2016-01-05 00:00:00Accounting & TaxesEnglishDepreciation is decline in value of fixed asset apportioned over the useful life of the asset. This article explains what is depreciation &...https://quickbooks.intuit.com/in/resources/in_qrc/uploads/2017/05/Accounting-Taxes-Accounting-for-Depreciation.pnghttps://quickbooks.intuit.com/in/resources/accounting-taxes/what-is-depreciation/Accounting for Depreciation | QuickBooks

Basic Accounting Term: What is Depreciation?

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The principles of accounting are developed to bring uniformity and consistency in accounting information. These principles act as guidelines that help in preparing financial statements. Now, one of the important principles that help in recording transactions is the Matching Principle of Accounting.

This principle emphasizes that the revenues of a given accounting period must match with the expenses of the same period. However, there are certain costs  whose benefit extends to more than one accounting period. Hence, it is not justified that the entire cost is charged as an expense in the same accounting period in which it is incurred.

For instance, the cost incurred in purchasing any fixed asset like plant and machinery. This cost cannot be charged as an expense in the accounting period in which it is purchased. In fact, such costs are spread over a number of periods. These periods refer to the span of tome over which the asset provides benefit to the business.

Now, the cost thus spread over a number of periods refers to depreciation. Depreciation is the decline in the value of a fixed asset apportioned over the useful life of the asset. Thus, it is an expired expense charged against the revenue of a given accounting period. So, let’s understand what is depreciation and how is it calculated to determine the correct profit or loss of a business.

What is Depreciation?

Depreciation refers to a decrease in the value of a fixed asset due to its use, obsolescence or passage of time. According to Accounting Standard 6,

Depreciation is a measure of wearing out, consumption or other loss of value of a depreciable asset.

Further, the decline in the depreciable asset’s value arises from its (i) use, (ii) expiration of time, (iii) obsolescence through technology and (iv) market changes. Thus, the depreciable amount is apportioned so as to charge a fair part of cost in each accounting period. This is done over the expected useful life of the asset.

In addition to this, depreciation comprises of amortization of assets whose useful life is known. Thus, depreciation as an expense helps in capturing the financial position and operational results of an Enterprise. However, it is important to note that depreciation is charged on depreciable assets. That is assets which:

  • are used for more than one accounting period
  • have a limited useful life
  • are owned by an Enterprise to either produce goods and services, lease out or use such assets for administrative purposes. However, such assets do not include the ones that are held for the purpose of sale in the normal course of business.

Examples include assets such as machines, plants, buildings, furniture, computers, trucks, equipments etc.

Points To Remember

Therefore, while calculating depreciation, you need to consider the following two points:

  • Depreciation is appropriation of depreciable amount. The depreciable amount is nothing but the historical cost less the estimated salvage value of an asset.
  • Depreciable amount is apportioned over the expected useful life of an asset. The expected useful life of an asset means either:
    • The period over which a depreciable asset is expected to be utilized by a business or
    • The number of units of production expected to be generated from the use of such asset by the business.

Characteristics of Depreciation

Following are the features of depreciation keeping the above definition in the backdrop:

  • It is the decline in the book value of the fixed asset.
  • The decline in the value of the depreciable asset is due to usage, expiration of time or obsolescence.
  • Gradual decline in the value of fixed asset is a continuous process.
  • Depreciation is a non – cash expense that does not involve any cash outflow. It involves just the process of writing down capital expenditure that has already been incurred.
  • Such an expense is deducted before charging tax as it is an expired cost.

Depreciation Example

Say for instance, Kapoor Pvt Ltd. purchased a machinery worth Rs. 1,00,000 on March 31st, 2018. However, in 2018, due to innovation in technology, a new variant of the same machinery comes into the market. As a consequence, the machinery purchased Kapoor Pvt. Ltd. becomes outdated. Such a technological innovation causes the value of the old machinery to decline. Say, the profit before depreciation and tax for Kapoor Pvt. Ltd for the year ended December 2018 is Rs.50,000. And depreciation for the same accounting period is Rs. 10,000. Hence, depreciation would be shown as under:

Profit before depreciation and tax Rs. 50,000
(-) Depreciation Rs. 10,000
Profit Before Tax Rs. 40,000

Depreciation, Depletion and Amortization

Now, terms like amortization and depletion are also used when we talk about the concept of depreciation. This is because both amortization and depletion have the same accounting treatment as depreciation. All these items represent the end of the usefulness of varied assets.

Depletion

The term depletion is used in context of the natural resources. Natural resources such as petroleum and natural gas in the ground are reported as a separate category of assets. Such assets once taken out of ground become inventory. Therefore, depletion is the process of extracting natural resources that results in diminishing the quantity of such a resource or asset.

Example

Say for instance, ABC Exploration Pvt Ltd is into mining business. It purchases a coal mine worth Rs. 10 crores. As the company extracts coal out of the mine, the value of coal mine declines. Such a decline in the value of the coal mine is termed as depletion. Now, how is depletion different from depreciation in such a case. The term Depletion refers to the exhaustion of an economic resource. Whereas, the term depreciation is concerned with the utilization of an asset. Despite this difference, the result in both cases is similar. Thus depletion and depreciation have the same accounting treatment.

Amortization

The term amortization is used in context of intangible assets. It means writing down of the cost of intangible assets that have utility for a specific period of time. Intangible assets are the ones that do not have any physical substance. Such assets include patents, copyrights, trademarks, franchises etc. The process to write down a part of the cost of intangible assets is the same as the depreciation of fixed assets.

Example

Say for instance, Kapoor Pvt Ltd purchases a patent worth Rs. 20 crores and determines its useful life to be 10 years. In this case, the company needs to write off Rs. 20 crores over 10 years. Thus the amount so written off is termed as amortization.

Determinants of Depreciation

Following are the three determinants of depreciation:

Cost of the Asset

The cost of an asset comprises of the purchase price and other costs incurred to put the asset into working condition. Such costs include freight and transportation, installation cost, commission, insurance etc.

Salvage Value

Salvage value is an estimated net realizable value of an asset at the end of its useful life. It is also known as net residual value or scrap value. Such a value is the difference between the sale price and the expenses necessary to dispose an asset.

Estimated Useful Life

The commercial or economic life of an asset is termed as the useful life of an asset. Now, an assets’s physical life is not considered for estimating the useful life of an asset. This is because an asset might be in a good physical condition after few years. But it may not be used for production purposes.

Different Types of Depreciation Methods

The commercial or economic life of an asset is termed as the useful life of an asset. Now, an assets’s physical life is not considered for estimating the useful life of an asset. This is because an asset might be in a good physical condition after few years. But it may not be used for production purposes.

The amount of depreciation to be charged for a given accounting period depends upon depreciable amount and the method of depreciation. In India, following two methods of depreciation are practiced:

  • Straight Line Method
  • Written Down Value Method

Beside the above two there are other methods of calculating depreciation as well. These methods include annuity method, depreciation fund method, insurance policy method, sum of years digit method, double declining method etc.

Information may be abridged and therefore incomplete. This document/information does not constitute, and should not be considered a substitute for, legal or financial advice. Each financial situation is different, the advice provided is intended to be general. Please contact your financial or legal advisors for information specific to your situation.

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