Module 5- Depreciation

Meaning
The monetary value of an asset decreases over time due to use, wear and tear or obsolescence.
This decrease is measured as depreciation.

Description: Depreciation, i.e. a decrease in an asset's value, may be caused by a number of

other factors as wellsuch as unfavorable market conditions, etc. Machinery, equipment, currency
are someexamples of assets that are likely to depreciate over aspecific period of time. Opposite
of depreciation is appreciation which is increase in the value of an assct over aperiod of time.
Causes of Depreciation:
1. Wear and Tear:

Some assets physically detcriorate duc to wcar and tcar in usc. 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, erosjon 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:
Appearance of new and improved machines results in discarding of old machines. Thus new
inventions, change in fasbions and taste, market condition, Government policies etc. are the
causes to discard the value of an asset. But this is not the cause of depreciation and not

depreciation in real sense.

A new macnine performs the same function more quickly and cheaply than the existing machine.
Assuch, existing machine may become out of date or outmoded or obsolete.
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. Non-Use:

Machines which are idly lying become less and less useful with the passage of time. Certain
types of machines exposed to weather conditions, may have more depreciation from not using it
than from its use.

6. Maintenance:

A good maintenance of machine will naturally increase its life. When there is n0 maintenance,
there is more depreciated value. When there is good maintenance, there is
longer life to the
machines. The long lifeof machine depends upon good and skilled maintenance.
7. Market Trend:

The market price may fluctuate in case of certain assets, for

instance, investments in gilt-edged
securities. When the prices go down, the concerned asset may depreciate its value. In
certain
cases, accident causes diminution in the value of assets.

Need For Depreciation:

Depreciation is provided for the assets with a view to achieve the following results:
1. To Ascertain the True Working Result:
Asset is an important tool in earning revenues. Huge
amounts are spent for acquisition of assets
which are worn out in the process of earning income.
Thus, the assets get depreciated in their
yalue, over a period of time due to many reasons
explained above.
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
sameshould be considered in arriving the
true profit earned during each year.
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 ofa
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. ToRetain Funds for

Replacement:
Assets used in the business need replacement after the expiry of their
service. It is always not
possible to determine the useful life of assets. But, in certain cases,
machine often becomes,
obsolete long before it wears out because of rapid changes in tastes and
technology. It is a
permanent loss in value of the asset. When an asset is continuously used, a time will
come when
the asset is to be given up and hence its replacement is
essential.
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. ToPresent True Position:
Financial position can be studied from the Balance Sheet and for the
preparation of the Balance
Sheet fixed assets are reguired 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.

Method of charging depreciation

Fixed Installment:
This is the oldest and simplest method of charging
depreciation. The life of the asset is estimated
and it 15S WTitten off equally in all the years. The amount of
depreciation is such that the. book
value o1 the asset is reduced to zero at the end of
purposeful life of the asset. The amount is
calculated by dividing the cost of the asset less estimated scrap value by the
asset Will be used number of years the

piminishing Balance Method:

 The depreciation is charged as a fixed percentage on the
diminishing balance of the asset given
charging depreciation, hence the name diminishing balance. The amount of
depreciation goes on
decreasing every year. The amount of depreciation and repairs charged to profit and loss
account
remains almost the same because depreciation decreases every year and
expenditure on repairs
increases with the passage of time.

The method does not reduce the asset to zero as in the fixed
installments system. Some balance,
though insignificant, remains in the asset account at the end of asset life.

Annuity Method:
In both the methods discussed earlier,
depreciation is provided only on the amount of asset and
no attention is given to the amount of interest which might
have been earned, had this amount
been used elsewhere. Annuity method considers both the
value of asset and the amount of
interest. The interest is taken on debit balance of the asset.

The interest is debited to asset account and is

credited to profit and loss account. A fixed amount
is charged as depreciation every year. The amount of depreciation is calculated with the help of
Depreciation Annuity Tables. The method is precise and exact from the point of view of
calculations, so it is called a scientific method. This is the only method which
takes into
Consideration interest on capital sunk in the asset.
4. Depreciation Fund Method:
This method provides funds for the replacement of the asset at the
end of its servicing life. The
amount of depreciation is credited to an account called Sinking Fund or
account which is shown on the liabilities side of the balance sheet. Depreciation Fund
This amount invested in
outside securities.

Every year the amount set aside for depreciation along with the
interest is again invested. The
amount So invested is debited to an account known as
Sinking Fund Investment Account and
these investments are shown as an asset in the
balance sheet. The amount of depreciation remains
the same for the year.

5. Insurance Policy
Method:
This method is almost similar to
Depreciation Fund Method. In
investments arc sold at a loss then the aim of replacement will be depreciation fund method if
policy mehod overcomes this drawback. In this method an adversely affected. Insurance
insurance policy is purchased tor the
value of the asset. This policy is taken up for the life of the asset and it matures at a time when
the asset is to be replaced.

Methods for charging depreciation

1.Straight Line Method

2. Written Down Value Method

Straight Line Method

Depreciation is charged at a fixed percentage on the originalcost of the asset.

The amount of depreciation remains equal from year to year and as such the method is also
known as 'Equal Instalment Method' or Fixed Installment Method'.

Yearly Depreciation = (Original cost of the asset-Estimatcd scrap value )/estimated lifeof the
asset

Depreciation rate = Amount of annual of yearly depreciation /Total cost of the asset
Example:

On 1st April, 2020,X Ltd. purchased a Machine for 90,000 and spent 6,000 on its carriage
and 4,000 on its installation. On the date of purchase it was estimated that effective life of the
machine will be 10years and after 10 years the scrap value will be 20,000. what will be the
annual depreciation and rate of depreciation under straight line method?

Solution: Cost of asset =1.00.000 (90000+t6000+4000)

Scrap value= 20,000

Estimated life of asset = 10 years

Annual Depreciation (Straight Line Method) = Cost of asset-scrap value /Estimated
usefull life

= (1,00, 000-20, 000)/ 10

 =8,000 every year

Rate of depreciation= (Amount of annual depreciation/ Total cost of asset) X

100 =
(8, 000/ 1, 00, 000) X100 = 8%

Written Down Value Method

The value of asset goes on diminishing year after year, the

amount of depreciation charged
every year also goes on declining.

Each year's depreciation is calculated og the book value of the asset at the
beginning of that
year, rather than on the original cost.

Book Value is the written down value of the asset. In other words, it is that
part of the original
cost of the asset which has not been depreciated so far.

Also known as 'Reducing Install1ment Method' or Diminishing Balance

Method'.
Book Value= Original Cost - Total Depreciation to date
> Written Down Value Rate, R={1-(n (s lc ))}x 100

Where, s= Scrap Value, c= Cost of asset and n= Expected Useful life

Example: If amachine is purchased for 1,00,000 and depreciation is to be

what will be the depreciation according to Written Down value charged at 10% p.a.,
method'?
Solution:

1st year 1,00,000 @10% = 10,000

2 nd year90,000 @10% =9,000

3rd year 81,000 (@10% = 8,100

4th year 72,900 (a@10% =7,290
And So on.
 Basis of Difference Straight Line Method Written Down Value Method

Basis of charging Original Cost Book Value(i.c. original cost

depreciation Less depreciation charged till date)
Annual depreciation charge Fixed(Constant)year Declines year after year

Total charge against profit and Uncqual ycar after ycar. It Almost cqual every ycar.
loss account in respect of
depreciation and repairs Increases in later years.

Recognition by income Not recognized Recognized by tax law

Suitability It is suitable for assets in which repair It is suitable for assets, which are affectedt
charges are less, the possibility of and technological changes and require mor
obsolescence is low scrap valuedepends expenses with passage of time.
upon the time period involved.