Depreciation

Depreciation

In accounting, Depreciation refers to the systematic allocation of the depreciable amount of an asset over its useful life. It represents the decrease in the value of a fixed asset due to its usage, wear and tear, passage of time, or obsolescence. Fixed assets, also known as non-current assets (like machinery, buildings, vehicles, furniture), are purchased for long-term use in the business operations and are not intended for immediate sale.

Over time, these assets lose their capacity to provide services. Depreciation is the accounting mechanism to recognise this loss in value and systematically spread the cost of the asset over the periods that benefit from its use. It is an expense related to the use of a long-term asset.

Meaning Of Depreciation

Depreciation is essentially a process of cost allocation, not a process of asset valuation. Its purpose is to charge a portion of the asset's cost as an expense in each accounting period during its useful life, reflecting the consumption of the asset's economic benefits. It is based on the Matching Concept, aiming to match the cost of using the asset with the revenue generated from its use in the same period.

Features Of Depreciation

• It is a decline in the value of fixed assets: Applies only to depreciable fixed assets (excluding land, which generally does not depreciate).
• It is a continuous process: The loss in value occurs over the entire useful life of the asset.
• It is a process of allocation of cost: It allocates the cost of the asset over its useful life. It does not determine the market value of the asset.
• It is a non-cash expense: Depreciation is recorded as an expense in the Profit and Loss Account, but it does not involve any cash outflow in the period it is charged. The cash outflow occurred when the asset was originally purchased.
• It reduces the book value of the asset: Depreciation is deducted from the original cost of the asset in the Balance Sheet, resulting in a lower book value (Cost - Accumulated Depreciation).
• It is caused by various factors: Including wear and tear, passage of time, obsolescence, etc. (Discussed in Section I3).
• It is based on estimates: The useful life and residual value of an asset are often estimates, making depreciation calculation subject to some degree of estimation.

Providing depreciation is mandatory under the Companies Act, 2013, and accounting standards in India.

Depreciation And Other Similar Terms

While depreciation refers to the decline in value of tangible fixed assets due to usage or time, there are similar concepts used for other types of long-term assets.

Depletion

Depletion refers to the process of allocating the cost of wasting assets (natural resources) over the period they are extracted or consumed. Wasting assets include mines, quarries, oil wells, forests, etc., whose value decreases as the underlying natural resource is physically removed or used up.

Key Difference from Depreciation:

Depreciation is for tangible assets created or acquired by humans (like machinery), while depletion is for natural resources. Depletion is often calculated based on the quantity of the resource extracted during the period.

$Depletion\ Charge\ per\ Unit = \frac{Cost\ of\ Asset - Estimated\ Residual\ Value}{Estimated\ Total\ Units\ in\ Asset}$

$Total\ Depletion\ for\ Period = Depletion\ Charge\ per\ Unit \times Units\ Extracted\ during\ Period$

Answer:

Amortisation

Amortisation refers to the systematic allocation of the cost of intangible assets (assets without physical substance) over their useful lives. Intangible assets include goodwill, patents, trademarks, copyrights, software, licenses, etc.

Key Difference from Depreciation and Depletion:

Amortisation is for intangible assets. Unlike tangible assets or natural resources, intangible assets do not physically wear out. Their value declines over time due to factors like the expiration of legal rights (for patents, copyrights) or the fading of their economic usefulness. The process of amortisation is similar to depreciation methods (like straight-line).

Answer:

In essence:

• Depreciation: for tangible fixed assets.
• Depletion: for wasting assets (natural resources).
• Amortisation: for intangible assets.

All three are methods of allocating the cost of a long-term asset over its useful life and are treated as expenses in the Profit and Loss Account.

Causes Of Depreciation

Fixed assets lose their value and ability to provide services over time due to various factors. Understanding these causes helps explain why depreciation is necessary.

Wear And Tear Due To Use Or Passage Of Time

This is the most common cause of depreciation for physical assets.

• Use: When an asset is used in the business operations, its components experience friction, stress, and fatigue, leading to physical deterioration. A machine used continuously will wear out faster than one used occasionally.
• Passage of Time (Effluxion of Time): Even if an asset is not used, its value can decline simply due to the passage of time and exposure to natural elements like sun, rain, and wind (e.g., a building, a vehicle left unused). Certain components might also deteriorate over time regardless of use (e.g., batteries, rubber parts).

This physical depreciation is a primary reason for allocating the asset's cost over its useful life.

Expiration Of Legal Rights

This applies primarily to intangible assets, but can also affect the useful life of tangible assets if their use is tied to a legal right. Assets like patents, copyrights, licenses, and leases have a limited legal life. Their value declines as the period of legal protection or right expires.

Answer:

For a tangible asset, if its use is tied to a 5-year lease, even if the asset could physically last longer, its depreciable life is limited by the lease term.

Obsolescence

Obsolescence refers to the decline in the value of an asset due to factors other than physical wear and tear. The asset is still physically capable of performing its function, but it becomes outdated, inefficient, or less desirable compared to newer alternatives.

Causes of Obsolescence:

• Technological Advancements: Newer, more efficient, or more advanced technology makes existing assets obsolete (e.g., older models of computers, phones, or machinery becoming less competitive).
• Market Changes: Changes in customer tastes, preferences, or demand for the product manufactured by the asset (e.g., machinery designed to produce a product that is no longer in demand).
• Legal or Regulatory Changes: New laws or regulations that make the use of an asset less feasible or prohibited.

Answer:

Obsolescence can shorten the useful life of an asset, requiring faster depreciation.

Abnormal Factors

Unforeseen events or accidents can cause a sudden and significant decrease in the value of an asset. While not a systematic cause like wear and tear or obsolescence, they contribute to the overall decline in value over time or necessitate immediate write-down.

Examples:

• Accidents (e.g., a vehicle involved in an accident).
• Fire or flood damage to machinery or buildings.
• Earthquakes or other natural disasters causing damage.

While these events might lead to an immediate loss or write-down of the asset (which is distinct from regular depreciation), they contribute to the cumulative loss in value of the asset during its life.

All these factors contribute to the decline in the economic value of fixed assets over their useful life, necessitating the accounting practice of depreciation.

Need For Depreciation

Providing for depreciation is not just an arbitrary accounting rule; it serves several crucial purposes, contributing to the accurate representation of a business's financial performance and position.

Matching Of Costs And Revenue

This is a core reason for charging depreciation, aligning with the Matching Concept. Fixed assets are used to generate revenue over multiple accounting periods. The cost of the asset is essentially a prepaid expense spread over its useful life. Depreciation ensures that a portion of the asset's cost (which contributes to revenue generation) is charged as an expense in the same accounting period in which that revenue is earned.

Answer:

Consideration Of Tax

Depreciation is a deductible expense for calculating taxable profit under the Income Tax Act, 1961, in India. Businesses are required to calculate and provide depreciation as per the rates and rules specified in the Income Tax Act to arrive at the correct taxable income.

• Charging depreciation reduces the net profit shown in the Profit and Loss Account.
• A lower net profit results in a lower taxable income.
• Lower taxable income leads to a lower tax liability for the business.

Tax laws often provide for depreciation as a legitimate business expense.

True And Fair Financial Position

Providing depreciation ensures that the value of fixed assets shown in the Balance Sheet is presented more realistically. The Balance Sheet shows assets at their book value (Original Cost - Accumulated Depreciation).

• Without deducting depreciation, fixed assets would be shown at their original cost year after year, which would overstate the true value of the assets that have been used and have lost utility.
• Deducting depreciation presents a truer picture of the investment currently locked up in fixed assets.

Thus, depreciation contributes to the objective of preparing financial statements that show a true and fair view of the financial position of the business.

Compliance With Law

The Companies Act, 2013, in India mandates that companies must provide for depreciation on their fixed assets according to the rates and methods prescribed. The Income Tax Act, 1961, also specifies rules for calculating depreciation for tax purposes.

• Compliance with these legal provisions is necessary for preparing valid financial statements and tax returns.
• Failure to provide depreciation can lead to overstatement of profits and non-compliance with legal requirements.

Legal requirements enforce the practice of depreciation, ensuring consistency and accuracy in financial reporting.

Factors Affecting The Amount Of Depreciation

The amount of depreciation to be charged for an accounting period depends on several factors related to the fixed asset. Different methods of depreciation use these factors in different ways, but they are the core inputs for calculation.

Cost Of Asset

This is the initial cost incurred to acquire the asset and bring it to its working condition and location for its intended use. According to the Cost Concept, assets are recorded at their historical cost.

Elements included in the Cost of Asset:

• Purchase price (net of trade discounts and rebates).
• Import duties and other non-refundable purchase taxes.
• Costs directly attributable to bringing the asset to the location and condition necessary for it to be capable of operating in the manner intended by management (e.g., site preparation costs, initial delivery and handling costs, installation and assembly costs, costs of testing whether the asset is functioning properly, professional fees).

The total of these costs forms the basis for calculating depreciation.

Estimated Net Residual Value (or Salvage Value)

This is the estimated value that the business expects to realise from the disposal of the asset at the end of its useful life. It is the expected scrap value or resale value.

• It is an estimate made at the time the asset is acquired.
• Estimated costs of disposal should be deducted to arrive at the net residual value.

If the estimated residual value is significant, it reduces the amount that needs to be depreciated over the asset's life.

Depreciable Cost

The Depreciable Cost of an asset is the portion of its cost that is subject to depreciation. It is the original cost of the asset minus its estimated net residual value. This is the amount that will be allocated as depreciation expense over the asset's useful life.

Depreciable Cost = Cost of Asset - Estimated Net Residual Value

Answer:

Estimated Useful Life

The Estimated Useful Life is the period over which the asset is expected to be available for use by the business, or the number of production units or similar units expected to be obtained from the asset by the entity.

• It is an estimate and may be shorter than the asset's physical or legal life due to factors like obsolescence, company's maintenance policy, or expected usage intensity.
• Useful life can be expressed in years, production units, hours of operation, etc.

The depreciable cost is spread over this estimated useful life using an appropriate depreciation method (e.g., Straight Line, Written Down Value).

Using the Straight Line Method (where depreciation is constant each year):

$Annual\ Depreciation = \frac{Depreciable\ Cost}{Estimated\ Useful\ Life\ (in\ Years)}$

$Annual\ Depreciation = \frac{Cost\ of\ Asset - Estimated\ Net\ Residual\ Value}{Estimated\ Useful\ Life\ (in\ Years)}$

Answer:

These three factors – Cost, Residual Value, and Useful Life – are essential for calculating the amount of depreciation to be charged periodically, regardless of the method used.