In this article we will discuss about:- 1. Meaning of Providing Depreciation 2. Methods of Providing Depreciation 3. Importance of Sound Depreciation Policy 4. Distinction between Depreciation and Obsolescence.
Meaning of Providing Depreciation:
CIMA defines Depreciation as “the measure of wearing out, consumption or other loss of value of a fixed asset whether arising from use, effluxion of time or obsolescence through technology and market changed”.
Depreciation is provided in Cost Accounts before working out the profitability of a job or cost unit. Depreciation is a gradual diminution, loss, or shrinkage in the utility of value of an asset due to wear and tear in use, effluxion of time or obsolescence. Depreciation is the allocation of the depreciable amount of an asset over its estimated useful life.
The cost of a product consists of not only normal expenses like direct material, direct labour, factory cost etc., which involve in cash outgo but also non-cash costs like depreciation which does not involve in cash outgo. Depreciation does not mean money set aside for the future replacement of assets. It is provided to match the use of asset, its deterioration and obsolescence with the income it generates.
Depreciation and Cash-Flow:
Depreciation is neither a source nor use of funds. The use of funds obviously began when the fixed asset was purchased. It would be double counting to regard each year’s depreciation as a further use of funds. The relevant figure for profit from operation is profit before charging depreciation. The quantum of operational funds flow cannot be influenced by the method of depreciation charged.
Depreciation and Inflation:
Depreciation should be provided irrespective of the increase in value of asset due to inflation. It is not appropriate to omit charging depreciation of a fixed asset on the grounds that its market value is greater than its net book value. If account is taken of such increased value by writing up the net book value of a fixed asset, then, an increased charge for depreciation will become necessary.
Methods of Providing Depreciation:
The principal methods of providing depreciation are as follows:
i. Straight Line Method:
Under this method an equal periodic charge for depreciation is made over the estimated economic life of the machine. In this method, a percentage of the original cost of the asset concerned less the residual value, if any, is written off every year till the end of its estimated life.
ii. Diminishing Balance Method:
Under this method a fixed percentage is written off every year on a diminished book value of the asset till the asset is reduced to its scrap value. This method is also called ‘written down value method’ and ‘reducing balance method’.
iii. Production Unit Method:
Under this method, an estimate is made of expected number of units that can be produced over the economic life of the machine. The depreciation per unit is arrived at by dividing the cost of asset with number of units it is expected to produce during its useful life.
iv. Machine Hour Rate Method:
Under this method depreciation charge is calculated by dividing net cost of asset with the estimated production hours over its economic life.
v. Revaluation Method:
Under this method the asset is revalued at the end of each accounting period and depreciation is the difference between the value of the asset at the beginning and the end of the accounting period. This method is used in loose tools, furniture of service industry etc.
vi. Replacement Cost Method:
The current replacement price is based on the price for which assets might be sold. This valuation assumes continuation of the ordinary course of business and is not based on forced or distressed sale prices. Under this method the depreciation is taken as the difference between the current replacement cost at the beginning and the end of the accounting period.
vii. Repair Provision Method:
Under this method, an aggregate of depreciation and maintenance cost is provided by means of periodic charges, each of which is a constant proportion of the aggregate of the cost of the asset depreciated and the expected maintenance cost during its life.
viii. Sinking Fund Method:
Under this method, an amount equal to the depreciation is invested outside in securities for replacement of the machinery.
ix. Endowment Policy Method:
Under this method, endowment insurance policy is taken on the life of the asset, so that at the end of a definite period, the insurance company will pay the assured sum with the help of which the asset can be repurchased.
x. Modified Accelerated Cost Recovery Method:
Under this system each kind of equipment is classified by its useful life and there is no consideration of salvage value under this method. The percentage of the value as stipulated by the Government is to be taken as depreciation each year.
For detailed study on methods of depreciation, the students are suggested to refer to books on ‘Financial Accounting’ subject.
Importance of Sound Depreciation Policy:
The sound depreciation policy is to be adopted for the following reasons:
(a) The original investment of the asset should be fully recovered into the product cost during the economic life of the asset.
(b) Depreciation acts as a tax shield, since these charges against income do not affect the net inflow of funds and hence, proper planning in depreciation charges is necessary to reduce the tax burden on the organization.
(c) Failure to recognize depreciation causes overstatement of income with an attendant possible distribution of capital through dividends. The adoption of sound depreciation will prevent the ‘impairment of capital’ through dividends based upon overstated earning.
(d) The method adopted to recover depreciation should be able to generate sufficient funds for replacement of the machinery at the end of its economic life.
(e) The depreciation charged should be absorbed into product cost on equitable basis.
(f) By providing adequate depreciation, the financial position of the company is correctly shown in the balance sheet.
(g) Depreciation should be a process of allocation of cost and it should not be a process of constantly valuing or revaluing fixed assets according to what they are currently ‘worth’.
(h) The ideal matching of expired cost against the related revenue and proper measurement of depreciable asset at each accounting date will ensure the uniform rate of return and the depreciation is equitably spread over the useful life of fixed asset.
(i) The cost of fixed asset is a long-term prepaid expense which by some equitable method must be proportionately charged over its useful life as an expense to be matched against revenue during each period.
Distinction between Depreciation and Obsolescence:
The distinguishing features of Depreciation and Obsolescence are given below:
1. It is the reduction in value of asset due to use or effluxion of time.
2. It is recovered by adopting suitable method of charging depreciation and is absorbed into product cost on some equitable basis.
3. It is provided on periodical basis.
4. The quantum of depreciation can be determined by adopting a suitable method.
5. Depreciation provision is made by a rate of depreciation.
1. It arises due to sudden loss in value of asset not due to wear and tear. It may be due to technological advancement, discarding of machine for better machine, changes in market conditions for the product etc.
2. All the amount of asset value is considered loss and it cannot be absorbed into product cost.
3. It may occur once in the life-time of an asset.
4. It is difficult to provide in advance.
5. Obsolescence reserve is created or written off as loss in full or on deferred basis.