What Is Depreciation?

What is Depreciation?

Depreciation
Introduction
Fixed assets are the assets which are used inwards delineate organisation for to a greater extent than than i accounting year. Fixed assets (technically referred to every bit "depreciable assets") tend to cut down value i time they are seat to use. In other words, if a delineate organisation company procures a machine in addition to uses it inwards production physical care for in addition to so the value of machine declines amongst its usage. Even if the machine is non used inwards production process, nosotros cannot aspect it to realize the same sales toll due to the passage of fourth dimension or arrival of a novel model (obsolescence). It implies that fixed assets are discipline to reject inwards value in addition to this reject is technically referred to every bit depreciation.

Meaning in addition to definitions
In full general words, depreciation is the reduction inwards the value of an property due to usage, passage of time, wears in addition to tea, technological outdating or obsolescence, depletion, inadequacy, decay or other such factors.

In accounting, depreciation is a term to depict whatever method of attributing the historical or buy cost of an property across its useful life. Roughly corresponding to normal vesture in addition to tear. It is mostly used when dealing amongst assets of a short, fixed service life, in addition to which is an illustration of applying the matching regulation every bit per to a greater extent than often than non accepted accounting principles.

Depreciation is calculated on all depreciation assets which tin hold out defined every bit those which remove hold a useful life for to a greater extent than than i accounting menses but is limited in addition to are held past times an company for utilization inwards the production or provide of goods in addition to service. Examples of depreciable assets are machine, plants furniture, building, computers, trucks, vans, equipments, etc. mover, depreciation is the resources allotment of depreciable amount'. Which is the "historical cost", or other amount substituted for historical cost less estimated preserve value.

The American institute of certified world accountants defines depreciation every bit "depreciation for the yr is the share of the total accuse nether such a scheme that is allocated to the year."

According to institute of cost in addition to management accounting, London (ICMA) terminology, "the depreciation is the diminution inwards intrinsic value of the property due to utilization and/or lapse of time."

Depreciation has a meaning effect inwards determining in addition to presenting the fiscal seat in addition to final result of operations of an enterprise. Depreciation is changed inwards each accounting menses past times referred to the extra of the depreciable amount.
In this way, depreciation is an resources allotment of the cost of assets over their useful life. Influenza A virus subtype H5N1 systematic physical care for for allocating the cost over the menses of its useful life inwards a rational trend is called depreciation accounting.

Features of depreciation
Above mentioned give-and-take highlights the next features of depreciation:
1.    It is reject inwards the mass value of fixed assets.
2.    It includes loss of value to effusion of time, usage or obsolescence.
3.    It is a continuing physical care for till the terminate of the useful life of assets.
4.    It is an expired cost in addition to hence must hold out deducted before calculating taxable profits.
5.    It is a non-cash expense. It does non involve whatever cash outflow.
6.    It is physical care for of writing-off the working capital missive of the alphabet expenditure already incurred.

Cause of depreciation
Depreciation may hold out said to arise from 2 cause-internal in addition to external. Internal deprecation arises from the performance of whatever drive natural to, or inhere rent in, the property itself. External depreciation arises from the performance of forces external to the asset. These remove hold been discussed below:

Internal causes
a.    Wear in addition to tear
"wear in addition to tear" is an importance drive of deprecation inwards the illustration of tangible fixed assets similar building, machinery, furniture, fixtures, tools, fittings, etc. "wear in addition to tear" final result from friction, vibration, strain, chemic reaction, weathering, intensity of the use, tending inwards handling, criterion of maitatenace, manor accidents inevitable inwards the handling of plant, etc. the term "depreciation" is to a greater extent than often than non used to dot the expired utility of an property due to reasons mentioned above.
b.    Depletion
Depletion is also i of the internal causes of decrease inwards the value of wasting assets such every bit manes, quarries, oil-wells in addition to forest-stands. The term "depletion" (neither "amortization" none "depreciation") is correctly used to refer to the expired utility of a wasting assets.

External causes
a.    obsolescence
In many cases, a detail machine is discarded before it is completely worn-out. This agency that at that topographic point are exactly about external factors also which are responsible for throwing out of utilization an property which is inwards expert condition. For illustration amongst the advent of electrical in addition to diesel fuel locomotives, current locomotives remove hold been discarded although they are inwards expert condition. This is a illustration of obsolescence. Similarly amongst the introduction of colouring textile TVs. Models of dark in addition to white TVs. Have move obsolete in addition to users remove hold discarded them although they are inwards expert condition. Obsolesce tin arise from such factors as
•    technological changes every bit a final result of continuousreserch resulting inwards technical improvements to the assets or emergence of to a greater extent than productive assets;
•    improvement inwards production methods;
•    modify inwards marketplace need for the production or service output of the assets;
•    Legal or other restrictions.
b.    inadequacy
When at that topographic point is a modify inwards the scale of operations it may Pb to the discarding of sure enough assets. For examples, a delineate solid because of the introduction of sophisticated appointment processing scheme may remove hold to discard the equipment nether manual system. Similarly, industrial plant life assets which cannot hold out utilized amongst optima mum efficiency because of changes inwards the scale of operations volition remove hold to hold out discarded fifty-fifty if they are inwards audio condition.

In the illustration of both obsolescence in addition to inadequacy, at that topographic point is no enquiry of scrapping the assert. These assets may hold out utilization to other enterprises in addition to so tin hold out sold to such other enterprise. Obsolesce in addition to inadequacies are also classified every bit economical or functions factors causing depreciation.

Effluxion of time
There are exactly about intangible fixed assets which decrease inwards value every bit fourth dimension elapses. For example, if Rs. 50,000 are paid for a sure enough lease( excluding lease of mine) for 10 years, in addition to so amongst the lapse of every years the value of the assets goes downwardly past times Rs. 50,000 whether, utilized or not. Its value is reduced to null at the terminate of the tenth year. Copyrights, patent rights are other illustration of intangible of intangible fixed assets which decrease inwards value due to effluxion of time. The term "amortization" is to a greater extent than often than non used to dot the autumn inwards the value of such assets.
   
Another way to form out causes of depreciation is to listing them every bit physical deterioration (wear in addition to tear discussed above), economical or functions factors (obsolescence in addition to inadequacy), the fourth dimension element in addition to depletion.
Factors affecting the amount of depreciation
The conclusion of depreciation depends on 3 parameters; viz. cost estimated useful life in addition to in all probability preserve value.
Cost of asset: cost (also known every bit master copy cost or historical cost) of an assets included invoice toll in addition to other cost, which are necessary to seat the property inwards utilization or working condition. Besides the buy price, it included freight in addition to transportation cost, transit insurance, installation cost, registration cost, price, it included freight in addition to transportation cost, transits insurance, installation cost, registration cost, committee paid on buy of assets add together items such every bit software, etc. inwards illustration of buy of a minute manus assets it included initial repair cost to seat the property inwards workable conditition. According to accounting standard-6n of ICAI, cost of a fixed property is "the total cost spent inwards connectedness amongst its acquisition, installation in addition to commissioning every bit good every bit for improver or improvement of the decipherable assets". For example, a photocopy machine is buy for Rs. 50,000 in addition to Rs. 5,000 is spent on its transportation in addition to installation. In this illustration the master copy cost of thee machine is Rs.55, 000 (i.e. Rs.50, 000 + Rs.5, 000) which volition hold out written off every bit depreciation over the useful life of the machine.

Estimated cyberspace residual value: cyberspace residual value (also known every bit crap value or preserve value for accounting purposes) is the estimated cyberspace realizable value (or sale value) of the property at the terminate of its useful life. The cyberspace residual value (or sale value) of the property at the terminate of its useful life. The cyberspace residual value is calculated after deducting the expenses necessary for the disposal of the asset. For example, a machine is purchased for Rs. 50,000 in addition to is expected to remove hold a useful life of 10 years. At the terminate of tenth yr it is expected to remove hold a sale value of Rs. 6,000 but expenses related to its disposal are estimated at Rs. 1,000. Then its cyberspace residual value shall hold out Rs. 5,000 (i.e. Rs. 6,000 – Rs. 1,000).

Estimate useful life: useful life of an property is the estimated economical or commercial life of the asset. Physical life is non of import for this purpose because every bit assets may notwithstanding be physically but may non hold out capable of commercially variable production. For example, a machine is purchased in addition to it is estimated that it tin hold out used inwards production physical care for for five years. After five years the machine may notwithstanding hold out inwards expert physical status but can't hold out used for production profitably, i.e. if it is notwithstanding used the cost of production may hold out rattling high.  Therefore, the useful life of the machine is considered every bit five years irrespective of its physical life. Estimation of useful life of an property is default every bit it depends upon several factors such every bit usage degree of asset, maintenance of the asset, technological changes marketplace changes, etc. every bit per accounting standard-6 useful life of an property is unremarkably to "period over which it is expected to hold out used past times the enterprise". Normally, useful life is shorter than the physical life. The useful life of an property is expressed inwards number of yard but it tin also hold out expressed inwards other units. E.g., number of units of output (as inwards illustration of mines) or number of working hour. Useful life depends upon the next factors:

•    Pre-determined past times legal or contractual limits, e.g. inwards illustration of leasehold asset, the useful life is the menses of lease.
•    The number of shifts for which property is also used.
•    Repair in addition to maintenance policy of the delineate organisation organization.
•    Technology obsolesces.
•    Innovation/ impartment inwards production method.
•    Legal or other restrictions.

Objective of providing depreciation
The depreciation on assets is provided inwards lodge to accomplish the next objectives:-
To calculate proper profit: depreciation is an operating accuse against the year's electrical current income because an property is an importance tool inwards earning revenues. The autumn inwards the mass value of assets reflects the cost of earnings from the utilization of property inwards the year, hence similar other costs viz. wages, salaries etc., depreciation must also hold out changed to revenue. It is, therefore, necessary to accuse depreciation to revenue income inwards lodge to ascertain right profits for the year.

To exhibit the property at its existent values: depreciation is provided to cut down the cost of assets to the extent of unexpired cost. If the depreciation is non changed, it agency the property is beingness shown inwards the residue canvas at its overstated value. Hence, inwards lodge to exhibit the assets at its existent value inwards the residue sheet, depreciation is a must.

To supervene upon the asset: depreciation cut down the amount of turn a profit in addition to saves the cash resources of the concern to the extent of depreciation from beingness distribute past times way of dividend. The amount so saved tin hold out aside every yr in addition to invested, is able to attain every bit much amount every bit necessary to supervene upon the property at the terminate of the life of the asset.

To cut down the tax-liability: past times charging depreciation to turn a profit in addition to loss account, the taxable profits of the companionship are reduced. It is an admissible deduction nether income taxation human activity thus it reduces the taxation liability of the concern.

To ascertain accurate cost of production: inwards manufacturing concerns especially, cost of production cannot hold out accurately determined unless depreciation cost has been considered inwards the calculations.


Accounting handling of depreciation
First method: when provision for depreciation delineate organisation human relationship is non maintained
Under this method, the assets look at what is called mass value namely, cost less depreciation. In the residue canvas property is shown at the mass value at the terminate of the year.
Second method: amongst maintaining provision for depreciation account

Under this method the assets e'er appears at master copy cost yr after year. In the residue canvas property is shown at master copy cost less depreciation provision. The amount of the credit of provision for depreciation delineate organisation human relationship shows the total depreciation written off to date. This method is to a greater extent than revealing every bit i tin empathise the relative historic menses of the property having regard to the cost of property in addition to the cumulative depreciation indicated past times the provision for depreciation account.
Methods of providing depreciation
The depreciation amount to hold out charged for during an accounting yr depends upwardly on depreciable amount in addition to the method of allocation. For this, 2 methods are mandated past times police in addition to enforced past times professional person accounting exercise inwards Nepal. These method are direct delineate method in addition to written downwardly vale method. Besides these 2 primary methods at that topographic point are other methods too. The choice of an appropriate method depends upon the following:
•    Types of the asset;
•    Nature of the utilization of such asset;
•    Circumstances prevailing inwards the business;
The selected depreciation method should hold out applied consistently from menses to period. Change inwards depreciation method may hold out allowed alone nether specific circumstances.

The virtually mutual methods of providing depreciation are mentioned below:
1.    Straight-line method
This is the earliest in addition to i of the widely used methods of providing depreciation. This method is based on the supposition of equal usage of the property over its entire useful life. It is called direct delineate for the argue that if the amount of depreciation in addition to corresponding fourth dimension menses is plotted on a graph, it volition final result inwards a direct line.

It is also called fixed installment method because the amount of depreciation remains constant from yr to yr over the useful life of the asset. According to this method, a fixed in addition to an equal amount is accuse every bit depreciation inwards every accounting menses during the lifetime of an asset. The amount annually charged every bit depreciation is such that it reduces the master copy cost of the property to its crap aloe, at the terminate of its useful life. This method is also known every bit fixed pct on master copy cost method because same pct of the master copy cost (in fact depreciable cost) is written off every bit depreciation from yr to year. The depreciation amount to hold out provided nether this method is computed past times using the next formula:

Depreciation= cost of assets- estimated residual value/ estimated useful life of the assets
   
Rate of depreciation nether direct delineate method is the pct of the total cost of the assets to hold out charged every bit depreciation during the useful lifetime of the asset. Rate of depreciation is calculated every bit follows:
Rate of depreciation= annual depreciation amount/ cost of property x 100

Advantages of direct delineate method
Straight delineate method has sure enough advantages which are started below:
•    It is rattling simple, slow to empathise in addition to apply. Simplicity arrive a pop method inwards practice;
•    Asset tin hold out depreciation upwardly to the cyberspace crap value or null value. Therefore, this method makes it possible to distribute total depreciable cost over useful life of the asset:
•    Every year, same amount is charged every bit depreciation inwards turn a profit in addition to loss account. This makes comparing of turn a profit for unlike years easy;
•    This method is suitable for those assets useful life tin hold out estimated accurate in addition to where the utilization of the property is consistent from yr to yr such every bit leasehold buildings.

Disadvantages of direct delineate method    
Although direct delineate method is elementary in addition to slow to apply it endure from sure enough limitations which are given below:
•    This method is based on the faulty supposition of same utility of the property inwards deviation accounting years;
•    With the passage of time, piece of employment efficiency of the property decrease in addition to repair in addition to maintained expense increase. Hence, nether this method this method total amount charged against turn a profit on delineate organisation human relationship of depreciation in addition to repair taken tougher volition non hold out uniform throughout the life of the asset, rather it volition move on on increasing from yr to year.

2.    Diminishing residue method
This method is also known every bit reducing or diminishing residue or written downwardly value method. Under this method, a depreciation pct charge per unit of measurement is applied to the acquisition or structure cost at the showtime of the accounting menses rather than thee master copy cost. Hence, a fixed pct of the diminishing value of the property is written off each yr so every bit to cut down the property to its break-up or combat value at the terminate of its life in addition to the annual accuse for depreciation decrease from yr to yr the effect is the terminate of its life in addition to the annual accuse for depreciation decrease from yr to year. The effect is that his initial years bring a higher hitting of depreciation chare every bit compared to the afterward years. Unlike the straight-line method where the cost of property is completely written-off, this never happens inwards the reducing residue method. It must hold out noted that preserve value is non considered inwards the calculation of depreciation. However, the mass value of the property is never brought below its preserve value.

The charge per unit of measurement of depreciation nether this method is determined past times the next formula:

N= number of years

Depreciation is charged at this charge per unit of measurement on the master copy cost of the property inwards the initiatory of all yr in addition to on mass value or written downwardly value of the previous yr from 2d yr onwards.

Advantages of diminishing residue method
1.    It is elementary to figurer depreciation nether this method.
2.    The storage dot inwards favor of this method is that nether it the total burden imposed on turn a profit in addition to loss delineate organisation human relationship due to depreciation in addition to repairs remains to a greater extent than or less equal yr after yr since the amount after depreciation goes on diminishing amongst the passage of fourth dimension whereas the amount of repairs goes on increasing an property grow older.
3.    Separate calculations are unnecessary for additions in addition to extensions, idea inwards the initiatory of all yr exactly about complications usually arise on delineate organisation human relationship of the fact that additions are to a greater extent than often than non made inwards the middle of the year.

Disadvantages of diminishing residue method
1.    This method ignores the enquiry of involvement on working capital missive of the alphabet invited inwards the property in addition to the replacement of the assets.
2.    This method cannot cut down the mass value of an property to null if it is desired.
3.    Very high charge per unit of measurement of depreciation would remove hold to hold out adopted otherwise it volition bring a rattling long fourth dimension to write an property downwardly to its residual value.
4.    A lower application of the pct used for computing depreciation may hold out harmful to the company leading to lower accuse of depreciation in addition to leading to nether accuse inwards the income statement. This may Pb to the company non selling aside plenty resources to supervene upon the property at the terminate of its useful life.

This method is virtually suited to computer program in addition to mechanism where additional in addition to extensions bring house so often in addition to where the enquiry of repairs is also rattling important. Written downwardly value method or reducing installment method does non adapt the illustration of lease, whose value has to hold out reduced to zero.

Change of depreciation method
Once a method of depreciation is selected past times the management, it should hold out applied consistently. That would ensure comparability of final result from menses to period. However, management may modify the method for the next reasons:
1.    Statutory compulsion
2.    Required past times an accounting standard
3.    Change would final result inwards a to a greater extent than appropriate training or presentation of the fiscal statements of an enterprise.
The modify may hold out made prospectively (from the electrical current year) or retrospectively.

1.    Change inwards electrical current yr (prospectively)
When the modify inwards the method is prospectively, unamortized depreciation amount of the assets should hold out changed to revenue over the remaining useful life past times applying the novel method. Such a modify should hold out treated every bit a modify inwards accounting policy in addition to its effect should hold out quantified in addition to disclosed.

Change retrospectively
Under this method of depreciations is changed considering the effect from the previous years. The modify is affected retrospectively amongst the next steps:
•    Calculate the depreciation on the property from the dorsum appointment past times adopting the novel method in addition to novel charge per unit of measurement upwardly to terminate of the previous year.
•    Find out the depreciation on the property already provided at the onetime rate.
•    In the electrical current the yr inwards improver to the depreciation for the electrical current year, accuse also the deviation nether (a) in addition to (b) mentioned above.

Annuity method
Under this method, it is assumed that the amount spent inwards the buy of the assets is an investment which should earn interest. The amount spent is accruing an property is assumed every bit an investment in addition to involvement is charged at a sure enough charge per unit of measurement on the diminishing residue of assets in addition to is debited to assets delineate organisation human relationship in addition to credited to involvement delineate organisation human relationship which is transferred to turn a profit in addition to loss account. The property is credited yr past times years amongst a fixed amount of depreciation. The amount of depreciation changed every yr is such that is spite of property beingness debited amongst involvement every year; the property is reduced to null or its residual value. The amount of depreciation is calculated on the footing of annuity table.

When additional are made to the property account, calculations remove hold to hold out revised. This method is used inwards the illustration of leases having large amounts spread over a number of years.
Advantages
The next are the advantages of the annuity method:
1.    This method takes involvement on working capital missive of the alphabet investment inwards the property into account.
2.    It is regarded every bit virtually exact in addition to precise from the dot of stance of calculations so it a scientific method.
Disadvantages
The next are the disadvanges of the annuity method:
1.    The method is hard to understand.
2.    The burden on turn a profit in addition to loss delineate organisation human relationship goes on increasing amongst the passage of fourth dimension whereas the amount of depreciation charged each yr remains constant. The amount of involvement credited goes on diminishing every bit years top by, the ultimate number beingness that the cyberspace burden on turn a profit in addition to loss delineate organisation human relationship grows heavier each year.
3.    When the property required frequent additions in addition to extensions, the calculation remove hold to hold out changed frequently, which is rattling inconvenient.

Sinking fund method or depreciation fund method
The higher upwardly discussed methods do non assist inwards accumulating the amount of depreciation which tin hold out readily available for the replacement of the assets when it is completely unusable. Sinking fund method is designed inwards such a way that it incorporates the advantages of depreciating the assets every bit good every bit accumulating the necessary amount for its replacement.

Under this method, a fixed amount is debited every yr to depreciation delineate organisation human relationship credited to depreciation fund delineate organisation human relationship instead of property account. The property is shown at its master copy cost, inwards the books, inwards every year. The amount which is credited inwards the sinking fund is invested inwards gilt-edged securities. The involvement on such investment is also invested inwards similar securities. The securities are readily convertible into cash, investment are buy every year. When the assets move useless, the investments are sold away in addition to thus novel assets tin hold out purchased without disturbing the fiscal position. This method is adopted peculiarly when it is desired non but to write off an property but also to provide plenty funds to supervene upon the property at the terminate of its working life. The amount laid aside every bit depreciation is such that this, amongst chemical compound interests, volition hold out sufficient to run into the cost of novel asset, less combat value, it any, for replacement. The depreciation nether this method tin hold out calculated amongst the assist of a sinking fund tabular array for a detail menses at a given charge per unit of measurement of interest.

Advantages of depreciation fund method or sinking fund method:
1.    It makes available a amount of coin for the replacement of the property past times maintaining separate provision.
2.    It helps to strength fiscal seat of a concern.
Disadvantages of the depreciation fund method or sinking fund method:
1.    The burden on turn a profit in addition to loss delineate organisation human relationship goes on increasing every bit years top past times since the amount of depreciation every yr remains same but the amount spent on repairs goes or increasing every bit the property becomes old.
2.    It creates complication due to frequent investment.
3.    Price of securities may autumn at the fourth dimension they are to hold out realized every bit a final result of which loss may remove hold to hold out suffered.

Insurance policy method
In this method, the delineate organisation takes a policy from an insurance company. The amount of the policy is such that every bit it is sufficient to supervene upon the property when it is worn out. The insurance companies concur to pay a lump amount inwards render for a amount known every bit premium to hold out paid at the showtime of every year. The amount so made available past times the insurance companionship is used for purchasing a novel asset.

Double declining residue method
According to this method, the depreciation is charged on the reducing residue method but the charge per unit of measurement of depreciations is determined past times multiplying the direct delineate charge per unit of measurement past times 2.

Sum of years digits method (SYD)   
Sum of the years' digits method an accelerate method of depreciation which is is also based on the supposition that the loss inwards the value of the fixed property volition hold out greater during the before years in addition to goes on decreasing gradually amongst the decrease inwards the life of such asset. The SYD is industrial plant life past times estimating an asset's useful life inwards years, in addition to so assessing consecutives consecutive numbers to each year, in addition to totaling to derive numbers for n years:

SYD= 1+2+3+4+ ……. + n

Machine hr charge per unit of measurement method
Under this method, the total number of working hours of a machine during the whole of its effective life is estimated, in addition to and so the cost of machine is divided past times the expected number of hours of useful life, this gives the charge per unit of measurement per hour.
Revaluation method
Under this method of depreciation, an property is shown at its electrical current value. The deviation betwixt its electrical current value in addition to the mass value at the terminate of each according yr is written off every bit depreciation. This method is appropriate inwards illustration of assets of pocket-size value similar livestock, liberate tools packages etc.

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