Depreciation: Features, Causes, Factors and Need
Depreciation refers to the decrease in the value of assets of the company over a time period due to use, wear and tear, and obsolescence. In others words, it is the method to allocate the cost of an asset over its useful life. Depreciation is always charged on the cost price of the asset and not on its market price. It is charged every year to the extent of the depreciable amount. Examples of assets that can be depreciated are Machines, Computers, Furniture, Vehicles, etc.
According to R.N. Carter, “Depreciation is the gradual and permanent decrease in the value of an asset from any cause.”
According to William Pickles, “Depreciation may be defined as the permanent and continuing diminution in the quality, quantity or the value of an asset.”
Assets can only be depreciated if,
- It is owned by the firm or individual.
- They are used in the business.
- They last for more than one accounting year.
- The useful life of the assets can easily be determined.
Features of Depreciation:
1. Decrease in the Book Value of Fixed Assets: Depreciation is a decline in the book value of a fixed asset and not the market value of the fixed asset, as depreciation is always calculated as a fixed percentage of cost price.
2. Non-Cash Expenses: Depreciation is a non-cash expense because it does not involve any outflow of cash. It is simply a charge to reduce the recorded cost of an asset over its useful life. In the cash flow statement, depreciation is added back to the profit in the operating activities section.
3. Continuous Process: Depreciation is a continuous process of reduction in the value of the fixed assets, as every year depreciation is charged on the fixed assets, and the depreciable amount is deducted from the book value of the asset.
4. Charge Against Profit: Depreciation is a charge against profit, i.e., depreciation is charged even if the firm is at loss. It is done because the asset has to be replaced at the end of its useful life, and actual profit can only be ascertained when depreciation is deducted from operational profit in the income statement.
5. Tax Benefit: It provides a tax benefit to the company, as the depreciation is adjusted to the profit before the payment of taxes. By this, the taxable income is reduced and the firm has to pay less tax on a decreased profit.
Causes of Depreciation:
1. By Constant Use: The constant use of any asset by a business causes wear and tear, which causes a decrease in the value of those assets. As a result, the capacity of the asset to serve in the business is reduced.
2. By Passing of Time: The value of assets also decreases when an asset is exposed to forces of nature like wind, rain, etc., even if it is not put to any use.
3. By Obsolescence: Obsolescence is also one main reason for depreciation. An existing asset can become outdated in some time due to technological changes, improvements in production methods, changes in market demand, etc., as a result, the demand for the asset decreases, as the old asset is not able to fulfill the requirements of the business.
4. By Expiration of Legal Rights: There are some assets that are used in the business for a certain time period. The time period is determined by an agreement in which the tenure to use that particular asset is mentioned. Example: Patents, Copyrights, Lease, etc.
5. By Accident: Assets can be destroyed due to some abnormal factors, such as earthquakes, floods, etc. This leads to a decrease in the value of the asset. Thus, it needs to be taken into account.
Factors Affecting Depreciation:
1. Cost of the Asset: The cost of a fixed asset is determined by adding all the expenses incurred on bringing the asset to usable condition with the purchasing price of that asset. If the cost of the asset is more, the depreciation charged on that asset will also be higher. For example, the company purchased an asset for ₹50,000 and also spend ₹10,000 on its installation. In this case, the cost price to be shown in the books will be 50,000 +10,000 = ₹60,000, and depreciation will be calculated at ₹60,000.
2. Estimated Useful Life: The number of years for which an asset can be effectively used in the business is called its estimated useful life. A machine having more number of useful years will have less yearly depreciation as compared to a machine that has a lesser number of useful years.
3. Estimated Scrap Value: Scrap value is the net realisable value of an asset at the end of its effective life. It is also known as residual value or break-up value. It is deducted from the total cost of the asset at the time of calculating depreciation.
For example, in 2020, a company purchased a machine for ₹1,00,000. At the time of purchase, the scrap value of the machine was estimated at ₹10,000 at the end of 3 years of use. So depreciation is calculated as:
1,00,000- 10,000 = 90,000
Therefore the annual depreciation on that machinery will be ₹30,000.
Need for Depreciation:
1. For Ascertaining the True Profit or Loss: The actual profit of any business can only be determined when all the expenses and losses of the business for the particular year are deducted from the total revenue earned by the business. If the company does not provide depreciation on assets, then it will not be adjusted in the revenue of the firm, and also the assets will be recorded as over-valued. Because of this, the true financial position of the company is not ascertained
2. For Tax Benefit: Depreciation provides tax benefits to the company as the depreciation is adjusted to the profit before the payment of taxes. By this, the taxable income is reduced, and the firm has to pay less tax on a decreased profit.
3. To Ascertain the Accurate Cost of Production: Depreciation is similar to any other expenses that are incurred in the normal course of business. The accurate cost of production can only be determined after taking depreciation into account.
4. To Provide Fund for Replacement of an Asset: Depreciation is debited to Profit and Loss A/c, but it is a non-cash expense, i.e., no actual cash is paid in charging depreciation. Hence, the amount of the depreciation is retained in the business and used for providing funds in purchasing a new asset.
5. To Prevent the Distribution of Profits out of Capital: If the depreciation is not charged by any company, the Profit and Loss A/c will show excess profit instead of actual profit. This excess profit can be withdrawn by the owner or the shareholders of the company. Hence, the amount distributed as profit includes some amount of depreciation which should not happen.
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