Depreciation Definition - Types, Method, Formula, Calculate depreciation

Meaning & Definition Of Depreciation 

Each business has certain assets that are necessary for the operation of business operations such as buildings, plants and machinery, motor vehicles, furniture, office equipment, etc. The life-span of all these properties is determined, after which these assets are useful for commercial purposes. Activities are closed. Constant decrease in their value and utility due to their continuous use or time lapse is called price loss. In other words, the process of sharing the value of permanent property over its useful life span is called 'Depreciation'.

Depreciation Formula Image
Depreciation  Formula

Definition Of Depreciation 

Various scholars have given the following definitions of value loss:

1. “Permanent and continuous reduction in the quality, quantity or value of a property, is called - William Pickles

2. “Price Haas is the measure of the end of the working life of property for any reason at any given time.” - Spicer and Pegler

3. 'It is a common knowledge that all permanent properties such as plants, machinery, buildings, furniture, etc. as they get old, their value declines and they become unusable by continuous use in business. - J.R. Batliboya

Characteristics Of Depreciation

  1. Depreciation refers to the decrease in the value of a permanent asset (excluding land).
  2. Such deficiency is of permanent nature. Once the value of the property decreases due to depreciation, the property cannot be brought back to its initial value.
  3. Depreciation is a silent and continuous process because the value of the property must decrease because of obsolescence, either through continuous use or over time.
  4. Depreciation is not a process of appraising property but it is a process of apportioning the cost of property over its working life.
  5. Depreciation reduces only the book value of a property and not its market value.
  6. The term depreciation is used only for tangible fixed assets. The term is not used for dilapidated properties such as mines, oil wells, etc.
  7. Depreciation is non-cash expenditure. This does not make the cash go out of business.

Causes of Depreciation

1. Continuous use - Continuous use of fixed assets breaks them and reduces their value.

2. Loss of time lapse - Most properties are such that whether they are used or not, their value becomes zero when a certain period of time is spent. Their price decrease is due to natural reasons like rain, strong winds, changes in weather, etc.

3. With the expiry of the period of legal rights - some properties are such that their life is absolutely certain, such as leased properties. For example, if a property is taken on a 20-year lease for Rs 5,00,000 then its value will decrease by 1/20 ie 25,000 every year and thus after 20 years its value will be reduced to zero, irrespective of its value. To use or not

4. Due to obsolescence - often due to the invention of a new invention or the introduction of new technology, the old property has to be used for a proportionate decrease in value.

5. Causes of accident - Many times a machine gets destroyed due to fire, earthquake, flood etc. or a vehicle crashes.

6. Causes of emptiness - Mines and oil wells etc. are those properties which have limited storage and they continue to empty due to the release of substances from them. Due to this, their value also keeps decreasing.

7. Permanent decrease in market value - The fluctuations in the market value of fixed assets are often ignored, as fixed assets are intended for use in business and not for resale. But some properties are such that if there is a permanent decrease in their value, then this decrease is considered as depreciation such as a permanent decrease in the value of appropriations.

In accounting, some other terms similar to depreciation have also been developed which are used to show the decrease in the value of different types of assets. These terms are explained below.

Depreciation: The term depreciation is used to indicate a decrease in the usefulness of a physical property such as a building, machinery, etc.

Depletion: The term Depletion is used for the measurement and accounting of natural means such as raw metal deposits, oil wells, drainage of mines. The difference between Depletion and Depreciation is that Depletion leads to a decrease in the availability of natural resources while depreciation indicates a reduction in the utilization capacity of an asset.

Amortization: The term underwriting is used for a proportionate reduction in the value of intangible assets such as patent, copyright, trade mark, reputation, etc.

Dilapidation: When a leased property is returned to its owner at the end of the lease term, its owner often demands that the property be in as good a condition as it was at the time of leasing. Deterioration is the amount that may be needed to bring the property to the initial stage. In order to make provision for disrepair, the lessee usually keeps some amount aside every year. This amount of disrepair adds to the cost of the leased property and is thus depreciated on the total cost fixed.

Factors determining the amount of depreciation

It is quite impossible to find the exact and exact amount of depreciation. This can only be approximated by keeping the following points in mind.

  1. Total cost of the property - In the purchase price of the property, all the expenses that have been incurred in bringing or establishing it, such as rent to bring the property, road insurance and the cost of its establishment, etc.
  2. Estimated useful life span of the property - The useful life period is the period in which the use of that property will be useful for business. For example, if a machine can run for 25 years but due to new inventions it will be used only for 15 years, then its estimated life span will be considered as 15 years.
  3. Estimated Residual Value of the property - The value obtained from selling it at the end of the life of the property is called the residual value/scrap value.

Estimated Scrap Value 

For Example, if a machine was bought for 6000 rupees, it cost 4000 rupees to bring it and it cost 1000 rupees for installation. According to Researcher's estimate, this machine will run for 10 years and after 10 years its scrap value will be 8000, then calculation of depreciation on this machine - 

60000+4000+1000-8000 = 57000

57000/7 = 5700 Per Year/Depreciation

Different Methods of Providing Depreciation

Several methods of depreciation are in use. Given the nature and nature of different properties, the method of depreciation is chosen on them. Following are the major methods of applying depreciation

  • 1. Fixed Instalment Method
  • 2. Diminishing Balance Method
  • 3. Annuity Method
  • 4. Depreciation Fund Method
  • 5. Insurance Policy Method
  • 6. Revaluation Method
  • 7. Depletion Method
  • 8. Machine Hour Rate Method

We will tell you about the most popular methods which are used the most. It is very easy to calculate depreciation from 2 methods.

Fixed Installment Method/Original Cost Method

It is also called the Original Cost Method because in this method depreciation is imposed on the original cost of the property by a certain percentage per year. This method has the same amount of depreciation every year, so this method is also called Equal Instalment Method or Straight Line Method. The amount of depreciation is calculated by subtracting its scrap value from the original cost of the asset and dividing the remaining amount by the years of the lifetime of the asset. Thus by deducting the same amount every year as depreciation, at the end of the lifetime of the property, the value of the property remains zero or equal to its Scrap Value. Following is the formula to calculate depreciation by this method:

Yearly Depreciation Original Cost of the Asset- Estimated Scrap Value / Estimated Life of the Asset

For example, If the original cost of a property is 1,00,000 and after 10 years its scrap value will be 15,000, then 1,00,000 - 15,000 = 85,000 per annum of depreciation will be written off.

Merits of Original Cost Method

  1. Simplicity - In this method it is very easy to calculate depreciation. Hence this method is quite popular.
  2. Equality of Depreciation Burden - In this method the same amount of depreciation is carried every year to the profit-loss account, ie the profit-loss account has the same effect every year.
  3. Assets can be completely written off - In this method, the book value of the property can be reduced to zero or its Scrap Value, which is not possible in some other methods.
  4. Knowledge of Original Cost and Up-to-date depreciation - In this method the position statement is shown by subtracting the total loss of the property from the original cost of the property till date, so It keeps track of the original cost of the property and the total depreciation till date. Different identities of different assets are also maintained in this method.

Demerits of Original Cost Method

  1. Difficuly in Computation: - If there are many machines and their lifetime is also different then calculating the depreciation becomes quite complicated task because the calculation of depreciation has to be done on each machine separately.
  2. Unequal Charge against income: - As the property gets old, repair expenses increase on it, but because the same depreciation is imposed every year in this method, so the depreciation and repair expenses are combined and the total written to the profit and loss account. The expenses will not be same every year. There will be less burden on the profit and loss account in the first few years and this burden will increase in later years.
  3. Undue pressure in later years: - Continuous use of the property reduces its usefulness and efficiency, so depreciation should be cut more in the first years and the loss should decrease in later years whereas In this method, the amount of depreciation remains the same every year, which is not appropriate.
  4. Omission of Interest Factor: - In this method, no arrangement of interest is made on the capital appropriated in the property whereas if the capital was appropriated elsewhere, the interest would have been received.
  5. Reducing the value of property to zero (Unrealistic to write off the value of asset to zero): - In this method, sometimes the value of property becomes zero while the property continues to be used even after that in business.
  6. Difficulty in the determination of scrap value - After 15 or 20 years of establishment of the property, it is a difficult task to determine what its residual value will be.

Suitability - This method is useful for properties whose useful life span can be accurately estimated and on which repair expenses are very low.

Accounting Method - In this method, the following entries are made.

1. Purchase entry of property:

Assets A/c 

To Bank A/c / Vender A/c

2. Applying depreciation at the end of each year:

Depreciation  A/c 

To Assets A/c

3. Entry of amount received from sale of property:

Bank A/c 

To Assets A/c

4. In case of loss on sale of property:

Profit & Loss A/c /Statement oF Profit & Loss A/c

To Assets A/c

5. In case of profit on sale of property:

Assets A/c

Profit & Loss A/c /Statement oF Profit & Loss A/c

Important Notes - * In case of companies, 'Statement of Profit & Loss' is prepared in place of Profit & Loss A /c.

Example 1

On 1 April 2009, Atul Glass Limited purchased a machine for 90,000 and spent 6,000 rupees and 4,000 for its installation. On the date of purchase it was estimated that the machine. It will run for 10 years and at the end of 10 years the residual value of the machine will be Rs. 20,000.

First four years make machine account and loss account, while depreciation is done using permanent installment method. The accounts are closed every year on 3 March.

When the rate of depreciation is not given in the question, the depreciation is calculated as follows:

Annual Depreciation = Cost Of Assets - Scrap Value/Residual Value /Estimated Life Of Assets

Rate Of Depreciation = Amount Of Depreciation/Total Cost Of Assets *100

Calculation - 

Annual Depreciation  = Cost Of Assets - Scrap Value /  Estimated Life Of Assets

100000-20000/10 = 8000

Rate Of Depreciation = Amount Of Depreciation / Total Cost Of Assets * 100

8000/100000*100 = 8%

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