What is Depreciation?

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

  1. 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.
  2. 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.
  3. 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 In common language, obsolescence means being “out-of-date”. Obsolescence refers to an actual asset becoming outdated on account of the availability of a better type of asset.
  4. 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.

THEORY QUESTIONS:

INTRODUCTION

Q.1- WHAT IS DEPRECIATION? DISCUSS THE OTHER CONCEPTS SIMILAR TO DEPRECIATION.
ANSWER:
(A) DEPRECIATION
  • “Depreciation” means decline in the value of a fixed asset due to normal use, passage of time or expected obsolescence.
  • It is a permanent and continuing decline in the value of fixed assets.
(B) OTHER CONCEPTS SIMILAR TO DEPRECIATION
(1) 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.
(2) AMORTISATION
  • The term ‘Amortisation’ is used with regard to ‘Intangible Assets’.
  • Amortization refers to writing off the cost of intangible assets like patents, copyright, trademarks, franchises etc.
(3) 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 VARIOUS CHARACTERISTICS OF DEPRECIATION.
ANSWER:
CHARACTERISTICS OF DEPRECIATION
  • Depreciation is fall in the value of tangible fixed assets.
  • It reduces the book value of the assets.
  • It is a continuous process.
  • Fall in the book value of an asset is permanent and a continuous process.
  • Depreciation is a non-cash charge.

CAUSES AND OBJECTIVES

Q.1- STATE THE CAUSES AND OBJECTIVES OF DEPRECIATION.
ANSWER:
(A) MAIN CAUSES OF DEPRECIATION
  • Use of assets
  • Efflux of time i.e. Elapse of time or Passage of time.
  • Expected Obsolescence
  • Accidents
(B) OBJECTIVES OF DEPRECIATION
  • To ascertain correct cost of production
  • To retain funds for replacement.
  • To ascertain the correct Profit or Loss.
  • To show true and fair view of the financial position.

FACTORS DETERMINING THE AMOUNT OF DEPRECIATION

Q.1- 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
  • Original cost of the assets.
  • Estimated residual value or scrap value.
  • 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 case of second hand assets, even expenses incurred on repair & overhauling, before putting it to use, are also included in the original cost.

METHODS OF DEPRECIATION

Q.1- EXPLAIN THE METHODS OF COMPUTING DEPRECIATION.
ANSWER:
(A) STRAIGHT LINE METHOD (SLM)
  • Under 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 ‘Original Cost method’ or ‘Fixed Installment method’.
(B) 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 Installment Method’.
Q.2- DIFFERENTIATE BETWEEN THE STRAIGHT LINE METHOD AND WRITTEN DOWN VALUE METHOD OF CHARGING DEPRECIATION.
ANSWER:
BASIS STRAIGHT LINE METHOD

(SLM)

WRITTEN DOWN VALUE METHOD (WDV)
(1) BASIS OF CHARGING DEPRECIATION Depreciation is calculated on the original cost of fixed assets. Depreciation is calculated on the book value of fixed assets.
(2) 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.
(3) RECOGNITION BY INCOME TAX SLM is not recognised by the Income Tax Department. WDV method is recognised by the Income Tax Department.
(4) 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.

STRAIGHT LINE METHOD

Q.1- STATE THE MERITS AND DEMERITS OF STRAIGHT LINE METHOD OF PROVIDING DEPRECIATION.
ANSWER:
(A) MERITS OF STRAIGHT LINE METHOD
  1. It is a very simple method of calculating depreciation.
  2. Under this method Asset can be depreciated up to the net scrap value or zero value.
  3. Under this method the same amount is charged as depreciation in Profit & Loss Account.
(B) DEMERITS OF STRAIGHT LINE METHOD
  1. It is difficult to know the estimated scrap value of assets.
  2. Calculation of depreciation is difficult, when there are different machine with different life spans.
  3. An asset can be used even after the value of assets is reduced to zero.

 

Q.2- GIVE THE FORMULA TO CALCULATE THE ANNUAL DEPRECIATION OR RATE OF DEPRECIATION ON COST AS PER STRAIGHT LINE METHOD.
ANSWER:
(A) ANNUAL AMOUNT OF DEPRECIATION UNDER SLM Annual Depreciation      = \(\frac{Origional\, Cost\, -\, Estimated\, Scrap\, Value}{Estimated\, Useful\, Life}\)
(B) RATE OF DEPRECIATION ON ORIGINAL COST Rate of depreciation =   \(\frac{Annual\, Depriciation}{Original\, Cost\, of\, Asset}\, X\, 100\)

WRITTEN DOWN VALUE METHOD

Q.1- STATE MERITS AND DEMERITS OF WRITTEN DOWN VALUE METHOD OF PROVIDING

DEPRECIATION.

ANSWER:
(A) MERITS OF WRITTEN DOWN VALUE METHOD
  1. This method is based on a more realistic assumption that the benefits from asset go on diminishing with the passage of time.
  2. Income Tax department accepts this method for tax purposes.
  3. Under this method depreciation is easy to calculate especially when new assets are purchased.
(B) DEMERITS OF WRITTEN DOWN VALUE METHOD
  1. Under this method book value of asset can never be zero.
  2. It is difficult to ascertain a suitable rate of depreciation.
Q.2- GIVE THE FORMULA TO CALCULATE RATE OF DEPRECIATION AS PER WRITTEN DOWN METHOD.
ANSWER:
(A) RATE OF DEPRECIATION ON ORIGINAL COST Rate of depreciation =

Where,

R= rate of depreciation

n = useful life of asset

S = scrap value

C = cost of asset.

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

ANSWER KEY
1-c, 2-b, 3-a

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.