Depreciation – Meaning, Characteristics, Causes, Objectives, Factors Affecting Depreciation Calculation
The term depreciation is derived from the Latin word depretium. Split into “de” and “pretium” de means decline and pretium means price. So, the literal meaning of depreciation is decrease in the value of an asset. True profit can be calculated only after charging depreciation on assets.
All assets are not depreciable. Only assets like building, plant, machinery, furniture etc., are subject to depreciation. It refers to the gradual diminution or loss in the utility value of an asset on account of wear and tear in use, efflux of time or obsolescence.
Table of Contents
- 1 Definitions of Depreciation
- 2 Characteristics of Depreciation
- 3 Causes of Depreciation
- 4 Objects of Providing Depreciation
- 5 Factors Affecting Depreciation Calculation
- 6 Infographic on Depreciation – Meaning, Characteristics, Causes, Objectives, Factors Affecting Depreciation Calculation
Definitions of Depreciation
Some important definitions of depreciation are given below.
Depreciation may be defined as a gradual deterioration in value due to use.
— R.G William
Depreciation may be defined as the measure of the exhaustion of the effective life of on asset from any cause during the given period.
— Spicer and Pegler
It is a matter of common knowledge that all fixed assets such as plant, machinery, tools, buildings, leasehold, furniture etc., gradually diminish in value as they get older and become worn out by constant use in the business.
In practice, the term depreciation is commonly used in a very wide sense, covering diminution in the values of assets caused by outside fluctuations in realisable and replacement values, and also the amortization of the cost of an asset over the period of its use.
— De Paula and De Paula
Depreciation is the diminution in the financial value of the asset owing to wear and tear, eflluxion of time, obsolescence or similar cause, the suggestion being other that of gradual deterioration than sudden loss or diminution in value.
Characteristics of Depreciation
A careful examination of various definitions of depreciation reveals the following characteristics.
1. Depreciation is calculated on the value of the depreciable assets like building, plant, machinery, furniture loose tools etc.
2. It is a permanent and continuous decreases in the value of an asset.
3. Depreciation is caused due to use, efflux of time, obsolescence etc.
4. Depreciation is charged to spread the cost of an asset over its useful life.
According to Accounting Standards issued by the Institute of Chartered Accountants of India depreciable assets are assets which:
- are expected to be used during more than one accounting period,
- have a limited useful life and,
- are held by an enterprise for use in the production or supply of goods and services, for rental to others, or for administrative purposes and not for the purpose of sale in the ordinary course of business.
Meaning of Useful Life
Accounting to AS 6, useful life is either:
- The period over which a depreciable asset is expected to be used by the enterprise or,
- The number of similar units expected to be obtained from the use of the asset by the enterprise.
Depreciable amount of an asset is its historical cost, or any other amount substituted for historical cost in financial statements minus the estimated residual value at the end of useful life. Historical cost includes:
- Purchase price
- Initial delivery and handling cost
- Installation cost
- Professional fees paid to architects, engineers etc.
- Financial cost like interest on deferred credit or borrowed fund for acquisition of fixed assets for the period up to the completion of construction or acquisition of fixed assets. After the assets are ready for use such financing costs should not be included.
- Expenditure incurred on start-up and commissioning of the project including expenditure on test runs and experimental production.
Administrative and other overheads are excluded from the historical cost of fixed assets.
Causes of Depreciation
Causes of depreciation may be of two: internal causes and external causes.
Internal Causes of Depreciation
Wear and tear, exhaustion, depletion, deterioration etc.. causes depreciation of assets which are internal in nature.
1. Wear and tear
Assets diminish in their value as they are constantly used in the organization. The difference between the value of an asset when it was bought and its value being used for sometime represents wear and tear. Although assets are kept in working conditions, a time comes when only scrap value remains.
Assets are bound to lose their value as time progress. Consequently, productivity declines. Assets exhaust their value and are found useless after the elapse of a certain fixed period. It is true that assets have their definite age.
Natural resources such as mines, quarries and oil wells are of a wasting character. As a result of gradual exhaustion, the value of wasting assets declines. They are consumed gradually. The process of earning income through extraction causes depletion of wasting assets.
Deterioration means erosion in value of those assets which have a very short life. Proper repairs and maintenance of these assets cause an additional loss by way of deterioration.
External Causes of Depreciation
Factors external to causes of depreciation include passage of time, obsolescence, permanent fall in market value and weather and accidental elements. These factors are not connected to the asset. Even then they cause depreciation.
1. Passage of time
The utility of some fixed assets is confined to a time frame. Assets like leasehold property become useless after a period. Relevant statutes may limit the period for which an organization can use assets in the production process. Assets like trademark, patents lose their value with the passage of time.
Obsolescence implies the chance of an asset becoming out of fashion. This is a loss arising on account of new invention, technological changes, improvement in production methods, legal restraints etc. These factors make it economical to replace the assets though they are still usable. Market changes are also a disturbing factor. For example, the demand for a product or service falls to such a level that it is no longer viable to continue with that product or service.
3. Permanent fall in the market value
Assets like investments lose their value due to a downfall in their market value. It is only the permanent fall in the value of asset. Temporary shrinkage in the value of assets should be ignored for depreciation calculation.
4. Weather and accidental elements
Assets lose their value due to weather, rain, sunshine or any accident like fire, earthquake, flood, tidal forces or similar other disasters. The effect of these factors enters into calculating depreciation.
Objects of Providing Depreciation
Occurrence of depreciation is unavoidable. For true and fair view of accounts, assets are restated at the balance sheet date. Investment decisions rest on depreciation. The objects and necessity of providing for depreciation are briefly described.
- True cost of production
- Correct income
- True and fair view of financial position
- Compliance procedures
- Assets replacement
- Keeping capital intact
- Tax planning
1. To compute true cost of production
In cost terminology, overhead charges include all indirect costs. Depreciation is one among them. The asset engaged in production loses its value due to physical wear and tear. The said reduction in value of asset would be included in the cost of production. As a revenue expense its inclusion gives true cost of production.
2. To determine correct income
Depreciation is a charge included in the profit and loss account. True and correct profit can be arrived at only by charging depreciation. Depreciation is not visible. It is never paid to an outside party. Yet, it is desirable to charge depreciation on the fixed assets as these assets are used for earning profit. Depreciation must be deducted from the income earned to calculate a correct income.
3. To show a true and fair view of financial position
A balance sheet reveals the financial position of its entity. Fixed assets should appear in the balance at their correct value. If assets are shown without any charge for depreciation, their value would be overstated. Consequently, the balance sheet will not show the correct state of business. Assets stated at their written down value will give a correct picture.
4. For legal compliance
The cost of non-compliance would always be heavy. It is compulsory under the Companies Act to provide for depreciation for dividend payment. No dividend shall be declared or paid out of profits before depreciation. Whether profits are sufficient or insufficient for dividend payment, depreciation must be provided for. Provision for depreciation ensures that dividend is paid out of profits.
5. To meet replacement cost
Occurrence of depreciation is gradual and not sudden. So, ample time is available to plan for replacement of existing assets at a future date. It is wiser to replace an asset than to incur additional expenditure on its maintenance and repair. By way of provision for depreciation the initial cost of the equipment is spread equitably over its period of usefulness. Amount of depreciation gets accumulated during the asset’s working life. It provides necessary funds so that replacement can be effected without financial strain.
6. To keep capital intact
Keeping the capital intact has always been the focal point in business. The amount of depreciation charged against every year’s profit should be appropriate. Omission or understatement of depreciation results in inflated profit. If any dividend is distributed out of inflated profit, it would be an incorrect return on capital. It will cause the value of the business to decrease. Capital should be kept intact.
7. To plan tax liability
Tax planning is the legitimate right of every assessee. Depreciation can be used as a tax saving device. It is an admissible expense while computing income from business. Income tax liability is reduced by claiming depreciation. A suitable depreciation policy is always essential to minimize tax liability.
Factors Affecting Depreciation Calculation
Certain factors enter into consideration for determining depreciation. They are Value of assets, Estimated working life, Repairs and renewal, Addition and extension, Scrap value, Loss of interest on capital invested and Legal provisions. They are briefly discussed as below.
1. Value of Assets
Value of depreciable asset is the cost of the same asset that represents its money outlay or its equivalent in connection with its acquisition, installation and commissioning as well as for additions to improvements thereof. An increase or decrease in long term liability on account of exchange fluctuations, price adjustments, changes in duties or similar factors may cause changes in the historical cost a depreciable asset.
2. Estimated working Life
Working life is determined by
- Legal or contractual limits such as the expiry dates of related leases.
- Extraction or consumption.
- Extent of use and physical deterioration on account of wear and tear which again depends upon operational factors like number of shifts for which the asset is to be used, repair and maintenance policy of the enterprise.
3. Repairs and Renewals
Repairs and renewals keep the assets in good working condition. A well maintained asset yields good results over its stipulated life. If it is poorly maintained, it will become useless after a short period. So, repairs and renewals are an important consideration while determining the amount of depreciation.
4. Additions and Extensions
Additions and extensions are normally made to existing assets like plants and buildings. The purpose is to increase their capacity. Expenditures on additions and extensions are of capital nature. The dates of incurrence of such expenditures are considered to ascertain depreciation.
5. Residual Value
Scrap value of an asset represents the amount which the assets will fetch when discarded. Residual or scrap value of the assets should be deducted from their original cost.
An asset is likely to become outdated due to change in technology. The possibility of an asset going out of fashion should be carefully weighed while calculating the amount of depreciation.
7. Loss of Interests
The purchase of an asset involves a heavy sum. It may be alternatively invested elsewhere. So, capital involved in the purchase of an asset implies a loss of interest on alternative investment.
8. Legal Requirements
Provision for depreciation on assets is subject to the Income Tax Act and Companies Act. Their legal provisions do enter into calculation of depreciation.