Accountancy

Depreciation – Meaning, Causes, Methods, features And Importance

Depreciation Meaning :- In every business there are certain assets of a fixed nature that are needed for the conduct of business operations. Some examples of such assets are Building, Plant and Machinery, Motor Vehicles, Furniture, Office equipments etc. These assets have a definite span of life after the expiry of which the assets will lose their usefulness for the business operations. Fall in the value and utility of such assets due to their constant use and expiry of time is termed as depreciation. In other words, the of allocation of the cost of a fixed asset over its useful life is known as process depreciation.

Causes Of Depreciation

(1) By Constant Use – Due to the constant use of fixed assets in business operations wear and tear arise in them which results in the reduction of their values.

(2) By Expiry of Time – The value of majority of assets decreases with the passage of time even if they are not being put to use in the business. Natural forces such as rain, winds, weather etc. contribute to the deterioration of their values.

(3) By Expiry of Legal Rights – There are certain assets which have a definite span of life such as Lease.

(4) By Obsolescence – Quite often, due to new inventions and improved techniques the old assets become obsolete and may have to be discarded even if they can be put to use physically.

(5) By Accident – Sometimes a machine may be destroyed due to fire, earthquake, flood etc. or a vehicle may be damaged due to accident.

(6) By Depletion – Depletion is the decrease in the value of wasting assets such as mines, oil-wells etc. due to their constant working.

Special Features Or Characteristics Of Depreciation

1. Depreciation is decline in the value of fixed assets (except land).

2. Such fall is of a permanent nature. Once the value of an asset is reduced due to depreciation, it cannot be restored to its original cost.

3. Depreciation is a gradual and continuing process because the value of the assets will decline either by their constant use or obsolescence due to expiry of time.

4. Depreciation is not the process of valuation of asset but process of allocation of the cost of an asset to its effective span of life.

5. It decreases only the book value of the asset, not the market value.

6. The term depreciation is used only in respect of tangible fixed assets. The term is not used for wasting assets such as mines, oil-wells etc.

7. It is a non-cash expense. It does not involve any cast outflow.

Methods Of Depreciation

Various methods have been devised for providing depreciation. Different methods are suitable for different assets depending upon the nature and type of the asset. These methods are enumerated as under :-

  1. Straight Line Method
  2. Written Down Value Method
  3. Annuity Method
  4. Depreciation Fund Method
  5. Insurance Policy Method
  6. Revaluation Method
  7. Depletion Method
  8. Machine Hour Rate Method

Importance Of Depreciation

(1) For ascertaining the true profit or loss – The true profit of a business can be ascertained only when all costs incurred for the purpose of earning revenues have been debited to the Profit and Loss Account. As the Assets are used in earning revenues, the depreciation in the value of an asset is as much an expense as any other, such as wages, salary, rent etc.

(2) For showing the ‘true and fair view’ of the financial position – If the depreciation is not charged, the assets will be shown in the Balance Sheet at an amount which is in excess of their true values. As such, the Balance Sheet will not present the “true and fair view’ of the financial position of a business.

(3) To ascertain the accurate cost of production – As depreciation is also an item of expense, the correct cost of production cannot be calculated unless it is also taken into account. Sale price chargeable from customers is determined on the basis of cost of production and hence if the depreciation is not included in Cost of Production, the sale price will be fixed at lower rates and this in turn will lead to reduced profits.

(4) To provide funds for replacement of assets –┬áDepreciation though debited to Profit & Loss Account, is not paid in cash like other expenses. Hence, the amount of depreciation is retained in the business and is used for the replacement of fixed assets after the expiry of their estimated span of life.

(5) To prevent the distribution of profits out of capital :-If the depreciation is not charged, the profit shown by the Profit and Loss Account will be in excess of the actual profits. Such an excess profit may be wholly withdrawn by the proprietor or may be distributed among the shareholders as dividend. Hence, the amount of dividend distributed will also include the amount of depreciation which is actually a part of capital.

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