What is depreciation?

Causes of depreciation:
Depreciation is a rational estimate of a decline in the usefulness (fall in the value) of an asset due to consumption, use, passage of time, technological changes etc. Decline in the usefulness of an asset may be caused by the following factors: 1. 2. 3. 4. Physical wear and tear With the passage of time Obsolescence Expiration of legal rights Objectives of depreciation Every business enterprise needs to make a suitable policy on depreciation of the fixed assets. The charging of depreciation on fixed assets is necessary because of the following objectives: 1. 2. 3. 4. 5. 6. To allocate depreciable cost: To ascertain True and Fair Profit or Loss: To show True and Fair Financial Position: To provide funds for Replacement: To compute Tax Liability: To determine Product Cost for Managerial Decision-Making: Basic factors for calculation of depreciation Calculation of amount of depreciation depends on the following three factors: Cost of an asset: Cost of an asset includes the money or its equivalent paid for its acquisition and other cost which are necessary to put the asset in to operation. These other expense include legal charges, installation cost etc. Net Residual Value or Salvage: Residual value refers to estimated net realizable value of an asset at the end of its useful life. It is also called scrap value or salvage. Depreciable cost = cost of an asset ± net residual value

Estimated useful life of an asset: it refers to that period for which it will work economically and efficiently. It is very difficult job to estimate useful life of an asset. It depends on number of complex factors such as use of an asset, maintenance of an asset, replacement policy, and technological changes etc. useful life of an asset can be expressed in following ways

(a) Number of units, (b) Number of working hours (c) Calendar years

Methods for calculating depreciation:
There are various methods for calculating amount of depreciation which are as follows: 1. Fixed Installment Method: Under this method, depreciation amount is calculated by dividing depreciable cost of the asset by the estimated life of the asset. Formula for calculating depreciation amount is as under:

It is called fixed installment method because the amount of depreciation remains fixed or same from year to year. It is also referred to as µstraight line method¶ or µconstant charge method¶. Under this method depreciation is generally calculated at a fixed percentage on the original cost of the asset. Advantages: The main merits of this method are: 1. It is easy to understand 2. It is easy to calculate. 3. Under this method, the book value of the asset becomes Zero or equal to its scrap value at the expiry of its useful life Disadvantage: The main demerits of this method are as under: 1. It does not provide for the replacement of the asset on the expiry of its useful life. 2. It does not take into consideration the interest on the capital invested in the asset. Suitability of this method: It is suitable if: a) b) Repair and maintenance expenses are almost same for each accounting period, Utility of asset does not decrease with passage of time.

2. Diminishing Balance Method: Under this method depreciation is calculated at a fixed percentage of written down value of the asset. This method implicitly assumes that benefit accruing to business by utilization of asset keeps on decreasing as the asset gets old. As the value of asset goes on decreasing from year to year, the amount of depreciation charged to different accounting year decreases with passage of time (but the rate of depreciation remains same).

Where µn¶ = Number of years of asset life As the amount of depreciation is based on written down value of the asset, it is also referred to as µWritten down Value Method. Another term used for this method is µReducing Balancing Method¶. Advantages: use of this method results in following advantages: 1. It makes proper allocation of cost because more depreciation is charged in the earlier years when its utility is more as compared to later years when it becomes less useful 2. Equal amount is charged to profit and loss account. This is so because amount of repair and maintenance increases and amount of depreciation decreases with the passage of time. 3. As major portion of depreciable cost is recovered in earlier years, technological changes which make existing assets obsolete and require replacement will not pose much problem. Disadvantages: it suffers from the following drawbacks 1. As depreciation is calculated at fixed percentage of written down value, depreciable cost of asset cannot be fully written off. 2. It does not take into consideration the interest on the capital invested in the asset. 3. It does not ensure liquid funds at the time of replacement of an asset. 4. It is very difficult to calculate the rate of depreciation.
Generally, manual calculation of rate is not very easy and logarithm tables are used for this purpose. Moreover, if residual value is zero, rate of depreciation cannot be calculated.

Suitability: This method is suitable for those assets in relation to which: a) The amount of repairs and renewals goes on increasing as the asset grows older b) The possibilities of obsolescence are more. c) This method is suitable for plant and machinery, building and furniture etc.

3. Annuity Method: Under this method the annual depreciation charges would be ascertained with the help of Annuity Table. This method gives importance to interest factor. Other methods do not take into account the interest factor while calculating depreciation. Fixed interest rate is charged on the opening balance of each year and then the cost of asset together with interest thereon is written off equally over the life of the asset.

It is worth noting that this method does not fall in line with AS-16 4. Depreciation Fund Method: Depreciation fund method provides an adequate financial requirement for the replacement of the asset when the asset is replaced by a new one. Depreciation Fund account is opened and the amount of depreciation is credited to that account. The asset account stands year after year at its original cost. At the end of each year, the amount of depreciation is debited and depreciation fund account is credited and the corresponding amount is invested in securities for the purpose of mobilizing funds for replacement.

5. Sum of Years of Digit Method 6. Double Decline Method 7. Insurance Policy Method 8. Depletion Method 9. Machine Hour Rate Method 10. Revaluation Method
Difference between Straight Line Method and Diminishing Balance Method Straight line method differs from written down value method as follows: Basis of Straight Line Method distinction Basis of Depreciation is calculated at a fixed percentage on the original calculation cost. Written Down Value Method

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Depreciation is calculated at fixed percentage on the original cost (in the first year) and on written down value (in subsequent years). Amount of The amount of depreciation The amount of depreciation goes on remains constant. decreasing depreciation The book value of the asset The book value of the asset does not Book value becomes zero equal to its scrap become zero. value. This method is suitable for those This method is suitable for those assets Suitability assets in relation to which (a) in relation to which (a) the amount of repair charges are less, (b) the repairs and renewals goes on possibility of obsolescence is less. increasing as asset grows older, (b) the possibility of obsolescence are more. It is easy to calculate the rate of It is difficult to calculate the rate of Calculation depreciation. easy or depreciation. difficult

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