ACCOUNTING (MODULE-3)

Accounting Concept of Depreciation

The assets which are held by a business for the production and
supply of goods and services, expected to be used for more than an
accounting year and have a limited useful life are known as
Depreciable Assets.

On purchasing a fixed asset we record it at its original cost or

purchase price in the books of accounts. An organization uses this
fixed asset to earn or generate revenues for a number of accounting
years until it sells or discards the asset.Thus, we charge depreciation
as an expense to the Profit and Loss A/c.

Purpose of Accounting for Depreciation

The main purpose of the concept of depreciation and its accounting is

the allocation of the cost of a fixed asset. Depreciation expense does
not involve any outflow of cash. Hence, the funds that we charge to
the Profit and Loss A/c every year remain in the business itself and
thus, we can use them at the time of replacement of the asset.

Therefore, the concept of depreciation and its accounting is the

process of allocating or apportioning the cost of the fixed assets over
their useful life. Its aim is to distribute the cost of the
depreciable asset over its useful life and charge the depreciation to
the Profit and Loss A/c in order to arrive at the correct profit or loss
for the year.

CAUSES:
Wear and Tear of the Asset
Every machinery or tool is bound to undergo wear over a period of
time. There will be parts that may need replacing or repairing.
Usually, such assets have a fixed span of life, after which, they need
to be scrapped. This wear and tear of the asset must be accounted for
in financial terms, hence depreciation.

Perishability of Inventory
Items such as raw material and inventory, undergone deterioration
over a quick span of time. This is faster in relation to a fixed asset,
which normally lasts for a few years at least. This perishability of
assets is a point of consideration for depreciation accounting.

Usage Right Expiration

Some assets such as software and licenses have a typical span over
which it can be used. As soon as this time span finishes, the owner
has to give up using the asset. So the depreciation of this asset must
be done over time, it cannot just be written off on the day of
expiration.

Obsolescence
Another cause of depreciation is the obsolute nature of certain assets.
Over a period of time, every asset loses its novel value. A new
alternative can always be developed for replacing the asset and its
functions.

Factors Affecting Amount of Depreciation

The amount of depreciation is impacted by a number of factors. Let
us take a look at some of them. There are four main factors to
consider when calculating the depreciation expense are as follows:

 The cost of the asset.

  The estimated salvage value of the asset. Salvage value (also
called residual value) is the amount of money that the company
expects to recover, less the disposal costs, on the date the asset is
scrapped, sold, or traded in.
 Estimated useful life of the asset. Useful life refers to the window
of time that a company plans to use an asset. Useful life can be
expressed in years, months, working hours, or units produced.
 Obsolescence should be considered when determining an asset’s
useful life and will affect the calculation of depreciation. For
example, a machine capable of producing units for 20 years may
be obsolete in six years; therefore, the asset’s useful life is six
years in this case.

Need to Provide Depreciation

Depreciation needs to be provided because an asset is bound to
undergo wear and tear over a period of time. This reduces the
working capacity and effectiveness of the asset. Hence, this should
reflect the value of the asset, at which it is carried in the books of
accounts.

Also, every asset becomes obsolete over a period of time, as

new technology and innovation take over. The value of the asset will
hence decrease over time and this must be accounted for.

Comparison Chart

BASIS FOR COMPARISON PROVISION RESERVE

Meaning The Provision means to provide for a future expected liability. Reserves means to
retain a part of profit for future use.

What is it? Charge against profit Appropriation of profit

Provides For Known liabilities and anticipated losses Increase in capital employed

Presence of profit Not necessary Profit must be present for the creation of reserves, except
for some special reserves.
Appearance in Balance Sheet In case of assets it is shown as a deduction from the concerned asset
while if it is a provision for liability, it is shown in the liabilities side. Shown on the liabilities side.

Compulsion Yes, as per GAAP Optional except for some reserves whose creation is
obligatory.

Payment of Dividend Dividend can never be paid out of provisions. Dividend can be paid out of
reserves.

Specific use Provisions can only be used, for which they are created. Reserves can be used
otherwise.