DEPRECIATION 1.

DEPRECIATION MEANING The word Depreciation has been derived from the Latin word Depretiun which means decline in price or value. The word Depreciation Relates to fixed assets which loose value on account of usage. Therefore, Depreciation means decline in the value of fixed assets on account of use. Some important definitions are given below:Depreciation may be defined as the permanent and continuing diminution in the quality, quantity or the value of an asset. Following facts about depreciation:

(1) Depreciation is apart of the operating cost. (2) It is a reduction in the value of an asset. (3) The decrease in the value of an asset is due to its use, caused by wear and tear or any other reason. (4) The decrease in the value of an asset is gradual and continuous. (5) Depreciation is a wider term & includes depletion & amortization. Depletion is a fall in the value of tangible wasting assets like coal mines oil reserve etc. Amortization refers to fall in the value of intangible assets like goodwill; copyrights, trade marks etc. (6) It is a charge against Profit. (7) It is not a sudden loss. (8) It is a process of allocation of expired cost. (9) It can be simply estimated. (10) (11) (12) It may be physical and functional. Its object is maintain the nominal capital invested in fixed assets. It is a must.

(13) Market value of a fixed asset does not affect the amount of depreciation. 1

(14)

It is calculated in respect of fixed assets only.

Causes of Depreciation : The main causes of depreciation are: (1) Wear and Tear: Wear and tear is an important cause of depreciation in the case of tangible fixed assets. It is mainly due to use of the asset. (2) Afflux of Time: Some assets have a definite life period like a lease; on the expiry of the life, the asset will cease to exist. Other assets, like plant and machinery, may not have a definite life; in their case, the useful life is estimated. (3) Obsolescence: If a better machine comes on the market, the old machines may have to be scrapped even though they are capable of being run physically. It is a reduction in usefulness of the asset. (4) To provide funds for replacement of asset. The gradual reduction or decline in the value of asset lead to a point of time when the asset has no value. It cannot be used it needs to be scrapped and replaced by another asset of similar type. At such a time, it becomes essential to purchase another asset. Or of similar type or right in such asset and to pay for the same. The depreciation aims to provide for such contingency also. Some methods of depreciation require: 1. Charging a fixed amount to Profit & Loss Account as Depreciation every year, 2. To invest such amount in security or policy every year and the interest received from year to year is also invested in securities. 3. At the time of replacement, investments are disposed off, amount is realized and utilized to pay for new asset. (5) To compute tax liability Depreciation is allowed as a deduction for computation of taxable income. Hence, it is necessary to provide for depreciation for taxation purpose.

Only in a few cases do fixed assets appreciate. Land may go up in value. But usually the value of fixed assets diminishes continuously. This is even if an asset is not used. Mere passage of time is sufficient to reduce the value of the asset.

One unfortunate thing about depreciation is that it is not visible like other expenses till the very end. In case of other expenses, the expenditure is obvious and, hence, everybody provides for such expenses while calculating loss or profit. It is not so with depreciation. Many people do not deduct depreciation from the gross earning to ascertain their net profit simply because there is no payment for it. This is fallacious. Let us clear it by an example. Suppose: 1. A starts a small manufacturing business and buys machinery worth Rs. 20,000; 2. He does not realize that this machinery is depreciating and, therefore, uses up all 'profits' which his business gives; By the end of ten years, he has earned a net income of Rs. 30,000, without considering depreciation; and 3. The machinery bought by A is useless at the end of 10th year. It is clear that A's net income is not Rs. 30,000 but only Rs. 10,000, because out of Rs.30,000,he must deduct the loss of machinery worth Rs. 20,000. Would it not have been better if he had deducted every year a due proportion of his expenditure on the machinery before ascertaining his profit? Further, if A has already used up Rs. 30,000, which according to his mistaken idea is his profits for the 10 years, he cannot continue to run his business, for his machinery is no longer serviceable unless he raises funds say, as a loan. If he had provided proper depreciation he would have retained sufficient funds to buy new machinery when the old one became useless. Provision of depreciation, therefore, is necessary first for ascertaining the true profit, and secondly, for retaining funds in the business so that the asset can be replaced (when its life is over) by a new one. METHODS OF DEPRECIATION : Straight-line depreciation: Straight-line depreciation is the simplest and most often used technique, in which the company estimates the salvage value of the asset at the end of the period during which it will be used to generate revenues (useful life), and will expense a portion of original cost in equal increments over that period. The salvage value is an estimate of the value of the asset at the time it will be sold or disposed of; it may be zero. Salvage value is scrap value, by another name. Straight-Line Method: Annual Depreciation =Cost of Assets Residual Value No. of years of life For example, a machinery costing Rs. 10,000 is bought, having an estimated life of 10 years. Its scrap value at the end of 10 years is estimated as Rs. 1,000. The annual charge of depreciation would be: Depreciation = Cost of Assets Scrap value 3

Estimated Life = 10,000 1,000 10 = Rs. 900 Features Some important features of the fixed installment or Straight line method can be stated as follows: 1. It is a widely used method of charging depreciation. 2. It offers the advantage of simplicity in charging the depreciation on the assets. 3. Its another attribute is that of clarity of presentation in the Balance Sheet 4. It reduces the book value of the assets to zero at the end of the economic life of the asset. 5. Under this method, the figures of periodic depreciation remain constant year after year. 6. Depreciation is charged at a certain rate on original cost of the asset every year. Diminishing Balance method/Reducing balance method/Written Down value: Under this method, depreciation is charged at a fixed rate every year but on reducing balance i.e., on balance reduced each year during the economic life of the asset by the amount of depreciation till the asset is reduced to its scrap value. For example, if the cost of the asset is Rs. 1,000 the rate of depreciation is 10 % on Rs. 1,000 i.e., Rs. 100, in the second year, it will be 10 % on Rs 900 i.e., Rs. 90 is the third year, it will be 10 % on Rs 810 (900-90) i.e., Rs. 81 and so on. The depreciation on the asset goes on reducing as the year passes. The main idea behind it as the asset gets older, the repairs and renewal charges become higher. But the total charge on account of depreciation plus repairs and renewals charges become higher. But the total charge on account of depreciation plus repairs and renewals may be more or less equal in all the years over life of the asset. This method is applied for depreciating assets like plant and machinery and building. Illustration : Q1) On 1/1/2006 Lakshmi and company purchased a imported Machine from the cost of the machine is Rs 12,00,000 and import duty of Rs 2,50,000 and installation charges 25,000. 4

On 1/6/2007 purchased a machine for Rs 1,00,000 and incurred installation cost of Rs 25,000. On 1/8/2008 the company purchased another machine for Rs 3,00,000 and the machinery purchased on 1/1/2006 was sold for Rs 5,00,000. Prepare machinery account and depreciation account for 2006, 2007, 2008 assuming that depreciation is charged on original cost method at 15%.Assume the year as calendar year. Q2) On 1/8/2006 Suraj and company purchased a imported Machine from USA the cost of the machine is Rs 22,00,000 and import duty of Rs 3,50,000 and installation charges 45,000. On 1/8/2007 purchased a machine for Rs 1, 00,000 and incurred installation cost of Rs 45,000. On 1/8/2008 the company purchased another machine for Rs 3,00,000 and the machinery purchased on 1/8/2006 was sold for Rs 6,00,000. Prepare machinery account and depreciation account for 2006-07, 2007-08, 2008-09 assuming that depreciation is charged on straight line method at 10% and the year is a financial year. Q3) On 1/4/2006 Reliance and company purchased a imported Machine from Spain , the cost of the machine is Rs 18,50,000 and import duty of Rs 3,50,000 and installation charges 45,000. On 1/6/2007 purchased a machine for Rs 1,00,000 and incurred installation cost of Rs 45,000. On 1/8/2008 the company purchased another machine for Rs 3,00,000 and the machinery purchased on 1/4/2006 was sold for Rs 7,00,000. Prepare machinery account and depreciation account for 2006-07, 2007-08, 2008-09 assuming that depreciation is charged on WDV at 10%. Q4) On 1/4/2006 and company purchased a imported Machine from France the cost of the machine is Rs 25,00,000 and import duty of Rs 1,50,000 and installation charges 35,000. On 1/6/2007 the imported Machine was sold for Rs 6,00,000. On the same date it purchased another machine for Rs 50,000. and installation charges 5,000. On 1/6/2008 the company purchased another machine for Rs 5,00,000 Prepare machinery account and depreciation account for 2006, 2007, 2008, assuming that depreciation is charged on diminishing balance method at 15%.

HOME WORK SECTION : Q1) On 1/4/2006 Amruta and company purchased a imported Machine from France the cost of the machine is Rs 15,00,000 and import duty of Rs 2,50,000 and installation charges 25,000. On 1/8/2007 the imported Machine was sold for Rs 5,00,000. On the same date it purchased another machine for Rs 1,00,000. On 1/8/2008 the company purchased another machine for Rs 4,00,000 Prepare machinery account and depreciation account for 2006-07, 2007-08, 2008-09, assuming that depreciation is charged on diminishing balance method at 10%. Q2) On 1/8/2006 Shyam and company purchased a imported Machine from France the cost of the machine is Rs 18,00,000 and import duty of Rs 2,55,000 and installation charges 1,25,000. On 1/6/2007 the imported Machine was sold for Rs 5,00,000. On the same date it purchased another machine for Rs 1,00,000. On 1/7/2008 the company purchased another machine for Rs 6,00,000 Prepare machinery account and depreciation account for 2006, 2007, 2005, assuming that depreciation is charged on Reducing balance method at 15%. Q3) On 1/8/2006 Shyam and company purchased a imported Machine from France the cost of the machine is Rs 18,00,000 and import duty of Rs 2,55,000 and installation charges 1,25,000. On 1/6/2007 the imported Machine was sold for Rs 5,00,000. On the same date it purchased another machine for Rs 1,00,000. On 1/7/2008 the company purchased another machine for Rs 6,00,000 Prepare machinery account and depreciation account for 2006, 2007, 2005, assuming that depreciation is charged on Reducing balance method at 15%. %. Q4) On 1/8/2006 Akshay5 and company purchased a imported Machine from the cost of the machine is Rs 10,00,000 and import duty of Rs 1,50,000 and installation charges 25,000. On 1/9/2007 purchased a machine for Rs 1,00,000. On 1/8/2008 the company purchased another machine for Rs 9,50,000 and the machinery purchased on 1/8/2006 was sold for Rs 5,75,000. Prepare machinery account and depreciation account for 2006-07, 2007-08, 2008 -09, assuming that depreciation is charged on original cost method at 20%.