Question

Explain the concept of depreciation. What is the need for charging depreciation and what are the causes of depreciation?

Answer 1

Every business acquires fixed assets for its use in the business over a period of time. As the benefits of these assets can be availed over a long period of time (due to their regular use), there exists continuous wear and tear and consequently fall in their value. This fall in the value of fixed assets (due to regular use or expiry of time) is termed as depreciation.

A machinery that costs Rs 1,00,000 and its useful life of 10 years, its depreciation will be calculated as:

1. To ascertain true net profit or net loss− Correct profit or loss can be ascertained when all the expenses and losses incurred for earning revenues are charged to profit and loss account. Assets are used for earning revenues and its cost is charged in form of depreciation from profit and loss account.

2. To show true and fair view of financial statements− If depreciation is not charged, assets are shown at higher value than their actual value in the balance sheet; consequently, the balance sheet does not reflect true and fair view of financial statements.

3. For ascertaining the accurate cost of production− Depreciation on plant and machinery and other assets, which are engaged in production, is included in the cost of production. If depreciation is not included, cost of production is underestimated, which will lead to low sale price and thus leads to low profit.

4. Distribution of dividend out of profit− If depreciation is not charged, which leads to overestimating of profit and consequently more profit is distributed as dividend, out of capital instead of the profit. This leads to the flight of scarce capital out of the business.

5. To provide funds for replacement of assets− Unlike other expenses, depreciation is not a cash expense. So, the amount of depreciation charged will be retained in the business and will be used for replacement of fixed assets after its useful life.

6. Consideration of tax− If depreciation is charged, then profit and loss account will disclose lesser profit as to when the depreciation is not charged. This depicts reduced profit and thus the business will be liable for lesser tax amount.

Below are given the causes for depreciation.

1. Constant use− Due to constant use of the fixed assets there exists normal wear and tear that leads to fall in the value of fixed assets.

2. Expiry of time− With the passage of time, whether assets are used or not, its effective life decreases. The natural forces like rain, weather, etc. lead to deterioration of the fixed assets.

3. Obsolescence− Due to the fast technological innovations and inventions today’s assets may be outdated by tomorrow’s sophisticated assets. This leads to the obsolescence of fixed assets.

4. Expiry of legal rights− If an asset is acquired for a specific period of time, then, whether the asset is put to use or not, its value becomes zero at the end of its useful life. For example, if a land is acquired for Rs 1,00,000 for 25 years on lease, then each year its value depreciates by of its gross value. At the end of the 25^th year, the value of the lease will be zero.

5. Accident− An asset may lose its value and damage may happen to it due to mishaps such as a fire accident, theft or a natural calamity. The loss due to accident is permanent in nature.

6. Permanent fall in value− Generally, we do not record fluctuations in the market price of the fixed assets in the books. However, if the fall in market price is permanent, it is accounted, which leads to a fall in the value of fixed assets in the books.