In day to day usage, the term depreciation denotes the decrease in the value of fixed assets

except land. With the exception of land most fixed assets have a limited useful life; that is they
will be of no use to the company over a limited number of accounting year.

So, a fraction of the assets is chargeable as an expense in each of the accounting years in
which it is used. The accounting process for tis gradual conversion of fixed assets into expense
is called depreciation. The net result of depreciation on an asset is that sooner or later, the
asset will become useless. Therefore, the cost of fixed asset is nothing but the price paid for a
series of future services. So, its cost is spread over a number of years during which benefit of
the asset is received. Thus, it is a problem of cost allocation and not of valuation.

The American Institute of Certified Public Accountants defines the term 'Depreciation' as
follows:-

“Depreciation for the year is the portion of the total charge under such a system that is
allocated to the year.”

In this way, depreciation is nothing but an allocation of cost of raided asset over the useful life
of the asset. A systematic procedure for allocating the cost over the periods of its useful life in a
rational manner is called depreciation accounting. It is, therefore, reasonable to charge
depreciation of fixed asset to the profit an loss account as an expense.

The productive life of an asset can be estimated only and not calculated accurately.

(i) Physical Causes. Under this classification, we may include-

(a) wear and tear due to use

(b) deterioration and decay with the passage of time, whether used or not
(c) damage and destruction due to an accident like fire, flood, earthquake, mishandling etc
(d) depletion of asset.

(2) Functional Causes. The following causes may be included under functional causes-

(a) uselessness for the present purpose.

(b) Obsolescence i.e., due to innovation, invention, change in technique etc.

Causes of depreciation may also be classified as internal and external. Internal causes are that
arising from the operation of any cause natural to or inherent in the asst itself such as wear an
there due to use an depletion. External causes are that arising from the operation of forces
outside the asset itself, such as obsolescence and effluxion of time.
i) To Calculate Proper Profits.
(a) Depreciation is an operating charge against the year's current income because an asset is
an important tool in earnings revenues. The fall in the book value f assets reflects the cost of
earnings revenues from the use of asset in the year, hence like other costs viz. wages, salaries
etc., depreciation must also be charged to revenue. It is, therefore, necessary to charge
depreciation to revenue income in order to ascertain correct profits for the year.
(b) The capital expenditure on acquisition of assets is a periodic cost and must be charged to
profits for the year in order to calculate correct profits.

(ii) To show the Asset at its Real Values. Is is a well-known principle of accountancy that
only that part of asset should be carried forward which represents the unexpired cost of
executed future set\ricer. Depreciation is thus provided to reduce the cost f asset to tat
extent. If the depreciation is not charged, it means the asset is being shown n the balance
sheet at its overstated value. Hence in order to show the asset at its real value in the balance
sheet, depreciation is a must.

(iii) To Replace the Asset. The depreciation reduces the amount of profits and saves the
cash resources of the concern (to the extent of depreciation) from being distribute by way of
dividend. The amount so saved ca be set aside every year and invested, is able to produce as
much amount as necessary to replace the asset at the end of the life of the asset.

(iv) To reduce the Tax-Liability. By charging depreciation to profit and loss account, the
taxable profits of the company are reduced. It is an admissible deduction under Income Tax
Act thus it reduces the tax liability of the concern.

(v) Internal Finance. It is a source of internal Finance.

Method:

(1) Straight Line Method or Fixed Installment Method

(2) Diminishing Balance Method or Written Down Value Method
(3) Sum of Years' Digit Method
(4) Sinking Fund Method
(5) Annuity Method
(6) Insurance Policy Method
(7) Revaluation Method
(8) Depletion Method
(9) Machine-Hour Rate Method
(10) The Production Unit Method and the Mileage Method

The amount of depreciation n is calculated dividing the cost of the asset less its salvage price
by the number of years of its economic life. Under tis method, deprecation is charged on
historical cost i.e., actual cost and no future variations in costs are taken into consideration.
For example- the cost of a machinery is Rs. 50,000. The salvage price at the end of its
economic life to 10 years is estimated to be Rs. 5000. The amount of annual depreciation in
this case will be

Cost – Salvage price

Depreciation = -----------------------------------------
Economic Life of the Asset
Under this method, depreciation is charged at a fixed rate every year but on reducing balance
i.e., on balance reduced each year during the economic life of the asset by the amount of
depreciation till the asset is reduced to its scrap value.

For example, if the cost of the asset is Rs. 1,000 the rate of depreciation is 10 % on Rs. 1,000
i.e., Rs. 100, in the second year, it will be 10 % on Rs 900 i.e., Rs. 90 is the third year, it will
be 10 % on Rs 810 (900-90) i.e., Rs. 81 and so on.

Appraisal. Under this method, the asset is never reduced to zero, thought it may be reduced
to a very small value. It means, the method should be and can be applied only where there is
residual value of the asset. The method is another suitable for such asset were there remains
no residual value. There is a logic in this method, that the charge in respect of asset is all the
most same during the life of the asset. The depreciation is more in the beginning and the repair
charges are much less. In later year the depreciation is charged less whereas repair charges go
on increasing year after year. The Income Tax Act also recognise this method of depreciations.

Sinking method
Under this method, the amount of Depreciation is ascertained in such a way, that if invested
every year with compound interest, it will yield an amount equal to the cost of asset. In this
way, it is very difficult to calculate the amount of Depreciation each year to be charged to
profit and loss account due to the amount of interest which varies year to year, hence it is
ascertained from Sinking Funds Tables. This annual appropriation is invested every year in
good securities outside the business along with the amount of interest received on the balance
of securities at the beginning of the year. The procedure is followed till the amount in
depreciation fund account is equal to the cost of asset. When the asst is to be replaced, the
investments are sold out and t sale proceeds if the investments are utilised in replace in the
old asset with the new one. The depreciation fund account is utilised to write off old assert
account.
Annuity:
Thus the interest factor is also taken into account. Therefore, under this method, the amount
of depreciation is calculated with the help of annuity table taking into account the cost of the
asset plus interest thereon. The annuity table gives the amount of Depreciation, if invested at
a fixed rate of interest would fetch Re, 1 after the specified period. The amount of interest is
debited to the asset account at a given rte on the balance of investment in asst. thus the
amount of depreciation remains the same year after year while the interest to be charged will
be less and less.
Insurance policy:

The amount of premium is equal to the amount of depreciation and is paid in cash to the
insurance company which goes on accumulating with the insurance company at a certain rate
of in tersest and is paid back at the maturity of the policy. The amount of policy is such that it
is sufficient to replace the asset when it is worn out. The amount so made available by the
insurance company is used for purchasing the new asset. The method to a great extent is
similar in spirit to Sinking Fund Method, of course the procedure is a little different.

Revaluation:
Under this method assets are revalued at the end of each year. The difference of the
revaluation price of the two years is the depreciation be charged to profit and loss account.
Depletion:
This method is used in case of wasting assets such as mines, oil and gas resources, timber etc.

These assets exhausted by exploitation. In such cases, the price paid for the acquisition of asset
is dividend by the estimated contents of the mines in terms of tons which will be the price paid
for one ton. The amount of total depreciation is calculated for the year by multiplying the total
output in tons with the price paid per ton. Thus the total price paid is recouped during the life of
the asset.
Machin hour method:
This method is applied for depreciating machines. The life of the machines is fixed in terms of
hour.

The total cost of the asset less depreciations is divided by the expected life of the machine in
terms of hours. Depreciation to be charged is ascertained by multiplying the hourly rate of
depreciations by the number of hours the machine actually works during the year. For example,
the life of a machine costing Rs. 10,000 is estimated 10,000 hours. The hourly rate thus comes
to Re 1/- per hour. If the machine is run 1000 hours in a year, the total depreciation chargeable
for the year will be Rs. 1000 @ Re 1/ per hour. This method is useful for costly machines where
a fair estimate of the life of asset can be made n terms of working hours.

Production method:
These two method are similar to machine hour rate method.

The only difference is that the life of the asset is ascertained in terms of units produced under
the production unit method an in terms of mileage covered instead of in terms of hours. The
procedure of or calculating annual amount of depreciation is the same.

Choice of Method. The above methods of depreciation re not the only methods of
depreciation. There may be other methods of depreciation depending upon the need and the
purpose of the business organisation and the nature of the asset. In selecting a suitable
method, the management must take into account the factors like consistency, suitability,
purpose orientation and cost variability etc.