Management 1(CS-3rd Year)-Module 1

Depreciation - Abhijit Ghose

The term depreciation refers to an accounting method used to allocate the cost of a tangible or physical asset over its useful life
or life expectancy. Depreciation represents how much of an asset's value has been used. Depreciating assets helps companies
earn revenue from an asset while expensing a portion of its cost each year the asset is in use.

It is the process of deducting the total cost of something expensive you bought for your business. But instead of doing it all in
one tax year, you write off parts of it over time. When you depreciate assets, you can plan how much money is written off each
year, giving you more control over your finances.

The number of years over which you depreciate something is determined by its useful life (e.g., a laptop is useful for about five
years). For tax depreciation, different assets are sorted into different classes, and each class has its own useful life. If your
business uses a different method of depreciation for your financial statements, you can decide on the asset’s useful life based on
how long you expect to use the asset in your business.

For example, the IRS might require that a piece of computer equipment be depreciated for five years, but if you know it will be
useless in three years, you can depreciate the equipment over a shorter time.
Asset
An asset is anything with a dollar value. The IRS also refers to assets as “property.” It can be either tangible or intangible.

A tangible asset can be touched—think office building, delivery truck, or computer.

An intangible asset can’t be touched—but it can still be bought or sold. Examples include a patent, copyright, or other intellectual
property.

Both tangible and intangible assets can be depreciated. In the case of intangible assets, the act of depreciation is called
amortization.

Kinds of assets can depreciate

The IRS sets guidelines for what types of assets you can depreciate. It needs to meet the following criteria:

● You own it
● You use it in your business, or to produce income
● You can determine its useful life
● You expect it to last more than one year
Depreciation - Concept
Assets such as machinery and equipment are expensive. Instead of realizing an asset's entire cost in year one, companies can
use depreciation to spread out the cost and generate revenue from it. This is done through depreciation, which allows a
company to write off an asset's value over a period of time, notably its useful life. It may be used to account for declines over
time in the carrying value, which represents the difference between the original cost and the accumulated depreciation of the
years.

Depreciation is taken regularly so a company can move the asset's cost from the balance sheet to the income statement.2

When a company buys an asset, it records the transaction as a debit to increase an asset account on the balance sheet and a
credit to reduce cash (or increase accounts payable), which is also on the balance sheet. Neither journal entry affects the
income statement, where revenues and expenses are reported.

As noted above, businesses can take advantage of depreciation for both tax and accounting purposes. This means they can
take a tax deduction for the cost of the asset, reducing taxable income. But the Internal Revenue Service (IRS) states that
when depreciating assets, companies must spread the cost out over time.
Some common examples of assets depreciated by small businesses include

● Vehicles
● Real estate
● Equipment
● Office furniture
● Computers

Depreciation schedule

A depreciation schedule is a table that shows you how much each of your assets will be depreciated over the years. It typically includes the
following information:

● A description of the asset

Depreciation is viewed as a cost, yet not at all like most costs. There is no money surge related. This is because an organization
has net money outpouring in the whole measure of the advantage when the benefit was initially bought, so there is no further
money-related action.

Lastly, depreciation is not planned to lessen the expense of a fixed resource for its fairly estimated worth. Market worth might be
generously unique and may even increase after some time. Rather depreciation is only planned to charge the expense of a fixed
asset for cost over its valuable life step by step.

Depreciation charge and various other bookkeeping errands make it wasteful for the bookkeeping division to appropriately track
and record fixed assets. They lessen this work by utilizing a capitalization breaking point to confine the number of consumptions
that are named fixed assets. Any consumption to which the expense is equivalent or more than that, and which has a valuable life
traversing more than one bookkeeping period (normally at any rate a year) is delegated to a fixed asset and is then depreciated.
This is the depreciation math definition.
Causes of Depreciation

1 – Due to Wear & Tear during Usage of Asset

It is one of the primary reasons for the depreciation of assets. Most of the assets are worn off or get deteriorated due to the
continuous usage of the asset. Such as Plant & Machinery used for the production of goods, buildings, vehicles, etc. As in
the case of machinery used for production, the continuous usage & running of machinery the working or production
capacity of the machinery diminishes over the period of time & the value of the machinery also decreases in the market. So
for the fair presentation of the financial position of the entity, it is necessary to reduce the proportionate value of the
machinery in the books.

2 – Compliance of Accounting Standards Applicable to Entity

As per the applicability of accounting standards on the entity, the entity needs to follow the provisions mentioned in the
standards. It is done as per the matching concept that needs to be followed on the accounting of the entity. As per the
matching concept, the depreciation is to be charged for the respective as the income through the asset has also been booked
for the period mentioned above in the books of accounts.
3- Technological Advancement of Supplementary Assets in Market

The value of the fixed assets used by the enterprise gradually decreases in the market in case the new
upgraded version of the asset with the better technological advanced features is present in the market,
providing more benefits to the customer in comparison to the old obsolete version of the asset. In such a
case, the requirement of the old asset gradually decreases, so does its recoverable amountin the market.
Hence it is necessary to show the value of the asset at a fair amount or reasonable amount in the financials.

4 – Use of Provided Life of Asset

In some of the cases of fixed assets, the useful life of the assets is provided in consumption units like an asset
‘X’ will run for 10000 hours. Hence the allocation of the cost of the asset is as per the consumption or its
usage in hours.
5 – Amortization of Assets as per License Period or Usage Period

Some of the assets like license, patent, copyrights, leasehold

properties, etc. can only be used for the provided period of time. At the lapse of such time, the asset could not be used.
Hence its cost needs to be allocated or amortized as per the usage period of the assets. At the end of the useful period, assets
should be written off from the books of accounts.

6 – Depreciation Needs to be Done for Wasting Assets as per Extraction of Resources

In case of wasting assets like coalmine, well of oils, etc. are amortized and used as per the extraction of natural resources
done from them during the period. In the case of such types of wasting assets, there are limited resources that an entity can
extract from such assets for the use of the organization. As per the estimated total extraction that will be done from the
wasting asset and amount already extracted, during the respective period will be considered for the depreciation of the asset
during that period.
7 – The Absolute Need for Maintenance of Fixed Assets for Proper Productivity of Asset

The plant & machinery used in the manufacturing of products in a manufacturing company needs regular maintenance over some
time for full-time productivity to be received from the usage of such machinery. Even after a certain period, some essential parts of
the machinery are to be replaced with brand new parts. For such, the depreciation needs to be charged so that the parts that are to be
replaced in the future are appropriately accounted for and written off during the period of its life.

Conclusion

The depreciation and amortization are allowed by the companies act or the statutory laws. It applies to the entity for writing off the
used part or cost of the asset in the statement of profit & loss account of the entity for the period mentioned above as per the
matching principle

in accounting. There are many causes or reasons for doing such treatment. This matching concept provides a fair presentation of the
financials of an entity as the cash inflow generated from the asset has been booked, and the respective usage cost of the asset is also
written off during the same period as per the matching concept in accounting. The income tax laws, as well as statutory laws
(including accounting standards), mandate the treatment and chargeability of depreciation in the books of accounts for the respective
period.
Need For Depreciation:
Depreciation is provided for the assets with a view to achieve the following results:

1. To Ascertain the True Working Result:

Asset is an important tool in earning revenues. Huge amounts are spent for acquisition of assets which are worn out
in the process of earning income. Thus, the assets get depreciated in their value, over a period of time due to many
reasons explained above.

When the value of assets decreases, this loss must be brought into account; otherwise a true working result cannot be
known. Depreciation is an operating expense of a physical asset, the same should be considered in arriving the true
profit earned during each year.

The basic need of depreciation is to ascertain the true income. If depreciation is ignored, the loss that is occurring in
respect of fixed assets will be ignored. So, depreciation should be debited to Profit and Loss Account before profit is
ascertained.
2. To Ascertain True Value of Asset:

The function of the Balance Sheet is to show the true and correct view of the state of affairs of a business. If no depreciation is charged and when assets are
shown at the original cost year after year, Balance Sheet will not disclose the correct state of affairs of a business.

3. To Retain Funds for Replacement:

Assets used in the business need replacement after the expiry of their service. It is always not possible to determine the useful life of assets. But, in certain
cases, machine often becomes, obsolete long before it wears out because of rapid changes in tastes and technology. It is a permanent loss in value of the
asset. When an asset is continuously used, a time will come when the asset is to be given up and hence its replacement is essential.

Therefore, if no depreciation is charged against the profit, during the life time of the asset, it will be very difficult to find cash to replace the asset and if
replaced it may cripple resources. Therefore, it is necessary to make provision and create funds to replace such assets, in proper time.
4. To Reduce Tax Liability:

Depreciation is a tax deductible expense. As such, it is permitted by the prevailing taxation laws to be deducted from profit.
Consequently, the owner of a business may avail himself of this benefit by charging depreciation to his profit and reducing his
tax liability.

5. To Present True Position:

Financial position can be studied from the Balance Sheet and for the preparation of the Balance Sheet fixed assets are required
to be shown at their true value. If assets are shown in the Balance Sheet without any charge made for their use, (that is,
depreciation) then their value must have been overstated in the Balance Sheet and will not reflect the true financial position of
the business.

Therefore, for the purpose of reflecting true financial position, it is necessary that depreciation must be deducted from the asset
and then at such reduced value may be shown in the Balance Sheet.
Consequences of Not Providing for Depreciation:

If depreciation is not accounted for, the profit of the company is overstated, in turn; it is distributed among the shareholders. Thus there
is no provision for replacement of machine. It must be pointed out that depreciation by itself does not create funds; it merely draws
attention to the fact that out of gross revenue receipts a certain amount should be retained to replace the asset used for carrying on
activities. The Companies Act of 1956 now makes it compulsory to write off depreciation on fixed assets before declaring dividend.
Depletion
Depletion refers to an accrual accounting method used to determine the expense of extracting natural resources from the earth,
such as wood, minerals, and oil.

Just like depreciation and amortisation, depletion is a non-cash expense. It incrementally lowers an asset's cost value through
scheduled income charges. Where depletion differs, it refers to the gradual degradation of natural resources reserves, as opposed to
wearing depreciable assets or ageing intangible lives.

How does Depletion Works

Depletion for accounting and financial reporting purposes is meant to assist in accurately identifying the value of the assets on the
balance sheet and recording expenses in the appropriate time period on the income statement.

When the costs associated with natural resource extraction have been capitalized, the expenses are systematically allocated across
different time periods based upon the resources extracted. The costs are held on the balance sheet until expense recognition occurs.

To calculate what expenses need to be spread out for the use of natural resources, each different phase of production must be taken
into consideration. The depletion base is the capitalized costs depleted across multiple accounting periods.
There are four main factors that affect the depletion base:

● Acquisition: Costs associated with purchasing or leasing the property rights to land that the company believes has natural resources.
● Exploration: Expenses linked to digging under the land that was leased or bought.
● Development: The costs necessary to prepare the land for natural resource extraction, such as tunneling or developing wells.
● Restoration: Expenses associated with restoring the land to its original condition after completion.

Depletion- Method
1. Percentage Depletion Method One way of estimating the cost of depletion is the way of depletion by percentage. It assigns a fixed amount
to the gross income to distribute expenses—revenues minus costs.

For example, if Rs 10,00,000 worth of oil is extracted, and the fixed percentage is 20 per cent, Rs 2,00,000 is lost from capitalised costs to
extract the natural resource. The percentage depletion approach needs multiple calculations and is thus not a form of depletion that is highly
dependent upon or embraced.

2. Cost Depletion Method The cost-depletion method is the second approach to measuring depletion. Price depletion is measured, taking into
account the base of the land, gross recoverable reserves, and the number of units sold. The basis of the property is distributed among the total
number of units which can be recovered. These are counted and taken out of the base of the property when natural resources are removed.

The capitalised Rs 10,00,000 expense, hypothetically, for example, yields 5,000 barrels of oil. If 1,000 barrels of oil are extracted in the first
year, the extraction cost for the year is Rs 2,00,000, i.e 1,000 barrels x (Rs 10,00,000/5,000 barrels).
Thank You