DEPRECIATION ACCOUNTING AND POLICY

MEANING OF DEPRECIATION
Generally, the term depreciation is used to denote decrease in value but in
accounting, this term is used to denote decrease in the book value of fixed asset.
Depreciation is the permanent and continuous decrease in the book value of a fixed
asset due to use, affluxion of time, obsolescence, expiration of legal rights or any
other cause. According to the Institute of Chartered Accountants of England and
Wales, “Depreciation represents that part of the cost of a fixed asset to its owner
which is not recoverable when the asset is finally 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 on the amount of profit
earned”.
Depreciation is not the result of fluctuations in the value of fixed assets since, the
fluctuation is concerned with the market price of the fixed asset whereas the
depreciation is concerned with the historical cost.
An analysis of the definition given above highlights the characteristics of depreciation as
follows :
(a) It is related to fixed assets only.
(b) It is a fall in the book value of an asset.
(c) The fall in the book value of an asset is due to the use of the asset in business
operations, effluxion of time, obsolescence, expiration of legal rights or any other cause.
(d) It is a permanent decrease in the book value of an asset.
(e) It is a continuous decrease in the book value of an asset.

Depreciation, Depletion and Amortisation

The terms depreciation, depletion and amortisation are used often interchangeably.
However, these different terms have been developed in accounting usage for
describing this process for different types of assets. These terms have been
described as follows:
Depreciation
Depreciation is concerned with charging the cost of man made fixed assets to
operation (and not with determination of asset value for the balance sheet). In other
words, the term 'depreciation' is used when expired utility of physical asset (building,
machinery, or equipment) is to be recorded.
Depletion
This term is applied to the process of removing an available but irreplaceable
resource such as extracting coal from a coal miner or oil out of an oil well.
Depletion differs from depreciation in that the former implies removal of a natural
resource, while the latter implies a reduction in the service capacity of an asset.
Amortisation
The process of writing off intangible assets is termed as amortisation. The intangible
assets like patents, copyrights, leaseholds and goodwill are recorded at cost in the
books of account, Many of these assets have a limited useful life and are, therefore,
written off.
Obsolescence
It refers to the decline in the useful life of an asset because of factors like (i)
technological advancements, (ii) changes in the market demand of the product, (iii)
legal or other restrictions, or (iv) improvement in production process.
Meaning of Depreciation Accounting
According to the American Institute of Certified Public Accountants (AICPA),
“Depreciation Accounting is a system of accounting which aims to distribute cost or
the basic value of tangible capital assets less salvage (if any), over the estimated useful
life of the unit (which may be group of assets) in a systematic and rational manner. It is
a process of allocation and not of valuation.

CAUSES OF DEPRECIATION
The main causes of depreciation include the following :
(a) Physical wear and tear : When the fixed assets are put to use, the value of
such assets may decrease. Such decrease in the value of assets is said to be due to
physical wear and tear.
(b) With the passage of time : When the assets are exposed to the forces of nature
like whether, winds, rains, etc., the value of such assets may decrease even if they are
not put to any use.
(c) Changes in economic environment : The value of an asset may decrease due
to decrease in the demand of the asset. The demand of the asset may decrease due to
technological changes, changes in the habits of consumers etc.
(d) Expiration of legal rights : When the use of an asset (e.g., patents, leases) is
governed by the time bound arrangement, the value of such assets may decrease with
the passage of time.
NEED FOR PROVIDING DEPRECIATION
The need for providing depreciation in accounting records arises due to any one or
more of the following objectives to be achieved :
(a) To ascertain true results of operations : For proper matching of costs with
revenues, it is necessary to charge the depreciation (cost) against income (revenue) in
each accounting period. Unless the depreciation is charged against income, the result
of operations would stand overstated. As a result the Income Statement would fail to
present a true and fair view of the result of operations of an accounting entity.
(b) To present true and fair view of the financial position : For presenting a
true and fair view of the financial position, it is necessary to charge the depreciation. If
the depreciation is not charged, the unexpired cost of the asset concerned would be
overstated. As a result, the Position Statement (i.e. the Balance Sheet) would not present
a true and fair view of the financial position of an accounting entity.
(c) To ascertain the true cost of production : For ascertaining the cost of
production, it is necessary to charge depreciation as an item of cost of production. If
the depreciation on fixed assets is not charged, the cost records, would not present a
true and fair view of the cost of production.
(d) To comply with legal requirements: In case of companies, it is compulsory
to charge depreciation on fixed assets before it declares dividend [Sec. 205(1) of the
Companies Act, 1956].
(e) To accumulate funds for replacement of assets : A portion of profits is set
aside in the form of depreciation and accumulated each year to provide a definite amount
at a certain future date for the specific purpose of replacement of the asset at the end
of its useful life.
7.4 BASIC ELEMENTS OF DEPRECIATION
In order to assess depreciation amount to be charged in respect of an asset in an
accounting period the following three important factors should be considered :
1. Cost of the asset : The knowledge about the cost of the asset is very essential
for determining the amount of depreciation to be charged to the profit and
loss account. The cost of the asset includes the invoice price of the asset
less any trade discount plus all costs essential to make the asset usable.
Cost of transportation and transit insurance are included in acquisition cost.
However, the financial charges such as interest on money borrowed for the
purchase for the purchase of the asset, should no be included in the cost of
the asset.
2. Estimated life of the asset : Estimated life generally means that for how
many years or hours an asset could be used in business with ordinary repairs
for generating revenues. For estimating useful life of an asset one must begin
with the consideration of its physical life and the modifications, if any, made,
factors of obsolescence and experience with similar assets. Infact, the
economic life of an asset is shorter than its physical life. The physical life
is based mostly on internal policies such as intensity of use, repairs,
maintenance and replacements. The economic life, on the other hand, is based
mostly on external factors such as obsolescence from technological changes.
3. Scrap. Value of the Asset : The salvage value of the asset is that value which
is estimated to be realised on account of the sale of the asset at the end of
its useful life. This value should be calculated after deducting the disposal
costs from the sale value of the asset. If the scrap value is considered as
insignificant, it is normally regarded as nil
7.5 METHODS OF CALCULATING DEPRECIATION
The following are various methods of allocating depreciation in use :
1. Fixed instalment method or straight line method.
2. Machine hour rate method.
3. Diminishing Balance method.
4. Sum of years digits method
5. Annuity method
6. Depreciation Fund Method
7. Insurance Policy Method
8. Depletion Method.
1. Straight Line Method : This is also known as fixed instalment method.
Under this method the depreciation is charged on the uniform basis year
after year. When the amount of depreciation charged yearly under this method
is plotted on a graph paper, we shall get a straight line. Thus, the straight line
method assumes that depreciations is a function, of time rather than use in
the sense that each accounting period received the same benefit from using
the asset as every other period. The formula for calculating depreciation
charge for each accounting period is :
amount of annual Depreciation = original cost –scrap vale/estimated life.

For example, if an asset cost Rs. 50,000 and it will have a residual value of Rs.
2000 at the end of its useful life of 10 years, the amount of annual depreciation
will be Rs. 4800 and it will be calculated as follow :

This method has many shortcomings. First, it does not take into consideration the
seasonal fluctuations, booms and depression. The amount of depreciation is the
same in that year in which the machine is used day and night to that in the another
year in which it is used for some months. Second, it ignores the interest on the
money spent on the acquisition of that asset. Third, the total charge for use of asset
(i.e., depreciation and repairs) goes on increasing form year to year though the
assets might have been use uniformly from year to year. For example, repairs cost
together with depreciation charge in the beginning years is much less than what it
is in the later year. Thus, each subsequent year is burdened with grater charge for
the use of asset on account of increasing cost on repairs.

3. Written Down Value Method : This is also known as Diminishing Balance

method. Under the diminishing balance method depreciation is charged at fixed
rate on the reducing balance (i.e., cost less depreciation) every year. Thus, the
amount of depreciation goes on decreasing every year. Under this method also the
amount of depreciation is transferred to profit and loss account in each of the year
and in the balance sheet the asset is shown at book value after reducing depreciation
from it. For example, if an asset is purchased for Rs. 10,000 and depreciation is to
be charged at 20% p.a. on reducing balance system then the depreciation for the
first year will be Rs. 2000. In the second year, it will Rs. 1600 (i.e. 20% of 8000),
in the third year Rs. 1280 (i.e. 20% of 6400) and so on. The rate of depreciation
under this method can be computed by using the following formula :
Depreciation rate = -1
For example, if the cost of an asset is 27000, scrap value Rs. 3375, economic life
3 year, the rate of depreciation would be :
Depreciation Rate = 1-3
= 1 - = 50%

Merits of Diminishing Balance Method : (i) It is very easy to understand and

calculate the amount of depreciation despite the early variation in the book value
after depreciation (ii) This method put an equal burden for use of the asset on each
subsequent year since the amount of depreciation goes on decreasing for each
subsequent year while the charge for repairs goes on increasing for each subsequent
year. (iii) This method has also been approved by the income tax act applicable in
India (iv) Asset is never reduced to zero because if the rate of depreciation is (say)
20%. Then even when asset is reduced to very small value, there must remain the
80% of that small value as on written off balance.
Demerit : (i) It ignores the interest on the capital committed to purchase that
asset. (ii) It does not provide adequately for replacing the asset at the end of its
life. (iii) The calculation of rate of depreciation is not so simple. (iv) The formula
for calculating the rate of depreciation can be applied only when there is some
residual of the asset.
Suitability : This method is suitable in those cases where the receipts are expected
to decline as the asset gets older and, it is believed that the allocation of depreciation
of depreciation ought to be related to the pattern of assets expected receipts