ACCOUNTING AND

CONCEPT OF
DEPRECIATION

SUBMITTED BY- PRACHI

22/10153
SECTION C
 ACCOUNTING OF DEPRECIATION
• In accounting, depreciation means allocation or distribution of the cost of the fixed asset to the years of charge
the depreciable cost to Statement of Profit or Loss before arriving at the profits of each of the a which the fixed
asset has been utilised.
• According to Accounting Standard (AS) 10 (Revised): Property. Plant and Equipment, Depreciation is the s
allocation of the depreciable amount of the asset over its useful life
• .As stated in the beginning, tangible fixed assets are bought or held by the enterprise or business entity for the
producing goods or providing goods and services. They are not held for sale in the normal course of business .
• Depreciable assets are tangible assets:
(a) which are available for use during more than one accounting period of generally twelve months.
(b) which have limited useful life
(c) which are held for use in production or supply of goods and services

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 CHARACTERISTICS OF DEPRECIATION
• On the basis of the general meaning of depreciation and its accounting concept, we can outline the characteristics of
(i) Depreciation is a gradual but continuous fall in book value of fixed assets
(ii) Depreciation in accounting is a process of allocating the depreciable cost (cost minus scrap value)over the estimated
useful life of the fixed assets. It is not a process of valuation of asset.
(iii) Depreciation arises directly through the deterioration because of use and indirectly through obsolescence.
(iv) Depreciation is not a substitute for repairs. Infact depreciation is provided along with repairs and maintenance
expenses.(r) Depreciation charge is not an exact amount but based on estimate.
(v) Depreciation is purely an internal transaction and so it has no outside connection.
(vi) Depreciation has nothing to do with the physical deterioration of fixed assets.
(vii) Depreciation is related to tangible fixed assets only and not to the current assets.
(viii) Depreciation is a charge against the profits.(x) Depreciation is not a source of funds for the replacement of an asset.
(ix) Total depreciation cannot exceed its depreciable value (i.e. cost less scrap value) or original cost where scrap value is
nil
(x) .Depreciation has no relationship with the market value of an asset.(ii) It is related to going concern concept.
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 NEED OR NECESSITY OF DEPRECIATION
• The need for charging a reasonable amount of depreciation over the estimated useful life of the asset arises
for following purposes or objectives:
(i) To calculate the true income: The calculation of income requires matching of costs with revenues.
Depreciation is a necessary cost of using the fixed assets.
(ii) To show the true financial position: For this purpose, assets and liabilities must be stated at their correct
values. In the absence of depreciation charge, the asset will be shown at its original cost year after year
in the balance sheet. This is an unfair practice and the balance sheet would fail to show the true financial
position.
(iii) To calculate the proper cost of the product: Depreciation is important expense and forms part of cost of
the production.
(iv) To compute tax liability of the owner: In such cases, the rate of depreciation would depend on relevant
tax-laws.
(v) To meet the legal requirements: In the case of joint stock companies, it is necessary to charge
depreciation on fixed assets before declaring dividends.
 THE CAUSES OF DEPRECIATION
• Depreciation occurs because of decline in the usefulness of the asset. The causes for the decline in the usefulness of the we
may be divided into two categories namely: Physical and Functional.
(i) The physical loss of an asset may arise due to wear and tear, passage of time and other causes
(a) Wear and tear from use: It is common knowledge that most fixed assets suffer from wear tear in use which ultimately
renders an asset unusable in course of time. Parts are worn down t friction or they break. There may be other damage such
as corrosion.
(b) Passage of time: Many long-term assets lose their usefulness with the passage of time sing because they are older-whether
they are being used or not. For example, the structure of building comprising of walls, roofs, flooring etc., is subject to
automatic decay due to rainfall, heavy stor etc.. Therefore, depreciation must be provided for building.
(c) Other physical factors are fire, flood, earthquake or accident.
(ii) The functional factors are: inadequacy and obsolescence:
(a)Inadequacy: A fixed asset becomes inadequate, if its capacity is not sufficient to meet the demands for increased production
e.g., when an old airport terminal building becomes inadequate
(b) Obsolescence: The most important functional cause is obsolescence which means the reduction of utility of an asset that
results from the development of a better machine or process. Thus, inventions, changes in manufacturing methods
(automation), shifts in demand for production or services or any other condition make the asset out of date.
(iii) Depletion: There are certain fixed assets of wasting nature due to extraction of minerals or of
them e.g. quarries, (mines), oil wells. When minerals are extracted, the asset gets depleted. This
is called depletion. The cost of such wasting assets has to be allocated in accordance with the
quantity of natural resources extracted or anticipated.
(iv) Time factor: For certain assets, the life is fixed legally such as leases, patents, copyrights
Providing depreciation on them is called amortisation.
 FACTORS OR ELEMENTS AFFECTING DEPRECIATION
• According to AS-10 (PPE),DEPRECIATION AMOUNT is a cost of an asset or other amount substituted for
cost less residual value.
• IT means that the amount of depreciation to be determined and ultimately charged to statement of Profit and
Loss is based on the following elements or factors namely:
1. Historical Cost: The cost of the asset (historical cost) includes all costs incurred in acquiring or constructing
an asset such as purchase price, legal charges, freight etc. necessary for making it ready for bringing the
asset to intended location or making ready for the intended purpose of the management.
2. Estimated Residual (Salvage or Scrap) value means the estimated amount which will be recovered when the
asset is sold or exchanged for a new asset at the end of its estimated or actual useful service life. The net
depreciable cost of the tangible fixed asset to the business (or other) enterprise is therefore, arrive at by
deducting the salvage value of the asset from its actual historical cost as described above in point.
According AS-10: Property, Plant and Equipment: the residual value of an asset is the estimate amount that
an entity would currently obtain from disposal of the asset, after deducting the estimate costs of disposal if
the assets were already of the age and in the condition expected at the end .
• Estimated useful life: The following points are generally recommended in estimating the useful life f tangible
fixed asset
(a) The intensity of use: The life of an asset ordinarily depends upon the way in which it is put t use c.g., a truck
used on a construction site may have relatively shorter life than a truck used for transportation on National
Highways due to good quality of roads.
(b) The standard of maintenance, for example, the careful handling and frequent overhauling or repairs
unusually tend to increase useful life.
(c) The replacement policy of the management: Machinery, for example, with an expected physic life of 15
years under normal conditions will have a useful life for depreciation purpose of years if the policy of the
management is to exchange or dispose of such asset after 10 years.
 IS D E P R E C IAT ION A SO U R C E O F F U N D S
• There is popular misconception that depreciation is a source of funds or working capital. Infact it is not so,
because fund are generated by the revenues or receipts from sales and other items of extraordinary income (e.g.
sale of fixed a profit) and not from depreciation. It is true that depreciation is non-cash expense and unlike other
operating expenses, does assets a not require the use of funds or working capital but under no circumstances
depreciation is source of funds or cash for that matter.
• The misconception can be cleared with the help of following journal entry that is usually passed or made for
depreciation accounting:
Depreciation expense account Dr.
To fixed asset account
• The depreciation expense account is clearly an expense account while the credit account is contra fixed asset
account. How can it be presumed from the above journal entry that the depreciation is source of funds or cash ?
• When the funds from operations are calculated for the purpose of funds flow statement, the depreciation
expense figures added back to the given net profit or income figure. Such a procedure has led to a good deal of
confusion because it is often concluded that depreciation is a source of funds
 C A L C U L AT I O N OF D E PR E C I AT I ON FOR A SSE T S
PUR C HA SE D DUR I N G T H E YE AR
• When an asset is purchased during the year, the following alternatives may be followed:
• (a) If the rate of depreciation is expressed as 10% or 20% without a mention of per annum, the depreciation would be
simply calculated as percentage of the total cost of the asset for full year. This is especially true when date of purchase or
date of sale is not given. However, if the date of purchase or sale is given and the rate of depreciation is expressed
without per annum, the depreciation must be calculated on the basis of time factor unless the examination problem
requires otherwise.
• (b) If the rate of depreciation is expressed as 10% or 20% per annum and the date of acquisition is also given, the
depreciation expense would be calculated with reference to the date of acquisition to the end of accounting period.
• (c) If the rate of depreciation is expressed per annum and the date of acquisition of the asset is not given, it would be
appropriate to calculate depreciation for 6 months on the assumption that it was acquired half way through the year. It
will be wrong in this case if the depreciation is charged for full year or no depreciation is charged at all. The point must
be clarified by giving specific note to this effect.
• (d) The effective date for charging the depreciation is that date when the asset has been put to use or where theasset is
ready for use irrespective of fact whether it is being used or not.