What is Depreciation?

What is Depreciation?

Depreciation
Introduction
Fixed assets are the assets which are used in business for more than one accounting year. Fixed assets (technically referred to as "depreciable assets") tend to reduce value once they are put to use. In other words, if a business enterprise procures a machine and uses it in production process then the value of machine declines with its usage. Even if the machine is not used in production process, we cannot expect it to realize the same sales price due to the passage of time or arrival of a new model (obsolescence). It implies that fixed assets are subject to decline in value and this decline is technically referred to as depreciation.

Meaning and definitions
In general words, depreciation is the reduction in the value of an asset due to usage, passage of time, wears and tea, technological outdating or obsolescence, depletion, inadequacy, decay or other such factors.

In accounting, depreciation is a term to describe any method of attributing the historical or purchase cost of an asset across its useful life. Roughly corresponding to normal wear and tear. It is mostly used when dealing with assets of a short, fixed service life, and which is an example of applying the matching principle as per generally accepted accounting principles.

Depreciation is calculated on all depreciation assets which can be defined as those which have a useful life for more than one accounting period but is limited and are held by an enterprise for use in the production or supply of goods and service. Examples of depreciable assets are machine, plants furniture, building, computers, trucks, vans, equipments, etc. mover, depreciation is the allocation of depreciable amount'. Which is the "historical cost", or other amount substituted for historical cost less estimated salvage value.

The American institute of certified public accountants defines depreciation as "depreciation for the year is the portion of the total charge under such a system that is allocated to the year."

According to institute of cost and management accounting, London (ICMA) terminology, "the depreciation is the diminution in intrinsic value of the asset due to use and/or lapse of time."

Depreciation has a significant effect in determining and presenting the financial position and result of operations of an enterprise. Depreciation is changed in each accounting period by referred to the extra of the depreciable amount.
In this way, depreciation is an allocation of the cost of assets over their useful life. A systematic procedure for allocating the cost over the period of its useful life in a rational manner is called depreciation accounting.

Features of depreciation
Above mentioned discussion highlights the following features of depreciation:
1.    It is decline in the book value of fixed assets.
2.    It includes loss of value to effusion of time, usage or obsolescence.
3.    It is a continuing process till the end of the useful life of assets.
4.    It is an expired cost and hence must be deducted before calculating taxable profits.
5.    It is a non-cash expense. It does not involve any cash outflow.
6.    It is process of writing-off the capital expenditure already incurred.

Cause of depreciation
Depreciation may be said to arise from two cause-internal and external. Internal deprecation arises from the operation of any cause natural to, or inhere rent in, the asset itself. External depreciation arises from the operation of forces external to the asset. These have been discussed below:

Internal causes
a.    Wear and tear
"wear and tear" is an importance cause of deprecation in the case of tangible fixed assets like building, machinery, furniture, fixtures, tools, fittings, etc. "wear and tear" result from friction, vibration, strain, chemical reaction, weathering, intensity of the use, care in handling, standard of maitatenace, manor accidents inevitable in the handling of plant, etc. the term "depreciation" is generally used to indicate the expired utility of an asset due to reasons mentioned above.
b.    Depletion
Depletion is also one of the internal causes of decrease in the value of wasting assets such as manes, quarries, oil-wells and forest-stands. The term "depletion" (neither "amortization" none "depreciation") is correctly used to refer to the expired utility of a wasting assets.

External causes
a.    obsolescence
In many cases, a particular machine is discarded before it is completely worn-out. This means that there are some external factors too which are responsible for throwing out of use an asset which is in good condition. For example with the advent of electric and diesel locomotives, stream locomotives have been discarded although they are in good condition. This is a case of obsolescence. Similarly with the introduction of colour TVs. Models of black and white TVs. Have become obsolete and users have discarded them although they are in good condition. Obsolesce can arise from such factors as
•    technological changes as a result of continuousreserch resulting in technical improvements to the assets or emergence of more productive assets;
•    improvement in product methods;
•    change in market demand for the product or service output of the assets;
•    Legal or other restrictions.
b.    inadequacy
When there is a change in the scale of operations it may lead to the discarding of certain assets. For examples, a firm because of the introduction of sophisticated date processing system may have to discard the equipment under manual system. Similarly, plant assets which cannot be utilized with optima mum efficiency because of changes in the scale of operations will have to be discarded even if they are in sound condition.

In the case of both obsolescence and inadequacy, there is no question of scrapping the assert. These assets may be use to other enterprises and therefore can be sold to such other enterprise. Obsolesce and inadequacies are also classified as economic or functions factors causing depreciation.

Effluxion of time
There are some intangible fixed assets which decrease in value as time elapses. For example, if Rs. 50,000 are paid for a certain lease( excluding lease of mine) for 10 years, then with the lapse of every years the value of the assets goes down by Rs. 50,000 whether, utilized or not. Its value is reduced to zero at the end of the 10th year. Copyrights, patent rights are other example of intangible of intangible fixed assets which decrease in value due to effluxion of time. The term "amortization" is generally used to indicate the fall in the value of such assets.
   
Another way to classify causes of depreciation is to list them as physical deterioration (wear and tear discussed above), economic or functions factors (obsolescence and inadequacy), the time factor and depletion.
Factors affecting the amount of depreciation
The determination of depreciation depends on three parameters; viz. cost estimated useful life and probable salvage value.
Cost of asset: cost (also known as original cost or historical cost) of an assets included invoice price and other cost, which are necessary to put the asset in use or working condition. Besides the purchase price, it included freight and transportation cost, transit insurance, installation cost, registration cost, price, it included freight and transportation cost, transits insurance, installation cost, registration cost, commission paid on purchase of assets add items such as software, etc. in case of purchase of a second hand assets it included initial repair cost to put the asset in workable conditition. According to accounting standard-6n of ICAI, cost of a fixed asset is "the total cost spent in connection with its acquisition, installation and commissioning as well as for addition or improvement of the decipherable assets". For example, a photocopy machine is purchase for Rs. 50,000 and Rs. 5,000 is spent on its transportation and installation. In this case the original cost of thee machine is Rs.55, 000 (i.e. Rs.50, 000 + Rs.5, 000) which will be written off as depreciation over the useful life of the machine.

Estimated net residual value: net residual value (also known as crap value or salvage value for accounting purposes) is the estimated net realizable value (or sale value) of the asset at the end of its useful life. The net residual value (or sale value) of the asset at the end of its useful life. The net residual value is calculated after deducting the expenses necessary for the disposal of the asset. For example, a machine is purchased for Rs. 50,000 and is expected to have a useful life of 10 years. At the end of 10th year it is expected to have a sale value of Rs. 6,000 but expenses related to its disposal are estimated at Rs. 1,000. Then its net residual value shall be Rs. 5,000 (i.e. Rs. 6,000 – Rs. 1,000).

Estimate useful life: useful life of an asset is the estimated economic or commercial life of the asset. Physical life is not important for this purpose because as assets may still exist physically but may not be capable of commercially variable production. For example, a machine is purchased and it is estimated that it can be used in production process for 5 years. After 5 years the machine may still be in good physical condition but can't be used for production profitably, i.e. if it is still used the cost of production may be very high.  Therefore, the useful life of the machine is considered as 5 years irrespective of its physical life. Estimation of useful life of an asset is default as it depends upon several factors such as usage level of asset, maintenance of the asset, technological changes market changes, etc. as per accounting standard-6 useful life of an asset is normally to "period over which it is expected to be used by the enterprise". Normally, useful life is shorter than the physical life. The useful life of an asset is expressed in number of yard but it can also be expressed in other units. E.g., number of units of output (as in case of mines) or number of working hour. Useful life depends upon the following factors:

•    Pre-determined by legal or contractual limits, e.g. in case of leasehold asset, the useful life is the period of lease.
•    The number of shifts for which asset is too used.
•    Repair and maintenance policy of the business organization.
•    Technology obsolesces.
•    Innovation/ impartment in production method.
•    Legal or other restrictions.

Objective of providing depreciation
The depreciation on assets is provided in order to achieve the following objectives:-
To calculate proper profit: depreciation is an operating charge against the year's current income because an asset is an importance tool in earning revenues. The fall in the book value of assets reflects the cost of earnings from the use of asset in the year, hence like other costs viz. wages, salaries etc., depreciation must also be changed to revenue. It is, therefore, necessary to charge depreciation to revenue income in order to ascertain correct profits for the year.

To show the asset at its real values: depreciation is provided to reduce the cost of assets to the extent of unexpired cost. If the depreciation is not changed, it means the asset is being shown in the balance sheet at its overstated value. Hence, in order to show the assets at its real value in the balance sheet, depreciation is a must.

To replace the asset: depreciation reduce the amount of profit and saves the cash resources of the concern to the extent of depreciation from being distribute by way of dividend. The amount so saved can be aside every year and invested, is able to produce as much amount as necessary to replace the asset at the end of the life of the asset.

To reduce the tax-liability: by charging depreciation to profit and loss account, the taxable profits of the company are reduced. It is an admissible deduction under income tax act thus it reduces the tax liability of the concern.

To ascertain accurate cost of production: in manufacturing concerns especially, cost of production cannot be accurately determined unless depreciation cost has been considered in the calculations.


Accounting treatment of depreciation
First method: when provision for depreciation account is not maintained
Under this method, the assets appear at what is called book value namely, cost less depreciation. In the balance sheet asset is shown at the book value at the end of the year.
Second method: with maintaining provision for depreciation account

Under this method the assets always appears at original cost year after year. In the balance sheet asset is shown at original cost less depreciation provision. The amount of the credit of provision for depreciation account shows the total depreciation written off to date. This method is more revealing as one can understand the relative age of the asset having regard to the cost of asset and the cumulative depreciation indicated by the provision for depreciation account.
Methods of providing depreciation
The depreciation amount to be charged for during an accounting year depends up on depreciable amount and the method of allocation. For this, two methods are mandated by law and enforced by professional accounting practice in Nepal. These method are straight line method and written down vale method. Besides these two main methods there are other methods too. The selection of an appropriate method depends upon the following:
•    Types of the asset;
•    Nature of the use of such asset;
•    Circumstances prevailing in the business;
The selected depreciation method should be applied consistently from period to period. Change in depreciation method may be allowed only under specific circumstances.

The most common methods of providing depreciation are mentioned below:
1.    Straight-line method
This is the earliest and one of the widely used methods of providing depreciation. This method is based on the assumption of equal usage of the asset over its entire useful life. It is called straight line for the reason that if the amount of depreciation and corresponding time period is plotted on a graph, it will result in a straight line.

It is also called fixed installment method because the amount of depreciation remains constant from year to year over the useful life of the asset. According to this method, a fixed and an equal amount is charge as depreciation in every accounting period during the lifetime of an asset. The amount annually charged as depreciation is such that it reduces the original cost of the asset to its crap aloe, at the end of its useful life. This method is also known as fixed percentage on original cost method because same percentage of the original cost (in fact depreciable cost) is written off as depreciation from year to year. The depreciation amount to be provided under this method is computed by using the following formula:

Depreciation= cost of assets- estimated residual value/ estimated useful life of the assets
   
Rate of depreciation under straight line method is the percentage of the total cost of the assets to be charged as depreciation during the useful lifetime of the asset. Rate of depreciation is calculated as follows:
Rate of depreciation= annual depreciation amount/ cost of asset x 100

Advantages of straight line method
Straight line method has certain advantages which are started below:
•    It is very simple, easy to understand and apply. Simplicity make it a popular method in practice;
•    Asset can be depreciation up to the net crap value or zero value. Therefore, this method makes it possible to distribute full depreciable cost over useful life of the asset:
•    Every year, same amount is charged as depreciation in profit and loss account. This makes comparison of profit for different years easy;
•    This method is suitable for those assets useful life can be estimated accurate and where the use of the asset is consistent from year to year such as leasehold buildings.

Disadvantages of straight line method    
Although straight line method is simple and easy to apply it suffer from certain limitations which are given below:
•    This method is based on the faulty assumption of same utility of the asset in difference accounting years;
•    With the passage of time, work efficiency of the asset decrease and repair and maintained expense increase. Hence, under this method this method total amount charged against profit on account of depreciation and repair taken tougher will not be uniform throughout the life of the asset, rather it will keep on increasing from year to year.

2.    Diminishing balance method
This method is also known as reducing or diminishing balance or written down value method. Under this method, a depreciation percentage rate is applied to the acquisition or construction cost at the beginning of the accounting period rather than thee original cost. Hence, a fixed percentage of the diminishing value of the asset is written off each year so as to reduce the asset to its break-up or scrap value at the end of its life and the annual charge for depreciation decrease from year to year the effect is the end of its life and the annual charge for depreciation decrease from year to year. The effect is that his initial years take a higher hit of depreciation chare as compared to the later years. Unlike the straight-line method where the cost of asset is completely written-off, this never happens in the reducing balance method. It must be noted that salvage value is not considered in the calculation of depreciation. However, the book value of the asset is never brought below its salvage value.

The rate of depreciation under this method is determined by the following formula:

N= number of years

Depreciation is charged at this rate on the original cost of the asset in the first year and on book value or written down value of the previous year from 2nd year onwards.

Advantages of diminishing balance method
1.    It is simple to computer depreciation under this method.
2.    The storage point in favor of this method is that under it the total burden imposed on profit and loss account due to depreciation and repairs remains more or less equal year after year since the amount after depreciation goes on diminishing with the passage of time whereas the amount of repairs goes on increasing an asset grow older.
3.    Separate calculations are unnecessary for additions and extensions, thought in the first year some complications usually arise on account of the fact that additions are generally made in the middle of the year.

Disadvantages of diminishing balance method
1.    This method ignores the question of interest on capital invited in the asset and the replacement of the assets.
2.    This method cannot reduce the book value of an asset to zero if it is desired.
3.    Very high rate of depreciation would have to be adopted otherwise it will take a very long time to write an asset down to its residual value.
4.    A lower application of the percentage used for computing depreciation may be harmful to the enterprise leading to lower charge of depreciation and leading to under charge in the income statement. This may lead to the enterprise not selling aside enough resources to replace the asset at the end of its useful life.

This method is most suited to plan and machinery where additional and extensions take place so often and where the question of repairs is also very important. Written down value method or reducing installment method does not suit the case of lease, whose value has to be reduced to zero.

Change of depreciation method
Once a method of depreciation is selected by the management, it should be applied consistently. That would ensure comparability of result from period to period. However, management may change the method for the following reasons:
1.    Statutory compulsion
2.    Required by an accounting standard
3.    Change would result in a more appropriate preparation or presentation of the financial statements of an enterprise.
The change may be made prospectively (from the current year) or retrospectively.

1.    Change in current year (prospectively)
When the change in the method is prospectively, unamortized depreciation amount of the assets should be changed to revenue over the remaining useful life by applying the new method. Such a change should be treated as a change in accounting policy and its effect should be quantified and disclosed.

Change retrospectively
Under this method of depreciations is changed considering the effect from the previous years. The change is affected retrospectively with the following steps:
•    Calculate the depreciation on the asset from the back date by adopting the new method and new rate up to end of the previous year.
•    Find out the depreciation on the asset already provided at the old rate.
•    In the current the year in addition to the depreciation for the current year, charge also the difference under (a) and (b) mentioned above.

Annuity method
Under this method, it is assumed that the amount spent in the purchase of the assets is an investment which should earn interest. The amount spent is accruing an asset is assumed as an investment and interest is charged at a certain rate on the diminishing balance of assets and is debited to assets account and credited to interest account which is transferred to profit and loss account. The asset is credited year by years with a fixed amount of depreciation. The amount of depreciation changed every year is such that is spite of asset being debited with interest every year; the asset is reduced to zero or its residual value. The amount of depreciation is calculated on the basis of annuity table.

When additional are made to the asset account, calculations have to be revised. This method is used in the case of leases having large amounts spread over a number of years.
Advantages
The following are the advantages of the annuity method:
1.    This method takes interest on capital investment in the asset into account.
2.    It is regarded as most exact and precise from the point of view of calculations so it a scientific method.
Disadvantages
The following are the disadvanges of the annuity method:
1.    The method is difficult to understand.
2.    The burden on profit and loss account goes on increasing with the passage of time whereas the amount of depreciation charged each year remains constant. The amount of interest credited goes on diminishing as years pass by, the ultimate consequence being that the net burden on profit and loss account grows heavier each year.
3.    When the asset required frequent additions and extensions, the calculation have to be changed frequently, which is very inconvenient.

Sinking fund method or depreciation fund method
The above discussed methods do not help in accumulating the amount of depreciation which can be readily available for the replacement of the assets when it is completely unusable. Sinking fund method is designed in such a way that it incorporates the advantages of depreciating the assets as well as accumulating the necessary amount for its replacement.

Under this method, a fixed amount is debited every year to depreciation account credited to depreciation fund account instead of asset account. The asset is shown at its original cost, in the books, in every year. The amount which is credited in the sinking fund is invested in gilt-edged securities. The interest on such investment is also invested in similar securities. The securities are readily convertible into cash, investment are purchase every year. When the assets become useless, the investments are sold away and thus new assets can be purchased without disturbing the financial position. This method is adopted especially when it is desired not merely to write off an asset but also to provide enough funds to replace the asset at the end of its working life. The amount set aside as depreciation is such that this, with compound interests, will be sufficient to meet the cost of new asset, less scrap value, it any, for replacement. The depreciation under this method can be calculated with the help of a sinking fund table for a particular period at a given rate of interest.

Advantages of depreciation fund method or sinking fund method:
1.    It makes available a sum of money for the replacement of the asset by maintaining separate provision.
2.    It helps to strength financial position of a concern.
Disadvantages of the depreciation fund method or sinking fund method:
1.    The burden on profit and loss account goes on increasing as years pass by since the amount of depreciation every year remains same but the amount spent on repairs goes or increasing as the asset becomes old.
2.    It creates complication due to frequent investment.
3.    Price of securities may fall at the time they are to be realized as a result of which loss may have to be suffered.

Insurance policy method
In this method, the business takes a policy from an insurance company. The amount of the policy is such that as it is sufficient to replace the asset when it is worn out. The insurance companies agree to pay a lump sum in return for a sum known as premium to be paid at the beginning of every year. The amount so made available by the insurance company is used for purchasing a new asset.

Double declining balance method
According to this method, the depreciation is charged on the reducing balance method but the rate of depreciations is determined by multiplying the straight line rate by 2.

Sum of years digits method (SYD)   
Sum of the years' digits method an accelerate method of depreciation which is is also based on the assumption that the loss in the value of the fixed asset will be greater during the earlier years and goes on decreasing gradually with the decrease in the life of such asset. The SYD is found by estimating an asset's useful life in years, then assessing consecutives consecutive numbers to each year, and totaling to derive numbers for n years:

SYD= 1+2+3+4+ ……. + n

Machine hour rate method
Under this method, the total number of working hours of a machine during the whole of its effective life is estimated, and then the cost of machine is divided by the expected number of hours of useful life, this gives the rate per hour.
Revaluation method
Under this method of depreciation, an asset is shown at its current value. The difference between its current value and the book value at the end of each according year is written off as depreciation. This method is appropriate in case of assets of small value like livestock, loose tools packages etc.