Depreciation

INTRODUCTION

The monetary value of an asset decreases over time due to use, wear and tear or obsolescence. This decrease is measured as depreciation.

Definition According to PICKLES, Depreciation is the permanent and continuing diminution in the quality or value of and asset

From the above definition it can be concluded that depreciation is a gradual decrease in the value of an asset from any cause.

OBJECTIVE OF DEPRECIATON 1. Reflect reduction in the book value of the asset

due to obsolescence or wear and tear, 2. Spread a large expenditure (Purchase Price of

the asset ) proportionately over a fixed period to match revenue receive from it,

3. Reduce the taxable income by charging the amount of depreciation against the company‘s total income

Causes of Depreciation 1. Wear And Tear

Wear and tear refers to a decline in the efficiency of asset due to its constant use. When an asset losses its efficiency, its value goes down and depreciation arises. This is true in case of tangible assets like plant and machinery, building, furniture, tools and equipment used in the factory.

2. Effusion of Time

The value of asset may decrease due to the passage of time even if it is not in use. There are some intangible fixed assets like copyright, patent right, and lease hold premises which decrease its value as time elapse.

Continuing 3. Exhaustion

An asset may loss its value because of exhaustion too. This is the case with wasting assets such as mines, quarries, oil-wells and forest-stand. On account of continuous extraction, a stage will come where mines and oil-wells get completely exhausted.

4. Obsolescence

Changes in fashion are external factors which are responsible for throwing out of assets even if those are in good condition. For example black and white televisions have become obsolete with the introduction of color TVs, the users have discarded black and white TVs although they are in good condition. Such as loss on account of new invention or changed fashions is termed as obsolescence

5. Accidents.

An asset may meet an accident and , therefore, it may get depreciated in its value.

Basic Features of Depreciation1. The Term depreciation is used only in respect of

fixed assets. Of course, the current assets may also lose their value. Loss on account of fall in their value is taken care of by valuing them for balance sheet purposes, at cost or market price whichever is less

2. Depreciation is a charge against profit. This means that true profit of the business cannot be ascertained without charging depreciation

Basic Features of Depreciation3. Depreciation is different from maintenance.

Maintenance expenses are incurred for keeping the machine in a state of efficiency. However. Any degree of maintenance cannot assure that the asset will never reach a state of scrap. Of course good maintenance delays this stage but it cannot absolutely prevent it

Basic Features of Depreciation4. All depreciation although the process

may be invisible or gradual

Methods of Depreciation Straight Line Depreciation Method Straight line method depreciates cost evenly throughout the useful life of the

fixed asset. Straight line depreciation is calculated as follows: Depreciation per annum = (Cost +Installation cost- Residual Value) / Useful Life

Where: Cost includes the initial and any subsequent capital expenditure. Residual Value is the estimated scrap value at the end of the useful life of the

asset. As the residual value is expected to be recovered at the end of an asset's useful life, there does no need to charge the portion of cost equal the residual value.

Useful Life is the estimated time period an asset is expected to be used from the time it is available for use to the time of its disposal or termination of use. Useful life is normally calculated in units of years but it may be calculated based on an alternative basis. Useful life of an oil extraction company may for example be the estimated oil reserves.

Example : An asset has a useful life of 3 years. Cost of the asset is $2,000. Residual Value is $500. Annual Depreciation cost will be $500 = (2000 - 500) /

3years Straight line depreciation method is appropriate where

economic benefits from the asset are expected to be realized evenly during its useful life. It is also convenient where no reliable estimate can be made regarding the pattern of economic benefits over an asset's useful life.

Example :A firm purchases a plant for a sum of 10,000 AFN on 1st January,2007. installation charges are 2,000 AFN. Plant is estimated to have a scrap value or 1,000 AFN at end of its useful life of fiver years. You are required to prepare Plant Account for five years charging depreciation according to Straight Line Method.

Example :ABC Co. Purchased Machinery Amount 20,00,000 on 1st January 2009, 25,000 was spent on Installation of the Machine. The Company follows Straight Line Method of Depreciation. Life of the Machine is 5 Years. Scrap Value is 2,00,000.

Example :The original cost of machine is 12,00,000 AFN it was purchased on 1-2-2008. it has a life of 5 years and a scrap value is 40,000 AFN. Depreciation is provided on the straight line method on 31st December each year. Prepare the machinery account for 4 years.

Diminishing Balance MethodUnder this method depreciation is charged at fixed

rate on this reducing balance

Formula

Where r stand for depreciation rate and S stands for salvage and C stands for cost of acquisition. The written down value methods acts as a tax shield. Asset never becomes Zero. This method can be applied only when there is some residual . This method is usuallly adopted in case of pant & Machinery

Merit of Diminishing Balance Method.1. Depreciation and repairs charges continues to be

uniform through the assets life. In the first year depreciation amount is higher and repair charges are less, but at the end of the assets life depreciation is less and repairs charges are more

2. It is easy and simple to understand this method

3. It is recognized by the tax authorities

Demerits1. It takes longtime to bring down the asset value to

scrap value

2. It is calculate depreciation rate

3. This method give more importance to historical cost

ExampleThe original cost of the machine is 9,00,000 it was

purchased on 01-04-2009. it has a life of 7 years and has scrap value of 25,000. Depreciation is provided on diminishing balanced method. The company closes accounts every year by 31st March . Prepare Machinery account for five years.

ExampleThe opening balance of furniture as on 1-1-2007 shows Amount 25,000 the rate of depreciation is 10 % per year and closes accounts annually on 31st March.

Prepare Furniture Account up to the end of financial year 2011.

ExampleABC Co. purchased a plant for 2,85,000 on 1-4-2007 and immediately installed it at and additional cost of 15,000 the company closes its books on 31st March every year. It follows diminishing balance method for providing depreciations @ 20 % p.a. show the plant account for four years.

Sum of Years digits MethodThis method is on the pattern of diminishing balance

method. The amount of depreciation to be charged to the profit and loss account under this method goes on decreasing every year the depreciation is calculated according to the following formula

formula= Remaining Life of the Asset / Sum of all the digits of the life of the asset in years * Original cost

ExampleIf the cost of an asset is 10,000 and it has 5 years life the amount of depreciation to be written off each year will be computed as follows