Ans:- Depreciation is the expense beared or sacrifice made for the benefit obtained from a fixed asset during a period of time. It is allocated so as to charge a fair portion of the depreciable amount in each accounting period during the expected useful life of the asset. It is allocated so as to charge a fair portion of depreciable amount in each accounting period during the expected use of life of the asset.
Depreciation is a measure of wearing out, consumption or other loss of value of a depreciable asset arising from use, passage of time, obsolescence through technology and market changes. Depreciation is the distribution of the total cost of asset over its useful life.
Q) What are the Different methods of valuing depreciation?
Ans- Straight Line / Equal Instalment Method-
This is the most popular and commonly used method because of its consistency and simplicity. It requires allocation of an equal amount to each of the periods. Thus every year the asset is written down by the same amount. This amount is such that the book value of the asset may be may be reduced to zero (0) or its residual value as the case may be at the end of its life.
Diminishing Balance Method-
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In this method a fixed rate on the reduced balance of the particular asset is charged as depreciation every year. Over the life of the asset the amount of depreciation charged every year decreases as a constant percentage rate is applied to the written down value. The assumption in this method is that the maximum loss in the assets occurs in the initial years as compared to its later years of useful life.
Sinking Fund Method-
In this method along with Depreciation provision for replacement of the asset is also taken into account. This method is based on present values and a fund is created by debiting Depreciation A/c and crediting sinking fund A/c.
Insurance Policy Method-
This method is similar to sinking fund method but, instead of investing the amount in the securities, the amount is used in paying the premium on a policy taken out with a insurance company.
Sum-of-the Year's Digits Method-
Here, it is assumed that the more depreciation should be charged in the early years of the life of the asset. Approximately 2/3rd of the cost is allocated to the 1st half of the asset's estimated economic life.
This method takes into consideration the time value of money and opportunity cost of capital locked up in the asset. Here, the total amount of depreciation written off during the life of the asset is equal to the net cost of the asset plus interest calculated on the reducing balance.
Revaluation Method- This method is used for writing off a fixed asset to its current value.
This method is an accounting for natural resources ( eg, mines, quarries, etc) rather than accounting for depreciation. These kinds of assets cannot be depreciated but can gradually be depleted.
Machine Hour Rate Method-
This is a method in which the annual machine hours in use is compared with total anticipated machine hours over the life of the machine for the purpose of providing depreciation..
Depreciation & Repairs Fund Method-
In this method total maintenance costs are removed for the the entire life of the asset and added to its capital cost in order to get a composite figure which is divided by years of life of the asset.
In relation to the above some important points are to be noted:-
The selection of the method is based on type of asset, nature of its use & the circumstances prevailing in the business.
As per ICAI guidance note on AS-6, a company may adopt different methods of depreciation for different types of assets provided the same methods are constantly followed every year in terms of sec 205(2) of the Companies Act.
There may also be a change in the method of depreciation during the useful life of a depreciable asset.
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Q) How is Depreciation Calculated?
Ans:- Accounting for depreciation is mandatory in nature as per AS-6 and is to be systematically allocated. Systematic allocation means any method of charging depreciation which gives systematic expenses on assets. There are two methods of systematic allocation which are widely accepted. They are (i) Equal Instalment Method & (ii) Diminishing Balance Method. Generally entities follow Diminishing Balance Method for plant, machinery & furniture and Fixed Installment method for buildings.
(i) Straight Line Method:-
Depreciation = Cost of Asset - Scrap Value
Estimated Life of the Asset
(ii) WDV/ Diminishing Balance Method:-
Where D= Rate of Depreciation to be charged
r = Scrap value
c = Cost of Acquisition
n = Number of years of useful life
Note:- In the above cases if scrap value is not given then the rate of depreciation cannot be calculated under this method.
Apart from the above points there are a few critical aspects in calculation of depreciation which must be highlighted.
As per AS-1 accounting policies should be followed for material items only. Items which are not material should be written off instantly.
Example:- Assets whose value is upto Rs 5000 is written off at once. Here accounting policies are to treat the material value of the assets. Again when the asset is purchased during the accounting period the time value must be taken into account.
Again, when the asset is purchased during the accounting period, the time factor must be kept in mind before calculating depreciation for the year of purchase.
When an asset is revalued, depreciation is calculated on the revalued figure in prospective basis.
Change in the method of Depreciation:-
According to AS-6 Depreciation method can be changed if required. If the method is changed it is called change in accounting policy and it should be done retrospectively. For this purpose the following disclosures are to be made:-
Reasons for change of policy:
For better presentation.
For compliance with law
For compliance with Accounting Standard.
Effect of change in profitability
Thus the effect for the change should be clearly shown in the profitability statement in retrospective manner. Retrospective effect means the deficit or surplus i.e., the difference between depreciation computed from the date of purchase of the asset till the date of change in method, in the new method and the old method, should be adjusted in the accounts by debiting or crediting P/L account as the case maybe.
Note: As per AS-6, if life of asset or scrap value of asset is changed, then the calculation for depreciation must be done in prospective basis, i.e. effecting from the date of such change and not past history.
Representation in the Financial statements:-
The annual report of Tata Steel (20011-12) has been taken as a example for showing the representation of depreciation in the Balance Sheet:-
Q) Why is Depreciation considered as a source of fund?
Ans:- Depreciation is a non cash expense but it is charged against profit just like salary, rent, etc. As it does not cause any outflow of cash in that particular period in which it is charged, some accountants prefer to consider it as an amount retained in cash. It may be believed that this helps the company to build a fund in cash which makes it easy to buy new and useful assets in the long run. But the hardcore fact is that the above belief is not at all correct. Depreciation is a portion of the total outflow of cash already made for acquiring an asset. It is an internal arrangement and it affects the value of the fixed assets and also the periodic revenue. Depreciation does not help in creating or maintaining any kind of fund. It definitely affects periodic revenue and amount of tax to be paid but it does not involve the creation or extinction of any fund.Â
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Thus, in a nutshell had the purpose of depreciation been to retain funds for replacement of fixed assets it could be achieved by transferring appropriate amounts to reserves. The transfer to reserve is an "appropriation of profit". But profit is calculated after calculating depreciation. So, Depreciation is not a source of fund