impairment of an asset, it can be considered a cause of depreciation, since either event changes the amount of depreciation remaining to be recognized.

Only in a few cases do assets appreciate. Land, gold, antique goods and old paintings may go up in value. But, usually the value of an asset diminishes continuously.

 NEED FOR DEPRECIATION:

Depreciation is provided for the assets with a view to achieve the following results:

1. To ascertain the true profit: Asset is an important tool in earning revenues. When the value of assets decreases, this loss must be brought into account; otherwise a true working result cannot be known. Depreciation is an operating expense of a physical asset, the same should be considered in arriving the true profit earned during each year.If depreciation is ignored, the loss that is occurring in respect of fixed assets will be ignored. So, depreciation should be debited to Profit and Loss Account before profit is ascertained.
2. To Ascertain True Value of Asset: The function of the Balance Sheet is to show the true and correct view of the state of affairs of a business. If no depreciation is charged and when assets are shown at the original cost year after year, Balance Sheet will not disclose the correct state of affairs of a business.
3. To Retain Funds for Replacement: Assets used in the business need replacement after the expiry of their service. When an asset is continuously used, a time will come when the asset is to be given up and hence its replacement is essential.Therefore, it is necessary to make provision and create funds to replace such assets, in proper time.
4. To Reduce Tax Liability: Depreciation is a tax deductible expense. As such, it is permitted by the prevailing taxation laws to be deducted from profit. Consequently, the owner of a business may avail himself of this benefit by charging depreciation to his profit and reducing his tax liability.
5. To Present True Position: Financial position can be studied from the Balance Sheet and for the preparation of the Balance Sheet fixed assets are required to be shown at their true value. If assets are shown in the Balance Sheet without any charge made for their use, (that is, depreciation) then their value must have been over­stated in the Balance Sheet and will not reflect the true financial position of the business.

Consequences of Not Providing for Depreciation: If depreciation is not accounted for, the profit of the company is overstated, In turn, it is distrib­uted among the shareholders. Thus there is no provision for the replacement of the machine. It must be pointed out that depreciation by itself does not create funds; it merely draws attention to the fact that out of gross revenue receipts, a certain amount should be retained to replace the asset used for carrying on activities. It is mandatory to charge depreciation in the profit and loss account in the Companies Act 2013. The Companies Act makes it compulsory to write off depreciation on fixed assets before declaring dividends.

 FACTORS OF DEPRECIATION

Depreciation is an allowable expense in general accounting purposes and income tax accounting purposes. But it differs categorically from other conventional expenses because depreciation charges do not occur in any outflow of business funds.

The periodical amount of depreciation is affected by the following factors:

1. The Cost of the Asset: Cost of the asset means the basic acquisition cost of the asset plus all incidental expenses which are required to the asset into use. The incidental expenses like freight, import duty, brokerage, taxes, legal expenses and installation charges also form a part of cost of asset.
2. The Life of the Asset: This is the period over which the organisation considers the fixed asset to be productive. Beyond its useful life, the fixed asset is no longer cost-effective to continue the operation of the asset.
3. The Salvage Value of the Asset: Post the useful life of the fixed asset, the company may consider selling it at a reduced amount. This is known as the salvage value of the asset.
4. Method of Depreciation: By the method of depreciation selected for amortisation of the asset must be systematic and rational.

 ACCOUNTING FOR DEPRECIATION

Depreciation is an expense and reduces the book value of the asset. Therefore, a simple journal entry is to be passed at the end of the year. Journal entry for depreciation depends on whether the provision for depreciation / accumulated depreciation account is maintained or not. 

Assets such as plant and machinery, buildings, vehicles, furniture etc. which are expected to last more than one year, but not for an infinite number of years are subject to depreciation. The below journal entry for depreciation assumes that depreciation is charged directly to the asset account. 

Journal entry for depreciation;

Depreciation A/C	Debit
To Asset A/C	Credit

(Assuming no provision/accumulated depreciation account is maintained)

The golden rules of accounting applied in the above journal entry are;

• Depreciation– Nominal Account > Dr. All expenses & losses
• Asset– Real Account > Cr. What goes out

 To Transfer Depreciation into P&L

Profit & Loss A/C	Debit
To Depreciation A/C	Credit

After the asset’s useful life when all depreciation is charged throughout the years, the asset approaches it scrap or residual value.

Thus, depreciation is shown as an indirect expense in the debit side of the profit and loss account and the asset’s value is to be shown after the reduction of depreciation in balance sheet.

There is also a method of accounting for depreciation, although it is rarely used. In this method rather than reducing the value of asset another account is credited named as accumulated depreciation and depreciation for all assets are transferred into it. It is then shown as negative item in the fixed asset balance sheet.

Example: Let’s assume that a piece of machinery worth Rs. 1,00,000 is charged depreciation (Straight line method) at 10%. The journal entry will be;

Depreciation A/C	10,000
To Machinery A/C	10,000

 To Transfer it to the Income Statement

Profit & Loss A/C	10,000
To Depreciation on Machinery A/C	10,000

METHOD OF DEPRECIATION

There are three methods commonly used to calculate depreciation. They are:

• Fixed Percentage Method or Straight-Line Method
• Diminishing Value Method or Written Down Value (WDV) Method
• Units of Production Method
• Sum of the Years’ Digits Method of Depreciation

 1. FIXED PERCENTAGE METHOD OR STRAIGHT-LINE METHOD

The simplest, most used and popular method of charging depreciation is the straight-line method. The Straight-Line Method of depreciation is also known as the ‘Original Cost Method’, ‘Fixed Instalment Method’ and ‘Fixed Percentage Method’.

Under this method, an equal amount is provided each year for the depreciation of each asset until the asset has been written down to nil or its scrap value at the end of the estimated life of the asset. The name of this method is derived from the fact if the successive annual depreciation over the life of the asset is plotted on a graph, the result will be a straight line with a slope equal to the annual depreciation. This method is also called the ‘Fixed Instalment Method’ because a uniform amount of depreciation is charged each year. Straight-line depreciation can be calculated by using the following formulas:

Depreciation Amt = (Cost of asset − Salvage Value) ∕ Useful life in years

The formula of the annual depreciation under the method is;

Depreciation per annum = (Cost of asset − Salvage Value) x Rate of depreciation

1. Example: Suppose a business has bought a machine for Rs. 10,000. They have estimated the useful life of the machine to be 8 years with a salvage value of Rs. 2,000.

Solution:

Now, as per the straight-line method of depreciation:

Cost of the asset = Rs. 10,000 and Salvage Value = Rs. 2000

Total Depreciation Cost = Cost of asset – Salvage Value = 10000 – 2000 = Rs. 8000

Useful life of the asset = 8 years

Thus, annual depreciation cost = (Cost of asset – Salvage Cost)/Useful Life = 8000/8 = Rs. 1000

Hence, the Company will depreciate the machine by Rs.1000 every year for 8 years.

2. Example: On 1 Jan 2016, Company A purchased a vehicle costing Rs.20,000. The company expects the vehicle to be operational for 4 years at the end of which it can be sold for Rs.5,000. Calculate depreciation expense for the year ended 31 Dec 2016, 2017, 2018 and 2019.

Solution:

Depreciable amount of the vehicle is Rs.15,000 (Rs.20,000 cost minus Rs.5,000 salvage value). Useful life is 4 years.

Depreciation expense for year ended 31 Dec 2016 = Rs.15,000 ÷ 4 = Rs.3,750 per year.

Depreciation expense shall remain the same over the useful life. Hence, an amount of Rs.3,750 shall be the depreciation expense for year ended 31 Dec 2017, 2018 and 2019.

The advantages of Straight-Line Method are;

1. Simple and easy to understand.
2. The book value of an asset can be reduced to Zero.
3. A fair evaluation ofan asset each year on the balance sheet.

Disadvantages of Straight-Line Method are;

a) The depreciation is equal for all the years. However, the expenditure on repairs and renewal goes on increasing as the asset gets older, resulting in higher amount charged to profit and loss account on account of depreciation and repairs in the subsequent years.

2. DIMINISHING VALUE OR WRITTEN DOWN VALUE (WDV) METHOD

The second type of depreciation method is the diminishing value method which is also known as ‘Written down value method’, ‘Reducing instalment method’, and ‘Fixed percentage on diminishing balance’.Written down value (WDV) method of depreciation is the most commonly used method of depreciation. In Income Tax Act, depreciation is allowed as per the WDV method.

According to the diminishing value method, depreciation is charged on reducing balance & a fixed rate. Depreciation, in this case, is charged over the useful life of an asset over its written down value.The percentage, at which depreciation is charged, remains fixed, however, the amount of depreciation goes on diminishes year after year. More depreciation tends to occur earlier in asset’s life.

This method is more relevant where the particular asset (viz; Vehicle, Computer, Office Equipment, etc.) is expected to give better performance in the initial periods of use as compared to the later. Thus, the charge of P&L account is higher in the initial year as compared to the later year of the life of such asset.

Annual Depreciation = Previous year’s value (WDV) x Percentage rate 

For example- Asset is purchased at Rs. 1,00,000 and the depreciation rate is 10% then first-year depreciation is Rs. 10,000 (10% of Rs. 1,00,000), second year depreciation is Rs. 9,000 (10% of 90,000 [1,00,000 – 10,000]) and third year depreciation is Rs. 8,100 (10% of Rs. 81,000 [90,000 – 9,000]).

3. Example: A machine was purchased for Rupees 1,00,000, the estimated useful life of which is 8 years. The estimated salvage value of the machine at the end of its useful life is Rs. 20,000. It was decided to charge depreciation at 10% every year on the written-down value of the machine.

The results under the written down value method after charging depreciation for 8 years will be as shown in the table below:

Year	Cost/WDV	Depreciation @ 10% on WDV	Net Book Value (at the end of the year)
1	1,00,000	10,000	90,000
2	90,000	9,000	81,000
3	81,000	8,100	72,900
4	72,900	7,290	65,610
5	65,610	6,561	59,049
6	59,049	5,905	53,144
7	53,144	5,314	47,830
8	47,830	4,783	43,047

In the example we discussed in the straight-line methods of depreciation, we saw that, at the end of the 8th year, using the straight-line method, only Rs. 20,000 (that is the Salvage value) was left to be written off. However, in the present scenario when we are using the written-down value method of depreciation, the net book value of the Asset at the end of the 8th year is Rs. 43,047. There is still an amount of Rupees (43047 – 20000) = 23047 left to be written off.

Hence a higher percentage rate is needed to reduce the Asset to its disposable value in a given time under the written down value method. This is because the fixed rate of depreciation is applied to the written down value or the diminishing balance of the Asset instead of the original cost of the asset as it was done in the straight-line method of depreciation. It is for the same reason that the diminishing balance method or the written down value method will never reduce an asset to zero net book value.

Advantages of Written Down Value Method: The following are the advantages of this method:

1. It matches the service of the asset with the depreciation charge. When an asset is more efficient in the initial years, higher depreciation is charged compared to later years. It is true about fixed assets such as motor vehicles.
2. It recognizes the risk of obsolescence by charging the major part of depreciation in the early years of the life of the asset.
3. It results in a better cash flow through tax deferral as under this method, the net income to be taxed is lower in the initial years and higher in subsequent years.
4. As and when additions are made to the asset, fresh calculations of depreciation are not necessary.
5. Income-tax authorities recognize this method.

Disadvantages of the Written Down Value Method: The main drawbacks of this method are as follows:

1. In subsequent years the original cost of the asset is completely lost sight of.
2. The asset can never be reduced to zero.
3. This method does not take into consideration the interest on capital invested in the asset.
4. This method requires elaborate bookkeeping. The determination of the correct rate of depreciation is a complex task. 

3. UNITS OF PRODUCTION METHOD

This method of charging depreciation on the asset is based on the units produced during the year. The estimated total production of the asset is the criteria for providing depreciation.

Unit of production depreciation, also called the activity method, calculates depreciation based on the unit of production and ignores the passage of time over the useful life of an asset; in other words, a unit of production depreciation is directly proportional to production. It is mainly used in the manufacturing sector.

This method is applied where the value of the asset is more closely related to the number of units it produces. Thus, in the years when the asset is heavily used, the amount of depreciation will be high.

Assets on which this method can be applied are Plant and Machinery. As their wear and tear will depend on how much we use them.

 Example,

A machine can produce 10, 00,000 meters of cloth over its useful life. The purchase price of the machine is Rs. 100,000/- and the scrap value is estimated at Rs.10,000/. During the first year of production, the machine produced 2,00,000 meters of cloth. The depreciation amount in the first year will be;

   = (100,000 – 10,000) x (200,000 / 10,00,000)

   = 90,000 x 0.20  = Rs. 18,000/- 

4. SUM OF THE YEARS’ DIGITS (SYD) METHOD OF DEPRECIATION

The sum of the Years Digit depreciation method involves calculating depreciation based on the sum of the number of years in an asset’s useful life.Sum of the years’ digits method of depreciation is one of the accelerated depreciation techniques which assumes that assets are generally more productive when they are new and their productivity decreases as they become old. The formula to calculate depreciation under the SYD method is:

In the above formula, the depreciable base is the difference between cost and salvage value of the asset and the sum of the years’ digits is the sum of the series:

1, 2, 3, … , n ; where n is the useful life of the asset in years.

Sum of the years’ digits can be calculated more conveniently using the following formula:

       

The sum of the years’ digits method can also be applied on a monthly basis, in which case the above formula to calculate the sum of the years’ digits becomes much more useful.

4. Example: Use the sum of the years’ digits method of depreciation to prepare a depreciation schedule of the following asset:

Cost	Rs.45,000
Salvage Value	Rs.5,000
Useful Life in Years	4
Asset is Depreciated	Yearly

Solution

Sum of the Years’ Digits = 1 + 2 + 3 + 4 = 4 (4 + 1) ÷ 2 = 10

Depreciable Base = Rs.45,000 − Rs.5,000 = Rs.40,000

Year	Depreciable Base	Depreciation Factor	Depreciation Expense		Accumulated Depreciation
1	Rs.40,000	4/10	4/10 × 40,000 =	16,000	Rs.16,000
2	Rs.40,000	3/10	3/10 × 40,000 =	12,000	Rs.28,000
3	Rs.40,000	2/10	2/10 × 40,000 =	8,000	Rs.36,000
4	Rs.40,000	1/10	1/10 × 40,000 =	4,000	Rs.40,000

Advantages of the sum years’ digits depreciation method

1. The sum years’ digits depreciation method as one of the accelerated depreciation methods better matches costs to revenues because it takes more depreciation in the early years of an assets’ useful life compared to the straight-line depreciation method.
2. This method reflects more accurately the difference in usage of different assets from one period to the other compare to the straight-line depreciation method

Disadvantages of the sum years’ digits depreciation method

1. SYD depreciation method might be more confusing and harder to compute compared to the straight line one.
2. It has declining amounts of depreciation expense. Declining amounts of depreciation expense usually offset by increasing the maintenance expense which might smooth the income over the years

REPLACEMENT OF A FIXED ASSET AND CREATION OF SINKING FUND

The sinking fund method of depreciation is used when an organization wants to set aside a sufficient amount of cash to pay for a replacement asset when the current asset reaches the end of its useful life. As depreciation is incurred, a matching amount of cash is invested, with the interest proceeds being deposited into an asset replacement fund. The interest deposited into this fund is also invested. By the time a replacement asset is needed, the funds needed to make the acquisition have accumulated in the associated fund. This approach is most applicable in industries that have a large fixed asset base, so that they are constantly providing for future asset replacements in a highly organized manner.