The word depreciation has been derived from Latin word 'Depretium' which means 'decline' or 'reduction' in price or value.
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| Depreciation |
Depreciation is a continuous, gradual and permanent decrease in value of fixed assets.
For example, machinery purchased today will not have the same value after 5 years, even if it is unused. This reduction in value of machinery is called as Depreciation.
Depreciation is considered as an operating (regular business) expense and the same is provided for (deducted/charged) from the value of the asset.
It is important to note that depreciation happens only in case of fixed assets.
Following are the causes of Depreciation:
Natural Wear and Tear- This refers to the reduction in value of a fixed asset due to its usage. More an asset is used, more will be the wear and tear. Machinery used less will have less wear and tear as compared to the same machinery used more often.
Passage of Time- Even if an asset is not used at all, still its value will decline over a period of time.
Obsolescence- Due to the advancement of technology, some assets would become obsolete even if they are still capable of being used. This loss in value of an asset is called as obsolescence.
Exhaustion/Depletion- Assets like oil wells and mines keep on getting depleted when used. As we keep on using these assets, a time comes when they get completely exhausted and nothing is left. In such cases, depreciation happens due to depletion.
Damage- Sometimes assets get damaged due to natural calamities like flood, earthquake etc. In such cases, the loss in value is written off (considered) as depreciation.
Why is there a need for providing depreciation?
Why is there a need for providing depreciation?
To ascertain true profit or loss- Depreciation (Reduction/Loss in value of fixed assets) is an expense and hence it’s important to record depreciation to ascertain true profit or loss of the business.
To show the true picture of the financial standing of the business- If the depreciation amount is not deducted from fixed assets, the accounts (balance sheet) of the business will not show the true financial position of the business. If depreciation is not deducted from fixed assets, the fixed assets would be overstated on the balance sheet. It is important that true and fair value of assets should appear on the balance sheet.
To make provisions for replacement of fixed assets- The amount of depreciation which is deducted from profits is kept aside and retained in the business. These funds can be utilized to replace the fixed asset, once it is no more required.
To meet legal requirements- It is necessary to charge depreciation as per provisions of the Companies Act and the Income-Tax Act.
Factors affecting Depreciation-
Cost of the Asset - The total cost of an asset = Purchase price of the asset + Incidental expenses of the asset. Incidental expenses include all expenses done on the asset till the asset is ready for use. For example, transport charges, installation charges etc.
Estimated Scrap value - This is the residual value of the asset at the end of the expected life of the asset. In simple words, it is the amount expected to be received by selling off the asset after its estimated life.
Estimated Useful Life of the Asset - It refers to the number of years the asset is expected to be useful for the business. It’s important to note that here we are not referring to the physical life of the asset. An asset may have a longer physical life as compared to its useful life.
After considering the above factors we can roughly calculate the depreciation by using the below formula:
Depreciation (per annum)
= (Purchase price + Incidental expenses - Estimated scrap value) / Estimated useful life of the asset
However, there are various ways of calculating depreciation apart from the formula given above.
Read further - Basic Accounting Terms
Read further - Basic Accounting Terms
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