Depreciation
The Fixed Assets Accounting

Depreciation is reduction in the value of an fixed physical asset due to its usage or or passage of time. It is a non-cash expense; this simply means that no money is actually paid at the time in which the expense is incurred.

Depreciation accounting is allocating the cost of fixed asset over its productive life and recording the expired cost against the revenue of the accounting year.

The purpose of treating and recording depreciation as an expense over a period of time is to spread the net purchase price of the fixed asset over its useful life.

Assets are normally depreciated for two reasons:

  1. Wear and Tear (decrease in value due to usage) and
  2. Obsolescence (getting outdated or being replaced by new models)
Methods of Charging Depreciation:

The different methods for charging depreciation are basically divided into four:

  1. Straight-Line Method
  2. Written Down Value or Diminishing Balance Method.
  3. Sum of the Year's Digits Method
  4. Remaining Value Over Remaining Life Method
1. Straight Line Method of Depreciation:

Under this method, the net acquisition cost of the asset is charged off in equal proportion during the useful economic life and the amount of depreciation is arrived at by dividing the net acquisition cost by the number of years of its useful economic life to get the depreciation expense per period. It is the most commonly used depreciation method for providing depreciation due to its simple calculation.

The net acquisition cost is calculated by deducting the salvage value from the acquisition cost.

2. Written Down Value or Diminishing Balance Method:

The Diminishing Balance Method of depreciation as the name suggests depreciates an asset at a higher rate in the earlier years of the asset's economic life than the Straight Line Method of depreciation.

Diminishing Balance Method of depreciation is a technique under which the amount of depreciation that is charged to an asset declines with the lapse of time of usage. In other words, the amount of depreciation charged is more at the beginning of the useful life and is less during the end of its useful life.

Thus, in the early years of their life time, assets generate more revenue than in later years of their life. According to the matching principle of accounting, we should depreciate more of the asset's cost in early years to match the depreciation expense with the revenue earned from the use of the asset.

3. Sum-Of-The-Years-Digits Method:

Under this method, accelerated techniques of depreciation calculation is adopted which are based on the assumption that assets are generally more productive when they are new and their productivity decreases as they become old.

This method considers the asset's expected life and adds together the digits for each year. So, if the expected useful life of the asset is three years, the sum of the years' digits would be obtained by adding 3 + 2 + 1 to get a total of 6. Each digit is then divided by this sum and the percentage of depreciation is then determined by which the asset should be depreciated each year.

4. Remaining Value Over Remaining Life Method:

Remaining value over remaining life is similar to that of straight-line depreciation with the only difference is that while the straight-line calculation is static; the remaining value over remaining life calculation is dynamic.

For instance, if there is a change in the asset's estimated useful life, the straight-line method of depreciation cannot adjust its future calculations so that the asset is fully depreciated to the end of its life. The Remaining Value Over Remaining Life Method of Depreciation, on the contrary, can consider the asset's remaining depreciable basis and depreciates that amount evenly over the asset's remaining estimated useful life.

Why Provision For Depreciation Is Treated As Short Term Provision?

Whenever we create any provision for depreciation, we reduce the amount of profit to the extent of that amount. Since it is a non-cash expense, it does not affect the cash balance of the concern. It rather saves cash from being distributed as dividend. On the contrary, when it is added back to profits of the firm to arrive at the earnings of the firm it definitely increases the earnings of the firm. Hence, it can be considered as internal source of very short term finance.

Can Depreciation Be Considered As A Source Of Internal Finance?

Depreciation is decrease in the value of assets due to its usage. Depreciation can be considered as source of internal finance for the concern as it is a non-cash expense. Depreciation is the amount written off in respect of fixed assets purchased. The amount written off is deducted from the profits of the concern. Depreciation is a great accounting tool if applied correctly. As assets are depreciated, tax liability of the concern decreases, allowing the money to keep funds that it otherwise would have needed to use to pay taxes. This frees up capital for investments and other endeavors.

Concept Of Annuity Method Of Depreciation:

Under Annuity Method of depreciation, the amount spent in purchasing an asset is considered as an investment earning interest at a certain rate.

The amount of interest is debited to Concerned Asset Account (increasing the value of assets) and is credited to Interest Account (treating it as income for the concern) which is eventually transferred to Profit and Loss Account.

While calculating of the amount of depreciation, the cost of the asset and interest thereon are added on the reducing balance of the asset account and the amount of interest gradually decreases every year. The amount of depreciation to be annually charged by equal installments and is calculated in such a way that inspite of increase in the value of asset every year due to addition of interest to the value of asset, the book value of the asset is reduced to zero.

The amount of depreciation charged is debited to depreciation account and credited to asset, while the interest amount is debited to asset account and credited to interest account.

Here it is to be noted that the amount of depreciation is calculated on the basis of annuity table. If any addition is made to asset account, the calculation has to be revised.

Journal Entries For Annuity Method Of Depreciation:

1. For Recording The Value Of Interest:

Asset A/c--------------------Dr.

            To Interest A/c

(Being interest added to the reducing value of asset)

2. For Charging Depreciation:

Depreciation A/c--------------------Dr.

            To Asset A/c

(Being the depreciation charged on asset)

Advantages Of Annuity Method Of Depreciation:

The following are the advantages of annuity method:

  1. Annuity method takes interest on capital invested in the asset into account which increases the capital investment of the concern.
  2. Annuity method is considered as precise from the point of view of calculations. So it is regarded as scientific method.
Disadvantages Of Annuity Method Of Depreciation:

The following are the disadvantages of the annuity method:

  1. For common man, the method is difficult to understand.
  2. It is not useful for that concern which requires frequent addition and extensions, the calculation have to be changed frequently, which is increases work burden.
Provision For Depreciation:

Provision for Depreciation is a separate account created to accumulate the amount of depreciation without affecting the value of the asset. In the Balance Sheet, the value of asset is shown at its original cost and the accumulated amount of depreciation is shown separately.

Under this method, although depreciation is treated as expenditure and is also debited but the amount of depreciation is not directly deducted from asset account. Rather a provision is created and is built up periodically by crediting provision for depreciation account. Finally, depreciation account is closed by transferring the amount of depreciation to profit and loss account.

In the balance sheet, the assets appear at its original cost and the accumulated depreciation is shown as a deduction from the asset account. So from the balance sheet, the original cost of the assets and the total depreciation charged to-date on that asset chalked out.

If any asset is sold or discarded, a proportionate amount of provision for depreciation is deducted from asset account and only then the residual value compared with the sale proceeds will reveal the actual amount of profit or loss on sale of asset which is then transferred to the profit and loss account. If there is sale as such, the proportionate amount of provision for depreciation will be treated as loss and will be debited to the profit and loss account

Journal Entries For Providing Depreciation:

For Providing Depreciation:-

Depreciation A/c --------------------------------------------------Dr

            To Provision For Depreciation A/c

(Being depreciation @ --- provided for the period)

For Closing Depreciation Account And Transferring To Profit And Loss Account:-

Profit And Loss A/c -------------------------------------------------- Dr

            To Depreciation A/c

(Being the amount of depreciation transferred to profit and loss account)