DEPRECIATION

What is Depreciation

Depreciation is the permanent and continuous decrease in the book value
of a fixed asset due to use, effluxion of time, obsolescence, expiration of
legal rights etc. Depreciation represents that part of the cost of a fixed
asset which is not recoverable when the asset is finally out of use.

Causes of Depreciation:

1. 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.
2. Passage of time: When the fixed assets are exposed to the forces of
nature like, weather, rains, winds etc. the value of such assets may
decrease.



3. Changes in Economic Environment: The value of fixed assets may
decrease due to decrease in the demand of such assets. The demand of
the assets may decrease due to technological changes, changes in the
habits of customers etc.
4. Expiration of Legal Rights: When the use of an asset (e.g. Patents,
Leasehold properties etc.) is governed by the time bound
arrangement, the value of such asset may decrease with passage of
time.

Importance for providing Depreciation in Accounting
records

1. To ascertain true results of business operation;
2. To present true and fair view of the financial position;
3. To ascertain the true cost of production;
4. To accumulate funds for replacement of fixed assets;
Factors determining the Amount of Depreciation

1. Historical Cost: It implies the cost incurred on acquisition,
additions and improvement of the fixed assets which are
capital nature. (e.g. Purchase Price of the fixed asset, Shipping
and forwarding charges, import duty, carriage inwards,
repairs charges, installation charges, brokerage & commission
of the middleman etc.)

2. Expected useful life: It implies the period over which a
depreciable fixed asset is expected to be used by the enterprise.

3. Estimated Residual Value: It implies the value expected to be
realiased from the sale or exchange of a depreciable fixed asset
on the expiry of its useful life.
Methods of Allocating Depreciation

A. Straight Line Method (SLM) / Fixed Installment Method (FIM)

Under this method a fixed and equal amount of depreciation (i.e. a fixed
percentage on original cost) of a fixed asset is written off during each
accounting period over the expected useful life of the asset.

Original Cost Estimated Scrap Value
i. Amount of Depreciation =
Expected useful life of the asset


Amount of Depreciation
ii. Rate of Depreciation = X 100
Original Cost

Merits:

1. It is easy to understand;
2. It is easy to calculate the amount and rate of depreciation;
3. Under this method, the book value of fixed asset either becomes
zero or equal to its scrap value at the expiry of its useful life;

Demerits:

1. It does not take into consideration the interest on capital
invested in the fixed asset;
2. It does not provide for the replacement of the fixed asset on the
expiry of its useful life;
Diminishing Balance Method (DBM) / Reducing Balance
Method (RBM)/ Written Down Value Method (WDVM):

Under this method amount of depreciation is calculated at a fixed
percentage on the original cost of a fixed asset (for only first year) and
on written down value (from subsequent years), is written off during
each accounting period over the expected useful life of the fixed asset.
The Rate of Depreciation (R in %) is calculated as under:

n S
R = { 1 - C } X 100

n = Useful life of the fixed asset (in years), S = Scrap Value at the end
of useful life of the fixed asset, C = Original Cost of the fixed asset.




Merits:

This method is logical in the sense that as the fixed asset grows older,
the amount of depreciation also goes on decreasing.

Demerits:

1. It is difficult to calculate the rate of depreciation;
2. It does not take into consideration the interest on capital
invested in the fixed assets;
3. It does not provide for the replacement of the fixed assets on the
expiry of its useful life.
Distinction between Straight Line Method (SLM) and
Diminishing Balance Method (DBM) of allocating
Depreciation
SLM DBM
1. Depreciation is calculated at a 1. Depreciation is calculated at a
fixed percentage on the original fixed percentage on the original
Cost of a fixed asset. cost of a fixed asset (for first year)
and on book value (from subsequent
years).
2. The rate and amount of
Depreciation remain constant. 2. The amount of Depreciation goes
on decreasing, but rate of
3. The book value of the asset depreciation remain constant.
becomes zero or equal to its scrap 3. The book value of the asset does
value at the end of its useful life. not become zero.

Accounting for Depreciation under
both Methods
Accounting for Change in Method of
Depreciation
Without Retrospective effect

With Retrospective effect

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