After reading this article you will learn about:- 1. Concept of Depreciation 2. Definition of Depreciation 3. Characteristics 4. Causes 5. Need 6. Basic.
- Concept of Depreciation
- Definition of Depreciation
- Characteristics of Depreciation
- Causes of Depreciation
- Need For Providing Depreciation
- Basic Factors in Estimating Depreciation
1. Concept of Depreciation:
One of the basic objectives of financial accounting it to calculate the true profit or loss from the operations of the enterprise for a particular period. As per matching principle of accountancy the costs of the product must be matched with the revenues in each period.
This principle indicates that if any revenue is earned and recorded then all costs whether paid or outstanding must also be recorded in books of accounts so that the profit and loss account could give a true and fair view of the profits earned or loss suffered during the period and balance sheet presents true and fair view of financial position of the business.
Depreciation is charged on fixed assets. It is an expense item. Fixed assets are those which are of material value, not meant for re-sale and having fairly long life and are used in the business. With the exception of land, all fixed assets have a limited useful life such as plant and machinery, furniture, motor van and buildings.
When a fixed asset is put to use then that part of its value which is lost or which cannot be recovered is known as depreciation. One of .the main characteristics of fixed assets is that because of their physical deterioration while in use their productive capacity can be held constant by putting periodic services to the asset but then the maintenance cost will increase with the life of the asset.
2. Definition of Depreciation:
The term depreciation is derived from the Latin words ‘do’ meaning down and ‘pretium’ meaning price. In common use it means putting down the value of an asset due to wear and tear, passage of time, obsolescence, etc.
It is very difficult to give a single definition of the term depreciation because under different situation this is handled differently and whatever seems to be correct in one situation may be improper in another. But even then some definitions are worth mentioning.
“Depreciation refers to the process of estimating and recording the periodic charges to expense due to expiration of the usefulness of a capital asset”– Malchman and Slavin.
According to J.N. Carter, “Depreciation is the gradual and permanent decrease in the value of an asset from any cause,” J.R. Batiliboi defined depreciation as follows:
“Depreciation represents loss or diminution in the value of an asset consequent upon wear and tear, obsolescence, effluxion of time, or fall in the market value.”
The Institute of Chartered Accountants of England and Wales has described depreciation as thus:
“Depreciation represents that part of the cost of fixed asset to its owner which is not recoverable when the asset is finally put out of use by him. Provision against this loss of capital is an integral cost of conducting the business during the effective commercial life of the asset and is not dependent upon the amount of profit earned.”
The definition given by A.N. Agrawal is as under:
“Depreciation is a permanent, continuing and gradual shrinkage in the value of a fixed asset.”
From the above definitions it is clear that depreciation is the gradual, continuing and permanent fall in value of fixed assets. The main causes for this fall in value are wear and tear of assets accidents, passage of time, obsolescence, inadequacies, ‘depletion etc.
Even in the recent editions of English language dictionaries the world ‘depreciation’ has been described as decline in the value of an asset due to such causes as wear and tear, action of elements, obsolescence and inadequacy.” Although these traditional views are under pressure because of the recognition of the changes in the value of rupee and replacement costs, even then they have their historical significance.
3. Characteristics of Depreciation:
The depreciation charged on fixed assets has the following features:
(i) Depreciation is always a fall in the value of asset.
(ii) This fall is always gradual.
(iii) The fall is of permanent character and it cannot be recouped afterwards.
(iv) The depreciation is a continuous process and it does not matter whether the asset was put to use during the period or not.
(v) Depreciation is always on fixed assets and not on current or floating assets.
(vi) Depreciation is the fall in the book value of the asset and not in market or exchange value.
(vii) Depreciation is the result of the use of assets, passage of time and obsolescence.
4. Causes of Depreciation:
(i) Use of the Assets or Wear and Tear:
The main cause of depreciation is the wear and tear of assets when they are put to use in the enterprise. It reduces the future technical capacity as well as earning power of the asset with the result that it brings reduction in the value of asset.
Another important contributing factor to depreciation is accident such as plant break down, loss by fire, etc.
(iii) Expiration of Certain Legal Rights:
In case of patents, leases and licenses depreciation is a time function as by the expiration of time for which legal right to use is created lapses.
Because of technological developments, the asset in use may become outdated and lose a large part of its value. This fall may also be the result of changes in tastes and habits of customers, changes in the supply and location of material resources, etc.
Sometimes there may be a necessity of putting the assets out of use despite the fact that the asset is in good physical condition. It is because of inadequacy. Inadequacy refers to the termination of the use of an asset because of growth and changes in the size of the firm. For the needs of the firm the asset may not be adequate and another firm of small size may buy it.
Where the asset is of wasting character, due to the extraction of some materials, such as mines, forests, quarries and oil wells, the asset will be depleted.
5. Need For Providing Depreciation:
The providing of depreciation on fixed assets is important because of the following reasons:
1. To Know the True Profit or Loss:
The depreciation is an expense though not payable to any outside party and does not involve outflow of funds. But even then when the fixed assets are put to use in the business, the loss in their value must also be acknowledged to know the true profits or losses. As per matching principle of accounting, all costs must be recorded whether paid or not which are incurred to earn revenue.
2. To Show True and Fair View of Financial Position:
The correct financial position of a business is depicted by balance sheet. While preparing balance sheet, it is necessary that fixed assets are shown at figures derived after deducting depreciation from their book values.
If the assets are shown in balance sheet at their book values without deducting the amount of depreciation then the fixed assets might be overstated and balance sheet may not show true and fair view of financial position.
3. To Provide Funds for Replacement of Assets:
Depreciation is a source of funds for the replacement of assets. After useful life, sufficient funds will be required at the disposal of the firm if proper depreciation provisions are made. If no depreciation has been charged then the firm may face financial difficulties for replacement after the assets become useless.
6. Basic Factors in Estimating Depreciation:
To determine the amount of depreciation of a fixed asset, the following factors are to be taken into consideration:
(a) Cost of the asset;
(b) Useful life of the asset, and
(c) Salvage value.
(a) Cost of Asset:
The cost of the asset includes all reasonable expenses that are incurred to bring the asset in a ‘workable condition. For example, if old machinery is purchased, the cost will include the purchase price paid, cost of overhauling, polishing and installation.
The main test whether an expense is to be included towards cost price or not, is that whether the expenditure was reasonable and necessary to make the asset in a workable condition.
If the answer is in affirmative, it will become the part of cost, otherwise not. Further, if the firm constructs its own asset, the amount of cost will include all the expenses incurred on its construction. The cost of the asset minus salvage value is the base because this will be the total amount which is to be written of as depreciation throughout the useful life of the asset.
(b) Useful Life of the Asset:
The determination of the useful life of an asset is of great importance because it is the useful life over which the whole cost of the asset is to be written off by way of depreciation.
The useful serviceable life is estimated either from depreciation rates published by income tax authorities or from opinions of engineers or experience with similar assets, guess work, etc. However the intensity of use of the asset, wear and tear, obsolescence and maintenance are the main factors which are taken into consideration for estimating the useful life of the asset.
(c) Salvage Value:
Salvage value is the amount that can be recovered from the sale of the asset after the expiry of its useful serviceable life. In those cases where this amount is insignificant, it is ignored altogether but when this amount is quite substantial, the depreciation is calculated on net cost of the asset, i.e. original cost less salvage value.