Depreciation Accounting & Its Causes

 

What is the depreciation in accounting?

Depreciation is the allocation of the cost of fixed assets over the years of its working life. Indian Accounting Standard (AS-6) states that Depreciation is allocated so as to charge a fair proportion of the depreciable amount in each accounting period during the expected useful life of the assets.

Long-term fixed assets are used in the process of earning revenue. Due to regular use, such assets gradually lose their service potentials. Such losses are considered as expired costs which have to be matched against the periodic revenues. The Latin word depretium literally means a reduction of value.

So Depreciation means the reduction in the value of assets which has to consider for determining revenue. R.S.Anthony and J.S.Reece observed that the cost of an asset that has a long but nevertheless limited life is systematically reduced over that life by a process called Depreciation.

Is depreciation an asset?

What do you think?? The depreciation is not a current or fixed asset. Depreciation is a non-cash expense. But net profit is Calculated after charging it. 

Depreciation is allocated for every accounting period as a cost or as an expense that is matched against the revenue of such period. Although it is a measure of the decrease in the value of assets put to use, it is actually a process of allocation. 

For this reason, International Accountingstandard (IAS)-4 provides that Depreciation is the allocation of the depreciable amount of an asset over its estimated useful life. 

In accounting Research Bulletin No. 22, AICPA observed that Depreciation for the year is the portion of the total charge under such a system that is allocated to the year. Although the allocation may properly take into account occurrence during the year, it is not intended to be the measurement of the effect of all such occurrences.

What are the internal and external causes of Depreciation:

A) Internal:

• Wear and tear: Plant & Machinery, Furniture, Motor, Vehicles, etc. suffer from loss of utility due to vibration, chemical reaction, negligent handling, rusting, etc.
• Depletion (or exhaustion): The utility resources of wasting assets (like mines etc.) decreases with regular extractions.

B) External or Economic causes:

• Obsolescence: Innovation of better substitutes, change in market demand, the imposition of legal restrictions may result in discarding assets.
• Inadequacy: Changes in the scale of production or column of activities may lead to discarding as assets

C) Time element: 

With the passage of time some intangible fixed assets like leases, patents, copyrights, etc., lose their value or effectiveness, whether used or not. The word amortization is a better term to speak for a gradual fall in their values.

D) Abnormal occurrences: 

An Accident, fire, or natural calamity can damage the service potential of an asset partly or fully. As a result, the effectiveness of the asset is affected and reduced.

Factors on which  Depreciation depends:

1. Historical (original) cost: This includes money spent for acquisition, installation, addition, and improvement of fixed assets, cost of the asset, wages paid for installation, transportation costs, legal expenses for registration of lease agreement, etc, are included. Therefore, historical cost refers to all-expense incurred before an asset is brought into use.
2. Useful life of the asset: It is the estimated period over which the utility of an asset will be enjoyed. It depends upon (a) legal or contractual provisions regarding the lease, etc., (b) level of use of the asset, (c) degree of maintenance, and (d) technological developments. Useful life is shorter than the physical life of an asset.
3. Estimated residual value: It is the value expected to be realized after the complete commercial utilization of a fixed asset.
4. Other relevant Factors: Some other relevant factors may be considered for deciding the amount to be charged as depreciation. These are --   

          a) Replacement cost is the cost that would be incurred if the old asset has to be replaced by a new asset.

         b) Provision of the Companies Act, Income Tax Act regarding depreciation.

         c) Costs of probable additions, alterations, or improvements of the existing asset.

Objects of Charing Depreciation:

 Eric Kohler defined depreciation as " the lost usefulness, expired utility, the diminution in service yield". Its measurement and charging are necessary for cost recovery. It is treated as a part of the expired cost for an asset. For the determination of revenue, that part or cost should be matched against revenue. The objects or necessities of charging depreciation are:

1. Correct calculation of the cost of production:  Depreciation is an allocated cost of a fixed asset. It is to be calculated and charged correctly against the revenue of an accounting period. It must be correctly included within the cost of production.
2. Correct calculation of profits: Costs incurred for earning revenues must be charged property for correct calculation of profits. The consumed cost of assets ( depreciation) has to be provided for the correct matching of revenues with expenses.
3. Correct disclosure of fixed assets at reasonable value: Unless depreciation is charged. The depreciable asset cannot be correctly valued and presented in the Balance Sheet. Depreciation is charged so that the Balance Sheet exhibits a true and fair view of the affairs of the business.
4. Provision of replacement cost: Depreciation is a non-cash expense. But net profit is Calculated after charging it. Through annual depreciation, cash resources are saved and accumulated to provide replacement costs at the end of the useful life of an asset.
5. Maintainance of Capital: A significant portion of capital has to be invested in purchasing fixed assets. The values of such assets are gradually reduced due to their regular use and passage of time. Depreciation on the assets is treated as an expired cost and it is matched against revenue. It is charged against profits. If it is not charged the profits will remain inflated. This will cause capital erosion.
6. Compliance with technical and legal requirements: Depreciation has to be charged to comply with the relevant provisions of the Companies Act and Income Tax act.

Problems of Measurement Of Depreciation:

1. The difficulty of ascertaining working life: It is really difficult to summarise the exact working life of an asset. Where the duration of the benefits of the assets is time-bound, like those of a leasehold asset, no problem arises. But in other cases, it becomes guesswork that takes into consideration -- (a) the nature of the asset; (b) the quality of the asset; (c) expert's opinions, and (d) previous experience. These are all conjectures found to vary. Thus an asset may become incapable of rendering service before its anticipated expiry date. On the other hand, its effectiveness may remain alive much after such date.
2. Estimation of residual value: Under the conservative approach, the residual value is taken below the expected value at the end of the useful life of an asset. This, at best, helps to avoid unforeseen losses. But residual value also depends upon market conditions, technological advancements, etc. So, its correct estimation often proves itself misleading.
3. Unwarranted happenings: Change of law, technological development, innovation, etc., may cause a drastic reduction or write-off of an asset. These external factors suddenly affect the re-determined quantum of depreciation. On the other hand, over-use or underuse of assets may also tell upon the amount of depreciation.

Accounting Implication of Depreciation:

1. Depreciation is a charge against profits. It is t a cash cost. It is a notional loss. the estimated depreciation of an accounting period is matched against revenues of that period. The profit or loss of that period is calculated after charging depreciation.
2. It is a compulsory charge. It is not an appropriation of profits. Unless it is considered, the process of matching costs with revenues becomes defective.
3. Depreciation, as already pointed out, helps to arrive at the correct profit or loss. Final accounts can be correctly prepared only when depreciation has been correctly charged.
4. Depreciation is necessary to value fixed assets at the end of each accounting period. Unless it is charged, the assets become overstated.
5. Due to inflation, the effective capital of a business is recorded continuously. It means, more amount of capital become needed to replenish the same amount of assets consumed or utilized every year in the process of production. By charging adequate depreciation, a proper balance of real capital is maintained.
6. Old order change yielding place to new. This age-old belief obviates the charging of depreciation. Old may be gold but that cannot be expected to last forever. Decay and senility have to be accepted for which the concept of depreciation has to be applied as a yardstick of measurement, of such decay.
7. Depreciation Accounting paves the way for the replacement of assets. When the effective and working life of an asset comes to an end, it is replaced by a new asset. Depreciation, being a notional cost, helps to set aside a fund every year. such fund is utilized to acquire the net asset. Thus the requirement of additional capital or loan can be avoided.