Depreciation

Introduction

• Depreciation is also referred to as “Capital Consumption Allowance” which represents the amount of capital that would be needed to replace those depreciated assets.
• It is the permanent decline in the value of a fixed asset. 
• It is the gradual decrease, both in the value and usefulness, of an asset due to its nature and usage. 
• It is also the measure of wearing out of a fixed asset.

Fixed Assets

• Fixed assets are assets which are permanent in nature and create revenue for a business. 
• Fixed assets of a business lose value or are said to depreciate with usage. 

Calculation of Depreciation of Fixed Assets 

• The economic service potential of fixed assets reduces over time. This means the value of fixed assets depreciates over time.
• The allocation of the cost of a fixed asset over its estimated useful life is a loss and must be taken into consideration when preparing the profit and loss accounts. When fixed assets are sold, the parts cost not recovered is termed depreciation.
• The formula for depreciation is: 

Depreciation = (Cost – Estimated Value) / Years of useful life

• Depreciation is calculated as the estimate of wear out and is charged to the Profit & Loss account either on a monthly or annual basis. 

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 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 In common language, obsolescence means being “out-of-date”. Obsolescence refers to an actual asset becoming outdated on account of the availability of a better type of asset.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 earthquakes, fire, floods, etc., Accidental loss is permanent but not continuing.

Important Terms

• Depreciable Assets: The assets whose lifetime can be estimated and useful during two or more accounting periods in the production or service activities of an organization can be called depreciable assets.
• Useful life: Useful life is the time during which the asset is helpful in the normal business activities of a firm. It can be less than the total lifetime of the asset. It can be exactly predetermined, or it should be estimated on a reasonable basis.
• Depreciable Amount: It is the cost of acquisition and installation of an asset after reducing any realizable value at the end of its useful life.
• Effluxion of time: It is the passage of time irrespective of the actual use of an asset as in the case of leased assets.
• Obsolescence: It refers to an asset becoming out of date due to improved models or methods.