FUNDAI/ENTqLS OF ACCOUNTING

DEPFIECIATION
(iii) Some accountants are of the opinion that depreciation is nothing but an arbitrary allocation of
*'hen the same i
cost. As such, according to them, conventional methods allocate historical cost over a number
consurning it in l
of years arbitrarily.
period, only a pr
The above criticisms may be overcome on the following grounds: ls there anv possibility to actually reduces
identify horv much an individual fixed asset contributes directly to earn revenue; if it u'ould have, no rendering capaci
doubt the conventional allocation method would have been considered a more logical one. Since this reduction is
revenue is the result of the collective contributions of current and fixed assets, labour and other factors of a fixed assct ir
it is impossible to identify how much each of them contributes to the total pool. According to the needless to menl
cause-and-effect relation, allocation of fixed cost is not possible until the contribution of individual capacity is consu
factors are ascertained. In that case, conventional allocation method simply attempts to allocate the revenues earned
historical fixed cost throughout the period of its lifespan in a systematic and rational manner. charged against l
For every conventional allocation method there must be some presuppositions. For example, of the asset by v
certain assumptions and approximations are made under each method on the relation between the allocated by rvA
market prices and the degree of their use, estimated scrap value, nature and type of repairs and respective period
maintenance etc. At present, t
The principle of allocationdepends on various factors. For example, anticipated change in fixed asset is cor
revenue, life of the asset, degree of uncertainty, etc., which have irnportant role in selecting the method effective life of t
of allocation, may be considered as the most appropriate and suitable ones, although all the said factors the pbriod ol its ,

may not be treated equally, At the same time, all the assumptions are not equally applicable to all the historical cost of
assets. As such, a particular method should be adopted for an individual asset depending on the nature effective life.
of the same instead of applying a general method.
(c) Expiration r
g Nature of Depreciation Depreciation
The nature of depreciation is enumerated: is commissioned
(a) Diminution of Yalue exhausted continr
(plant or machine
It has been highlighted above that depreciation is considered as the diminution of value of a fixed
as an outlay. Und
asset which arises due to normal wear and tear, obsolescence, or the passage (effluxion) of time. In the
fixed assets whicl
past, depreciation was considered as a reduction in the value of a fixed asset. But, at present, this
against the reven
theory, i.e., diminution in value, is not accepted on the lollorving grounds:
practically similar
Here, the term 'value' denotes different meanirrgs and interpretations and, as such, it is a
controversial term. Thus, when it is used in connection rvith depreciation, the meaning and the method (d) Diminution r
of computation of depreciation change, which, in other rvords, provides a different result. Besides, the It has been t
value so computed with the help of any method does not remain sratic throughout the period of the occur even u,hen
rassets due to change in price level and other eronomic factors. As a result, this concept suffers from dimintttiort of the
certain limitations in measuring the periodic depreciation. Since the term'value'has oniy a subjective proportional to th
significance. this concept of value actually fails to convey the real significance of depreciation in the consecutive accou
area of financial accounting. Thus, at present, the concept of depreciation as diminution of value is not the revenues earnt
recognised. (e) 1!{aintenance
(b) Allocation of Cost
Depreciation
Depreciationisconsidered asanallociztionof cost(whichhasalreaclybeenpointedout)of afixed invested in a fix
asset. It may be regarded as a periodic charge or expense which is to be matched against tl-ie revenues rLe O \'Ci'\ ,Cl the e n
earned. We ail know that a fixed asset, having a long iife, is acquired not for resale but for the purpose as a result of its u
of use in a firm and such fixed asset has a specific number of years of useful life (excepting land). and those rvhich
Every fixed asset is used in the business for the purpose of earning revenue through the process of recei.;ed back.
manufacturing or trading at a particular accounting period. Since the fixed asset renders services for the This is nothir
said period, it loses its proportional ability to render service.in future as there is a flow-out of the fixed ma'\ be said that p
asset. This principle, however, is not applicable in case of a current asset which is consumed in full to maintain the irr

tr\
 5.3
DEPBECIATION

.of rvhen the same is used in the business. But, in case of fixed assets, the services can
be used without
Jmber consuming it in full. As such, although the entire asset is used in the business operation for a particular
or This consumption in the value of asset
period, only u portion of the same is consumed exhausted.
r"iu."i the future service-rendering capacity ofthc asset. This reduction in the future service-
ossibility to actualty
etc. But
luld have, no rendering capacity of the asset may be due to either utilisation or obsolescence, or innovations,
this reduction is not always exactly equal to the scrvice rendered by it. As a result, this partial florv-out
nl one. Since
of a fixed asset is accounied for by way of an impured transaction which is known as depreciation.
It is
I other factors
ording to the needless to mention that, as the fixed asset has a long life and only a portion of its service-rendering
capacity is consumed, the entire cost of the asset cannot be charged by ivay of depreciation against
the
of individual
o allocate the ."r.nr", earned for a particular period. That is, only a part of the total cost of fixcd asset should be

charged against the revenues earned in each of the consecutive accounting periods througttout the life
rer.
For examPle, of ttie asset by way bf depreciation. In other rvords, a part of the total cost of fixed asset shculd be
allocated by wfy of depieciation to each accounting period, against the revenues earned in
the
r between the
,f repairs and respective periods.
At present, this concept (i.e. allocation of cost) is ividely accepted. Under this concept, the cost of
ed change in fixed asset is considered as deferred charge which should be rvritten-off against revenues during the
og the method effective life of the asset. Therefore, the cost (i.e. historical cost) of the asset is spread over throughout
the period of its effective life in a proper way. Hence, depreciation is considered as a part of the
total
re said factors
historical cost of a fixed asset which is allocated against the respective revenues over the pcriod of its
able to all the
on the nature effective life.
(c) Expiration of CaPital OutlaY
Depreciation may also be considered as an expiration of the capital outlay. When plant or machine
is commissioned into use by a going concern in order to earn revenue, its usable capacity gets
exhausted continuously. The capital outlay consists of financial capital or cash invested in fixed
asset
(plant or machine) rvhich is simultaneously expired by the amount of exhaustion of its usable capacity,
as an outlay. Under this concept, depreciation is the measure of that portion of the capital outlay
aiue of a fixed on the
of time. In the fixdd assets which has expired. And, as such, the expired portion of the capital outlay must be charged
,t present, this against the revenue for recovery of capital for the period. It may be mentioned that this concept is
practically similar to the concept (b) stated above, i.e., allocation of cost.
such, it is a (d) Diminution of Life
nd the method
It has been highlighted above that depreciation is based on allocation of cost and hence it may
It. Besides, the
: period of the occur even when the value of the asset rises due to rise in prices. G. O. May identifies depreciation as
rt suffers from diminution of the life of the asset. It is a different concept which is based on the process that a cost
ly a subjective proportional to the expired life of the asset is charged against the revenue earned during each of the
'eciation in the accounting periods, i.e., cost of the asset proportionate to its expired life is charged against
"on.r".utir"
the revenues earned. Practically, the concept is also similar to the concept of allocation of expired cost'
of value is not
(e) Maintenance of CaPital
Depreciation is frequently regarded as a means of maintenance of nominal capital which is
out) of a fixed invested in a fixed asset. Depreciation which is charged against revenues earned allolvs for the
rsco\.cr) of the entire historical cost of fixed asset which is expired graduaily over a number of years
a
st the revenues
as a result of its use. ln other words, the amount of capital which is invested for acquiring fixed
assets
lor the purPose is
and those which are consumed gradually in order to earn revenue for a nun.rber of years again
ng land).
received back.
Lthe process of
services for the This is nothing but the maintenance of nominal capital invested in fixed assets. And, as such, it
rut of the fixed may be said that provision for depreciation on fixed assets on the basis of historical cost actually hclps
nsumed in full to maintain the lomiral capital intact. But this method fails to maintain the real capital value of the

.ir-
\
 FUNDAMENTALS OF ACCOUNTING DEPRECIATION

assets the price level rises and, consequently, iclentical fixed assets cannot be acquired rvith the same
if Hurvever, th
nominal capital rvhich is create<J by the said provision for depreciation. Moreover, charging periodical Standard Board),
depreciation on tlie basis of historical cost helps to maintain at least the nominal capitai of the asset be subject to mar
intact. But during the period of inflation, the maintenance of nominal capital does not indicate the conditions anticil
maintenance of real capital since there rvill be an erosion in the purchasing porver of money and, period of the asse
consequently, there rvill be an erosion of reai capital. Therefore, rvhen there is a fall in the purchasing Accordin_e to
power of money or prices rise as a resuit of inflation, the rnaintenance of real capital through the also defined the r
p.o."r, of provision for depreciation on the basis of historical cost should not be considereci for the that dcpreciation
pu.por" of maintaining the real capital. On the contrary, the higher current replacement cost for the the period.: No dc
,u11. *uy be taken into consideration from one period to another. The depreciation of a particular
period must be acljusted with the repiacement cost and prevalent price level. If, horvever, there is a Causes of Deprer
constant rise in price due to inflatiolt, the toial adjusted depreciation so calculated rvill fail to be equal The main causes (

to the total replacement cost of an identical fixed asset rvhich is to be replaced in place of the existing (i) Physical c
asset at the encl of its rvorking life.-Hence the adjusted deprcciation should further be readjusted again time (i.e., time fac
for the purpose of replacement against the constant rise in price, (i) Phl.sic'ttl tl
(t) sources of Fund for \Yorking capital, or, Is Depreciation a source of Fund? It is caused b.
of fund or a source of rvorking capital. It has
Sornetimes clepreciation is considered as a source exposure to rvind
been stated above that depreciation is an cxpense as expired cost. Like other business expenses, operated. Thesc ar
depreciation is charged against gross revenue of the period in rvhich cost for fixed assets degenerates (ii) Economic'-
into expenses as expired cost. Nevertheless, an altogether different situation is believed to arise from
These factors
charging depreciation to gross revenue as expenses as against the effect of charging other business
condition. These
expenses to the asset. This difference may be ascribed to the fact that tvhereas other business expenses
equipment; declin,
are cash-consuming, depreciation-as business expense-is of a non-cash variety. There is no inflorv
from the existing
of cash or other liquid assets in respect of imputed expenses of depreciation. As a result, whereas increase in the l'o1
charging of other business expenses to gross revenue goes to compensate the loss of cash that is spent
in total by lvay of incurring these expenses, apparently it is not so in case of non-cash consuming (iii) Pnssctge (

expense as involved in charging depreciation to gross revenue. Here, the supposed loss of a portion of There are sor
fixed assets*although not caused by any physical transfer of the same-is attained to be compgnsated simply rvith the pr
or replaced by holding back an equivalent quantity of liquid resources out of gross revenue. As a result, over a particular 1

there is an increase of fund, although the sb-called cost of fixed assets actually stands exactly rvhere it period ol its Iegal 1

did in the past. This difference in consequence of charging depreciation to gross revenue on one hand this type of asse
and other business expenses is believed to be the process by rvhich depreciation may serve as a source depreciation.
of working capital. (iv) Dapletictn
(g) Decline in Service Potential Therc are som
The American Accounting Association Committee on Concepts and Standards defines depre- extractive of rarv n
ciation as; "any decline in the service potential ofplant and other long term assets should be recognised e.g. mines, quarriel
in the account in periods in rvhich such decline occurs ...... . The service potential of assets may depletion (provisio
decline because of ,..... gradual or economic deterioration because of obsolescence or change in Characteristics ol'
consumer demand."1 According to this definition, the initial cost of an asset is assumed to represent the
The important char
value of a store house of services that can be released over the life of the asset. Whenever a portion cf
these services expires through use or other causes, the quantity of service potential declines; and a
(i) Dcpreciati
portion of the cost of the asset should be transferred to an expense, another asset, or a loss account. fixed asset
This definition is a static concept since it is based on an allocation of cost to each quantity of potential (ii1 Depreciiiti
service of the asset. (iii) Depreciati
Itt s s.

t Concepts anrJ Standards, Accounting antl Reporting Stanclards for Corporate Financial )'Commirtee
AAA Co.11ittee on Accounting on Conce
Statements and Preceding Statements and Supplements (AAA, 1957), pp. 4-6 Supplementrrv Statem
 -J
- same
r'eriodical
of the asset
.ot indicate the
of moneY and,
, the purchasing
ital through the
nsidered for the
ent cost for the
L of a Particular
rever, there is a , Causes of Depreciation
fail to be equal
e of the existing
readjusted again
g capital. It has
siness expenses,
;sets degenerates
,ed to arise from
g other business
usiness exPenses
rerc is no inflorv
r result, whereas
cash that is sPent
-cash consuming
ss of a portion of
r be comPgnsated
enue. As a result,
r exactly where it
rnue on one hand
serve as a source
1s defines dePre-
ruld be recognised
:ial of assets may
nce or change in
ed to represent the
never a portion of
al declines; and a
or a loss account.
rantit.v of Potential
rr Corporate Financial
DEPRECIATION
Horvever, this definition is less static than the delinition made by FASB (Financial Accounting
Standard Board), since the latter recognises that the loss of service potential n'ray be irregular and may
be subject to many factors lvhich cannot be foreseen rvhen the asset is purchased. It assumes that the
conditions anticipated at the time of purchase rvill continue rvithout material change throughout the
period of the asset.
According to the AAA Committec on Accounting Concepts and Standards-Long-Lived Assets-
also defined the term as an expiration of service potential of the asset. The Cornmittee further stated
that depreciation must be based on the current cost of restoring the service potential consumed during
the period.2 No doubt this definition is based on deciine in the value of the asset.
The main causes of depreciation are:
(i) Physical deterioration (i.e., rvear and tear); (ii) Economic factors; (iii) Passage (Effluxion) of
time (i.e., time factors); and (iv) Depletion (i.e., exhaustion).
(i) Plrysicaldeteriorotion
It is caused by-(a) normal wear and tear resulting from use, (b) rust, rot. erosion etc. arising from
exposure to wind, rain, sun and other climatic factors, and (c) careless handling of the assets when
operated. These are known as depreciation by physical detcrioration.
(ii) Economic factors
These factors prove the use of asset uneconomic although the same may be.in good physical
condition. These arise due to: (a) obsolescence-caused by invention of improved techniques or
equipment; decline in demand (by change in customers' preference, taste, etc.) for articles producible
from the existing plant; (b) inadequacy-rvhich relers to the termination of the use of an asset due to
increase in the volume of activities.
(iii) Passctge (E/fluxion) ol time
There are some fixed assets, e.g. lease, patents, licences, copyright, etc. which lose their value
simply with the passage of time. Even if such an asset is not used at all, it loses its rvorking capacity
over a particr'lar period of time. And, as such, it should be rvritten-off gradually during the entire
period of its legal life in order to it off fuily by the end of its lif-e. If any provision is made against
this type of asset, the same is"vritetermed as provision for amortisation rather than provision for
depreciation.
(iv) Depletion
There are some fixed assets which are wasting in nature and which lose their uscfulness due to the
extractive of rarv materials from them, i.e., they get fully exhausted. They are termed as wasting assets,
e.g. mincs, quarries, oil-rvells etc. Actually, natural resources come under this category. The charge for
depletion (provision for depletion) is made on the basis of consumption of the respective assets.
Characteristics ol' Depreciation
The important characteristics of depreciation are:
(i) Depreciation refers to a permanent/gradual and continuous decrease in the utility value of a
fixed asset and it continues till the end of the useful life of the asser.
(ii) Depreciation is a charge against profit (i.e., revenue earned) ior a particular accounting period.
(iii) Depreciation is always computed in a systematic and rational manner since it is not a sudden
loss.
2
Comrnittee on Concepts and Standards-Long-Lived Assets, AAA, "At,ttsunting
Jbr ltutd, Builtting (ittd Equipmetl!s
Supplementary Statement No, l, Accounting Revier.v 39 (July 196,1). p. 696