Depreciation Explained: Meaning, Causes, Methods & Examples
Depreciation – 20 Marks Answer
1. Meaning of Depreciation
Depreciation is the gradual and permanent decrease in the value of a fixed asset due to wear and tear, usage, passage of time, or obsolescence. It is considered a revenue expenditure because it is charged to the Profit and Loss Account annually.
Key Definitions:
ICAI: “Depreciation is the decrease in the value of an asset due to wear and tear, obsolescence, or efflux of time.”
Spicer & Pegler: “Depreciation is the measured amount of the cost of a tangible fixed asset that is allocated as an expense during an accounting period.”
2. Need for Depreciation
To allocate the cost of an asset over its useful life.
To determine true profit, as assets lose value over time.
To show the true financial position of the business.
To maintain reserves for replacement of old assets.
To comply with accounting standards and legal requirements.
3. Causes of Depreciation
Wear and Tear: Physical usage of assets like machinery, vehicles, furniture.
Obsolescence: Asset becomes outdated due to technological advancement.
Efflux of Time: Depreciation due to the passage of time, even if not used.
Accidents or Natural Causes: Damage due to accidents, fire, or natural disasters.
4. Objectives of Depreciation
To allocate asset cost systematically over its useful life.
To ascertain correct profit by matching expenses with revenue.
To present a true financial position of the business.
To provide funds for replacement of worn-out assets.
To comply with accounting standards and ensure uniformity.
5. Methods of Providing Depreciation
A. Straight Line Method (SLM)
Definition: Depreciation is charged equally every year over the useful life of the asset.
Formula:
Depreciation = (Cost of Asset − Scrap Value) / Useful Life
Example: Asset cost = 50,000, scrap value = 5,000, life = 5 years → Depreciation = (50,000 − 5,000) / 5 = 9,000 per year
B. Diminishing Balance Method (Reducing Balance)
Definition: Depreciation is charged on the reducing book value of the asset each year.
Formula:
Depreciation = Book Value at Beginning × Depreciation Rate (%)
Example: Book value = 50,000, rate = 10% → 1st year = 5,000; 2nd year = 4,500
C. Revaluation Method
Asset is revalued periodically; depreciation = (Original Value − Revalued Value) / Remaining Life
D. Annuity Method
Depreciation is charged like loan repayment, considering interest on the diminishing value of the asset.
E. Production/Units of Output Method
Depreciation based on actual usage or output of the asset.
Formula:
Depreciation per unit = (Cost − Scrap Value) / Total Expected Units
6. Conclusion
Depreciation is a systematic allocation of asset cost over its useful life. It ensures true profit determination, accurate financial position, and provision of funds for replacement. The choice of method depends on the nature of the asset, usage, and accounting policy, but all methods aim to fairly reflect the consumption of economic benefits of the asset.