CONCEPT OF DEPRECIATION?

 

 

 

 

 

 

» CONCEPT OF DEPRECIATION
» FIXED ASSETS
» MEANING AND DEFINITION OF DPRECIATION
» METHODS OF CALCULATING DEPRCIATION

 

 

CONCEPT OF DEPRECIATION

Depreciation is the process of spreading the cost of fixed asset over the different accounting periods which drive the benefit from their use. The cost of fixed assets apportioned to a given period from part of the overall cost to be matched with the revenues generated in that. So, depreciation is of great significance in the concept of income measurement. It measures the service potential of the fixed assets period.

FIXED ASSETS

They include all assets whose benefit is derived by businessman for a long period of time, usually more than one year period, Examples : Machinery, Furniture, Buildings, Leases, etc. land is affixed asset but not subject to depreciation because it has infinite lifetime. Assets are any property owned by a person or business. Tangible assets include money, land, buildings, investments, inventory, cars, trucks, boats, or other valuables. Intangibles such as goodwill are also considered to be assets. Capital Assets, also known as Fixed Assets, are those assets such as land, buildings, and equipment acquired to carry on the business of a company with a life exceeding one year. Fixed assets are assets that help companies reap economic benefits over a period of time. Assets such as land, building, plant and machinery are all fixed assets. The general consensus is that fixed assets cannot be liquidated easily. This is quite apparent when compared to current assets such as cash and bank account and inventories, which can be liquated or converted into cash relatively easily. It may be noted that intangible assets can also be part of this head as they benefit companies over a long period of time. Few more examples of the same would be trademarks, designs and patents.

MEANING AND DEFINITION OF DPRECIATION

Depreciation is a permanent decline in the value of an asset. The gradual decrease, both in the value and usefulness, of an asset due to its nature and usage is termed as depreciation. Depreciation is the measure of wearing out of a fixed asset. All fixed assets are expected to be less efficient as time goes on. Depreciation is calculated as the estimate of this measure of wearing out and is charged to the Profit & Loss account either on a monthly or annual basis. The cost of the asset less the total depreciation will give you the Net Book Value of the asset.

It is common experience that whenever an asset is used it reduces in value. The net result of depreciation is that sooner or letter, the asset becomes useless. So, it can be stated that depreciation is that portion of the cost of an asset which is reduced from revenues for the services of the asset in the operation of a business.

According to Spicer and Pegler “Depreciation is thee measure of the exhaustion of the effective life of an asset from any cause during a given period.”

According to the Institute Of Chartered Accountants Of India, “Depreciation is a measure of the wearing out, consumption or other loss of value of a depreciable asset arising from use effluxion of time or obsolescence through technology and market changes.”

According to International Accounting Standards Committee, “Depreciation is the allocation of the depreciable amount of an asset over its estimated useful life. Depreciation for the accounting period is charged to income either directly or indirectly.”

The following important terms from these definitions are important:

• Depreciable Assets: The assets whose lifetime can be estimated and useful during two or more accounting periods in production or service activities of an organization can be called depreciable assets.

• Useful life: Useful life is the time during which the asset is helpful in the normal business activities of a firm. It can be less than the total life time of the asset. It can be exactly predetermined or it should be estimated on reasonable basis.

• Depreciable Amount: It is the cost of acquisition and installation of an asset after reducing any realizable value at the end of useful life.

• Realizable value at the end of useful life.

• Effluxion of time: It is the passage of time irrespective of actual use of an asset as in the case of leased assets.

• Obsolescence: It refers to an asset becoming out of date due to improved models or methods.

METHODS OF CALCULATING DEPRCIATION

1. Straight Line Method or Fixed Installment Method.

2. Written Down Value Method or Diminishing Balance Method.

3. Annuity Method.

4. Depreciation Fund Method.

5. Insurance Policy Method.

6. Revaluation Method.

Straightline Method or Fixed Instalment Method or Original Cost Method

Under this method, the same amount of depreciation is charged every year throughout the life of thee asset. The amount and rate of depreciation is calculated as under.

1. Amount of depreciation = Total cost - Scrap value / Estimated life

2. Rate of depreciation = Amount of depreciation / Original cost x 100

MERITS:

1. Simplicity: It is every simple and easy to understand.

2. Easy to calculate; It is easy to calculate the amount and rate of depreciation.

3. Assets can be completely written off: Under this method, the book value of the asset become zero or equal to its scarp value at the expiry of its useful life.

DEMERITS: The amount of depreciation is same in all the years, although the usefulness of the machine to the business is more in the initial years, although the usefulness of the machine to the business is more in the initial years than in the later years.

Written Down Value Method or Dimnishing Balance Method or Reducing Balance Method

Under this method, depreciation is charged at a fixed percentage each year on the reducing balance (i.e. cost less depreciation) goes on decreasing every year.

Merits:

1. Uniform effect on the profit and loss account of different years. The total charge (i.e.. depreciation plus repairs and renewals) remains almost uniform year after year, since in earlier year the amount of depreciation is more and the amount of repairs and renewals is more.

2. Recognized by the income tax authorities: This method is recognized by the income tax authorities.

3. Logical Method: It is a logical method as the depreciation is calculated on the diminished balance every year.

DEMERITS: It is very difficult to determine the rate by which the value of assets could be written down to Zero.

Annuity Method

The annuity method considers that the business besides loosing the original cost of the asset in terms of depreciation and also loses interest. On the amount used for buying the asset. This is based on the assumption that the amount invested in the asset would have earned in case the same amount would have been invested in some other form of investment. The annual amount of depreciation is determined with the help of annuity table.

Depreciation Fund Method or Sinking Fund Method

Under this method, funds are mad available for the replacement of asset at the end of its useful life.th depreciation remains the same year after year and is changed to profit and loss account every year through the creation of depreciation fund. The aggregate amount of interest and annual provision is invested every year. When the asset is completely written off or is to be replaced, the securities are sold and the amount so realized by selling securities is used to replace the old asset.

Insurance Policy Method

According to this method, an insurance policy is taken for the amount of the asset to be replaced. The amount of the policy is such that it is sufficient to replace the asset when it is worn out. A sum equal to the amount of depreciation is paid as premium every year. The amount goes on accumulating at a certain rate of interest and is received on maturity. The amount so received is used for the purchase of new asset, replacing the old one.

Revaluation Method

Under this method, the asset like loose tools are revalued at the end of the accounting period and the same is compared with the value of the asset at the beginning of the year. The difference is considered as depreciation.

Straightline Method or Fixed Instalment Method or Original Cost Method

Under this method, the same amount of depreciation is charged every year throughout the life of the asset .The amount and rate of depreciation is calculated as under.

1. Amount of depreciation = Total cost - Scrap Value / Estimated life

2. Rate of depreciation = Amount of depreciation / Original Cost x 100

Merits:

1. Simplicity; It is very simple and easy to understand.

2. Easy to calculate; It is easy to calculate the amount and rate of depreciation.

3. Assets can be completely written off; Under this method, the book value of the asset become Zero or equal to its scrap value at the expiry of its useful life.

DEMERITS:

The amount of depreciation is same in all the years, although the usefulness of the machine to the business is more in the initial years than in the later years.

Written Down Value Method or Dimnishing Balance Method or Reducing Balance Method

Under this method, depreciation is charged at a fixed percentage each year on the reducing balance (i.e., cost less depreciation) of asset. The amount of depreciation goes on decreasing every year.

MERITS:

1. Uniform effect on the profit and loss account of different years. The total charge( i.e.… depreciation plus repairs and renewals) remains almost uniform year after year, since in earlier year the amount of depreciation is more and the amount of repairs and renewals is less, Whereas in later years the amount of depreciation is less and the amount of repairs and renewals is more.

2. Recognized by the income tax authorities; this method is recognized by the income tax authorities.

3. Logical Method: It is a logical method as the depreciation is calculated on the diminished balance every year.

DEMERITS:

It is very difficult to determine the rate by which the value of asset could be written down to zero.