Meaning of Depreciation
Depreciation can be defined as a continuing, permanent and gradual decrease in the book value of fixed assets. This type of shrinkage is based on the cost of assets utilised in a firm and not on its market value.
Features of Depreciation
Following are the 3 principal features of depreciation:
- Depreciation is a decrease in the book value of fixed assets.
- Depreciation involves loss of value of assets due to the passage of time and obsolescence.
- Depreciation is an ongoing process until the end of the life of assets.
Causes of Depreciation
- Wear and Tear due to Use or Passage of Time: Wear and tear is nothing but deterioration and the following decrease in the value of an asset, resulting from its use in business operations for earning revenue.
- Expiration of Legal Rights: Some categories of assets lose their value after the agreement directing their use in business comes to an end after the expiry of the predetermined period.
- Obsolescence: Obsolescence is another factor driving to the depreciation of fixed assets. In common language, obsolescence means being “out-of-date”. Obsolescence refers to an actual asset becoming outdated on account of the availability of a better type of asset.
- Abnormal Factors: Drop in the use of the asset may be caused by abnormal factors. Namely, accidents due to the earthquake, fire, floods, etc., Accidental loss is permanent but not continuing.
Depreciation Formula:
1. Annual amount of depreciation under Straight Line Method
Annual Depreciation =
\(\begin{array}{l}\frac{Original\, Cost\, -\, Estimated\, Scrap\, Value}{Estimated\, Useful\, Life}\end{array} \)
2.Rate of depreciation on original cost
Rate of depreciation =
\(\begin{array}{l}\frac{Annual\, Depreciation}{Original\, Cost\, of\, Asset}\, X\, 100\end{array} \)
Advantages and Disadvantages of Straight Line Method:
Advantages | Disadvantages |
- It is a very simple method of calculating depreciation.
- Under this method, Asset can be depreciated up to the net scrap value or zero value.
- Under this method, the same amount is charged as depreciation in Profit & Loss Account.
| - Under this method book value of the asset will be charged more for maintenance and repair in the final years as compared to initial years.
- It is difficult to ascertain a suitable rate of depreciation.
- It is not suitable for assets having long life and high value.
|
Methods of Calculating Depreciation
Straight Line Method (SLM)
Under the depreciation Straight Line Method, a fixed depreciation amount is charged annually, during the lifetime of an asset. The amount of annual depreciation is computed on Original Cost and it remains fixed from year to year. This method is also known as the ‘Original Cost method’ or ‘Fixed Instalment method’.
Written Down Value Method (WDV)
Under the Written Down Value method, depreciation is charged on the book value (cost –depreciation) of the asset every year. Under the WDV method, book value keeps on reducing so, annual depreciation also keeps on decreasing. This method is also known as ‘Diminishing Balance Method’ or ‘Reducing Instalment Method’.
Straight Line Method vs Written Down Value Method
| Straight Line Method | Written Down Value Method |
| Basis of Charging Depreciation |
| Depreciation is calculated on the original cost of fixed assets. | Depreciation is calculated on the book value of fixed assets. |
| Amount of Annual Depreciation |
| The amount of annual depreciation is fixed for all years of useful life. | The amount of depreciation declines year after year. |
| Recognition by Income Tax |
| The Straight Line Method is not recognised by the Income Tax Department. | The Written Down Value method is recognised by the Income Tax Department. |
| Cost of Depreciation and Repairs |
| The combined cost on account of depreciation and repairs is lower in the initial years and higher in the later years. | The combined cost on account of depreciation and repairs remains, more or less, equal throughout the life of the asset. |
Theory Questions:
| Q.1- What are the other concepts similar to depreciation? |
| Answer: |
| Depletion | - The term ‘Depletion’ is used with regard to the ‘Natural Resources’ like oil wells, Mines etc.
- When natural resources are extracted and their stock value is reduced. This reduction is termed as depletion.
|
| Amortisation | - The term ‘Amortisation’ is used with regard to ‘Intangible Assets’.
- Amortisation refers to writing off the cost of intangible assets like patents, copyright, trademarks, franchises, etc.
|
| Obsolescence | - It refers to a decline in the value of assets due to innovation or improved techniques, changes in the taste or fashion of the existing asset.
|
| Q.2- State the objectives of depreciation. |
| Answer: |
| Objectives of Depreciation | - To ascertain the correct cost of production
- To retain funds for a replacement.
- To ascertain the correct Profit or Loss.
- To show a true and fair view of the financial position.
|
| Q.3- List the factors required for calculating the amount of depreciation. Also give the components of original cost. |
| Answer: |
| (a) Factors/elements required to calculate depreciation | - The original cost of the assets.
- Estimated residual value or scrap value.
- The estimated useful life of the assets.
|
| (b) Original cost | Original cost = Purchase price + Freight + Installation cost + Any other expenses incurred before the asset is put to use for the first time. - In the case of second-hand assets, even expenses incurred on repair & overhauling, before putting it to use, are also included in the original cost.
|
| Multiple Choice Questions |
| Q.1- Amortisation refers to writing off the cost of: |
| a. Fixed Assets b. Tangible Assets c. Intangible Assets d. All of the above |
| Q.2- ________refers to decline in the value of assets due to Innovation or improved techniques, changes in the taste or fashion of the existing asset. |
| a. Intangible Assets b. Obsolescence c. Amortisation d. Depreciation |
| Q.3- Depreciation is a ________expense. |
| a. Non-cash b. Cash c. Credit d. All of the above |
The above mentioned is the concept, that is elucidated in detail about the ‘Depreciation’ for the class 11 Commerce students. To know more, stay tuned to BYJU’S.
Also See:
Difference Between Depreciation Expense and Accumulated Depreciation
Amortisation Vs Depriciation
What Is Depreciation Expense
Mcqs on Depreciation
FAQs
In Accounts, Depreciation can be defined as the method of allocating the cost of a physical asset over its useful life or the time period it is to be used for. In simple words, depreciation is the reduction in the value of an asset due to the passage of time, normal wear and tear and obsolescence.
What is the formula for depreciation method? ›
How is depreciation calculated? The most common way to calculate depreciation is the straight-line method. The difference between the fixed asset cost and its salvage value is divided by the useful life of that asset in years to get the depreciating value, which is the same for each year of the asset's life.
What is the meaning of depreciation? ›
Definition: The monetary value of an asset decreases over time due to use, wear and tear or obsolescence. This decrease is measured as depreciation. Description: Depreciation, i.e. a decrease in an asset's value, may be caused by a number of other factors as well such as unfavorable market conditions, etc.
What is depreciation expense formula in accounting? ›
Tracking the depreciation expense of an asset is important for reporting purposes because it spreads the cost of the asset over the time it's in use. The simplest way to calculate this expense is to use the straight-line method. The formula for this is (cost of asset minus salvage value) divided by useful life.
What is depreciation calculation? ›
Formula: (asset cost – salvage value) / useful life. How it works: You divide the cost of an asset, minus its salvage value, over its useful life. That determines how much depreciation you deduct each year.
What is the easy formula for depreciation? ›
The formula for calculating straight line depreciation is: Straight line depreciation = (cost of the asset – estimated salvage value) ÷ estimated useful life of an asset. Where: Cost of Asset is the initial purchase or construction cost of the asset as well as any related capital expenditure.
What is an example of a depreciation expense? ›
The method takes an equal depreciation expense each year over the useful life of the asset. For example, Company A purchases a building for $50,000,000, to be used over 25 years, with no residual value. The annual depreciation expense is $2,000,000, which is found by dividing $50,000,000 by 25.
How to calculate depreciation expense per month? ›
Subtract the asset's salvage value from its total cost to determine what is left to be depreciated. Divide this value by the number of years of the asset's lifespan. Divide this figure by 12 to learn the monthly depreciation.
When to use depreciation expenses? ›
To choose a depreciation expense method, you assess three aspects of the asset:
- Determine if the asset maintains a consistent value. ...
- Decide if the value of an asset depreciates rapidly in the first year. ...
- Determine if an asset loses value through use or production.
The formula to calculate annual depreciation using the straight-line method is (cost – salvage value) / useful life.
The straight-line method is the simplest and most commonly used way to calculate depreciation under generally accepted accounting principles.
What is a simple way to explain depreciation? ›
What does depreciation mean? Depreciation is what happens when assets lose value over time until the value of the asset becomes zero, or negligible. Depreciation can happen to virtually any fixed asset, including office equipment, computers, machinery, buildings, and so on.
How to account for depreciation? ›
Depreciation is recorded as a debit to a depreciation expense account and a credit to a contra asset account called accumulated depreciation. Contra accounts are used to track reductions in the valuation of an account without changing the balance in the original account.
How do you determine depreciation method? ›
How to Choose a Depreciation Method
- Straight line depreciation spreads the cost evenly over a number of years.
- Accelerated depreciation writes off a greater portion of the cost in early years and a smaller portion in later years.
- Units of production depreciation writes off an asset as it is actually used.
To calculate depreciation using the straight-line method, subtract the asset's salvage value (what you expect it to be worth at the end of its useful life) from its cost. The result is the depreciable basis or the amount that can be depreciated. Divide this amount by the number of years in the asset's useful lifespan.
What is the formula for depreciation in MACRS? ›
In MACRS straight line, LN calculates the percentage for a year by dividing one depreciation period by the remaining life of the asset, and then applying this amount with the averaging convention to determine the depreciation amount for that year.
What is the formula for written down value method for depreciation? ›
Written-down value is a method used to determine a previously purchased asset's current worth and is calculated by subtracting accumulated depreciation or amortization from the asset's original value. The resulting figure will appear on the company's balance sheet.
