Depreciation: Meaning, Reasons and Rate | Cost Accounting

In this article we will discuss about Depreciation of Assets:- 1. Meaning of Depreciation 2. Factors for Rate of Depreciation of Plant and Machinery 3. Reasons 4. Rates 5. Life Expired Assets 6. Replacement Value of Assets.

Contents:

  1. Meaning of Depreciation
  2. Factors for Rate of Depreciation of Plant and Machinery
  3. Reasons for Charging Depreciation
  4. Rates of Depreciation
  5. Depreciation of Life Expired Assets
  6. Depreciation on Replacement Value of Assets



1. Meaning of Depreciation:

Depreciation is the diminution in the value of a fixed asset says a machine due to use and lapse of time. A fixed asset has a span of life during which it renders service for production purposes and on the expiry of which, the asset has either no value or has only small scrap value.

The life of an asset is enhanced by efficient maintenance and reduced by its extensive use. Throughout its life, the machine has been gradually diminishing the value to reach the scrap value at the expiry of its life. The gradual reduction in the value is called depreciation.

Depreciation, thus, is the result of two factors viz., usage and lapse of time. An asset continues to depreciate with the passage of time even if it is not in active service, though the rate of depreciation may be lower.

The more the use to which an asset is put, the larger will be the depreciation. If an asset works on two or more shifts, the depreciation may be doubled or trebled. The methods of depreciation take either the usage or time factor or both into consideration while calculating depreciation.



2. Factors for Rate of Depreciation of Plant and Machinery:

Following are the factors to be considered while considering the rate of depreciation of plant and machinery:

(i) Time factor

(ii) Usage factor

(iii) Element of maintenance

(iv) Element of interest. This is based on opportunity cost i.e., if not invested in machines, the amount would have earned revenue if employed elsewhere. Thus, element of maintenance is one of the factors to be considered.

The method of depreciation should provide a uniform charge each period for aggregate depreciation and maintenance cost. The problem of heavy expenses on maintenance in one year and less in another year is avoided under repairs reserve method.



3. Reasons for Charging Depreciation:

The various reasons for including the depreciation charge in cost accounts are:

(i) To ascertain the true and comparable cost of production.

(ii) To show a true and fair picture in the Balance Sheet.

(iii) To keep the asset intact by distributing the loss in its value over a number of years.

(iv) To keep the capital intact and to make a provision for the replacement of the asset in future.

(v) To provide for depreciation before distribution of profit as required under the Companies Act.

(vi) To provide depreciation in those concerns where selling price is directly related to cost e.g., in case of cost plus contracts.

The amount of depreciation for a period and relating to a department is specifically allocated and booked to the standing order numbers. Separate standing order with suitable sub-numbers may be used to indicate the section number where the asset is located and to book depreciation for various types of assets like plant and machinery, building etc.

Depreciation should be estimated in advance if it is charged on the basis of predetermined overhead rates.

Generally, depreciation can be directly allocated to various departments or cost centres but where it is not possible it may be apportioned on the basis of value, floor space, or cubic capacity of the building in each department in case of building and on the basis of written down value of the assets in each cost centre in case of plant and machinery.

Time factor or usage factor, or both factors or inclusion of maintenance cost or an element of interest are the general principles which are taken into consideration while calculating depreciation for the purpose of charge to costs. Nature of the asset and the use to which it is put to in a particular concern will determine the method to be selected for depreciation of an asset.



4. Rates of Depreciation:

Depending upon the requirements of a concern, the rates of depreciation may be worked as:

(а) Single Rate:

This is the depreciation rata which is calculated by reference to the estimated life of a single asset. Hence the total charge of depreciation is composed of the aggregate of the charges of the individual assets.

The system is simple to calculate and usefully employed where it is necessary to charge the cost of an asset to the products or services which it alone produces. But this system becomes unwieldy owing to maintenance of a large number of records in respect of each asset.

(b) Composite Rate:

This is the depreciation rate which is calculated by dividing the aggregate of the individual depreciation charges (however calculated) in any one period of all assets concerned, by the aggregate of the costs of those assets.

This rate is used when processes are continuous or when the assets concerned are engaged on the same job or product or service. Sometimes a group rate is calculated for those assets which form the group of identical types having similar physical characteristics.

(c) Accelerated Rate:

This is the depreciation rate which consists of normal depreciation rate augmented to provide for additional depreciation sustained by asset depreciated.

When an asset normally working on single shift is worked for double shift, the asset depreciates much more and, therefore, extra depreciation must be provided for the additional usage. The Income Tax also provides for accelerated rate of depreciation in case of double shifts or triple shifts.

(d) Retarded Rate:

This rate may consist of usual depreciation rate reduced to cater for less depreciation due to reduced usage of the asset depreciated. For example, some concerns may calculate depreciation for idle machines at 2/3rd of the normal rate.

(c) and (d) both are based on activity factor.



5. Depreciation of Life Expired Assets:

Sometimes an asset is capable of rendering effective service even after the expiry of its normal life and its entire cost has been recovered and the cash value of such asset is nil.

This may be due to overcharging of depreciation due to adoption of a higher rate, incorrect assessment of the working life of the asset, efficient maintenance leading to increased life of the asset and continued use of the asset due to difficulties in its replacement.

As the asset (say machine) is rendering service in production, depreciation should be charged to cost of production to utilise its services and to have comparable cost data for comparison with its cost of the earlier period.

Secondly, working life of the asset should be assessed on technical considerations. The asset should be revalued and debited to Asset Account by giving corresponding credit to Profit and Loss Account if the value is large, it can be credited alternatively to a Capital Reserve Account.

The depreciation charge should be calculated on its new value and debited to current cost of production by giving a credit to Profit and Loss Account.

The additional depreciation charge will create an additional fund and can be utilised to meet the increased cost of replacement of the asset, if necessity for this arises. In Cost Ledger Accounting System, the amount of such depreciation is credited to Costing Profit and Loss Account.



6. Depreciation on Replacement Value of Assets:

In all the methods of depreciation so far discussed, depreciation has been provided on historical cost or cost of acquisition basis. Though the objective of apportioning the total cost of the asset over its useful life is achieved but in times of rising prices the objective of retaining funds for the replacement of the asset at the end of its working life cannot be achieved.

For example, a machine costing Rs.70,000 is depreciated on historical cost basis.

At the end of its working life Rs.70,000 will be available for replacement of the machine through depreciation charge to profit and loss account but it would be impossible to replace the machine if due to rise in prices its cost has increased from Rs.70,000 to Rs.1,50,000.

Some accountants have, therefore, suggested that depreciation should be charged to profit and loss account on the replacement cost rather than on historical cost basis as it will provide sufficient funds to replace the machine at the end of its working life and will not create any financial problem in the concern for its replacement.


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