DEPRECIATION

Generally the term Depreciation is used to denote decrease in value, but

in accounting this term is used to denote decease in the book value of a
fixed asset.
Meaning :
Depreciation is the permanent and continuous decrease in the book value
of a fixed asset due to use, effluxion of time, obsolescence, expiration of
legal rights or any other cause.
Definition :
Carter defines depreciation as the graduation and permanent decrease in
the value of an asset from any cause.
Need for providing Depreciation
The need for providing depreciation in accounting records arises due to any
one or more of the following reasons.
1. Ascertain correct profit or loss
For proper matching of cost with revenue, it is necessary to charge
depreciation against revenue in each accounting year to calculate the
correct net profit or net loss.
2. Ascertain true and fair view in balance sheet
If depreciation is not provided in the books of accounts, the fixed assets will
be shown at a higher value than its real value in the balance sheet. i.e., it
will be overvalued. As such this over valuation of fixed asset will not
represent a true and fair value of the business.
3. Ascertain the real cost of production
For manufacture of goods, the plants, machineries, tools, equipments etc.,
are required. Depreciation on these assets is a factory overhead, which
must be included to find out cost of production accurately. If depreciation is

excluded from cost of production, it will result in the non-recovery of

depreciation at the time of selling the goods.
4. Comply with legal requirements
As per the Company Act (1956), it is compulsory for companies to provide
depreciation on fixed asses before it declares dividend.
5. Replacement of Assets
Depreciation is provided to replace the assets which it becomes useless.
6. Saving in Income Tax
When depreciation is debited to profit & loss account, the profits are
reduced consequently the tax liability on profit is also reduced.

Causes of Depreciation
Causes of depreciation

Internal

External

(The internal causes arise from (External causes arise from the
operation of any cause natural to or operation of forces outside the
inherent in the asset itself)
business)
1. Wear and tear
2. Dis-use
3. Maintenance
4. Depletion

1. Obsolescence
2. Effluxion of time
3. Expiration of legal rights

1. Wear and Tear : It is due to use of the asset. Wear and tear is an
important causes of depreciation in the case of tangible fixed asset.
2. Disuse : When a machine is kept continuously idle, it becomes useless.
3. Maintenance : The value of machine deteriorates rapidly because of
lack of proper maintenance.
4. Depletion : It refers to the physical deterioration by the exhaustion of
natural resources e.g. mines, quarries, oil wells etc.,
5. Obsolescence: The old asset will become obsolete (useless) due to
new inventions, improved techniques and technological advancement.
6. Effluxion of time : When assets are exposed to force of nature, like
wind, rain, etc., the value of such assets may decrease even if they are not
put into any use.
7. Expiration of legal rights: Lease, copy-right, patents are acquired for a
fixed period. On the expiry of the fixed period of time, the assets cease to
exist.

Factors Determining the Amount of Depreciation

1. Original cost of the asset: It implies the cost incurred on its
acquisition, installation, commissioning and for addition or improvements
thereof which are capital nature.
2. Estimated Life: It implies the period over which an asset is expected to
be used.
3. Residual value: It implies the value expected to be realized on its sale
on the expiry of its useful life. This is otherwise known as scrap value of
turn-in value.

Methods of Calculating Depreciation

1. Straight line method or Fixed installment method
2. Written down value method or Diminishing balance method.
3. Annuity method
4. Depreciation fund method
5. Insurance Policy method
6. Revaluation method
1. Straight line method : Under this method, the same amount of
depreciation is charged every year throughout the life of the asset. The
amount and rate of depreciation is calculated as under:
Amount of depreciation
=

Rate of depreciation =

2. Written down value method : Under this method, depreciation is

charged at a fixed percentage each year on the reducing balance (i.e cost
less depreciation) of asset.
The amount of depreciation goes on
decreasing every year.
Rate of depreciation (R) = 1
Where

n = Estimated useful life in years

S = Scrap / Residual value
C = Acquisition cost
R = Rate of depreciation to be applied.