Depreciation

In every business, certain fixed assets such as buildings, plant and machinery, motor vehicles, furniture, and office equipment are essential for operations. These assets have a limited useful life, after which they lose their utility. The reduction in the value and usefulness of these fixed assets due to usage and the passage of time is called depreciation. It is the process of allocating the cost of a fixed asset over its useful life.

---

Definition of Depreciation

“Depreciation is the measure of the exhaustion of the effective life of an asset from any cause during a given period.”
— Spicer & Peglar

“Depreciation is the gradual and permanent decrease in the value of fixed tangible assets from any cause.”
— R. N. Carter

---

Features of Depreciation

• Depreciation is a permanent decline in the value of fixed assets (except land). Once reduced, the value cannot be restored to original cost.
• It is a gradual and continuous process caused by use, obsolescence, or time expiry.
• Depreciation is an allocation of cost, not a valuation of the asset.
• It decreases only the book value, not the market value.
• The term applies only to tangible fixed assets, not wasting assets like mines or oil wells.
• It is a non-cash expense and does not involve any cash outflow.

---

Causes of Depreciation

• Constant use
• Expiry of time
• Expiry of legal rights
• Obsolescence
• Accident
• Depletion
• Permanent fall in market price

---

Factors Affecting Depreciation

Actual depreciation cannot be precisely calculated but estimated considering:

• Total cost of the asset
• Estimated useful life of the asset
• Estimated scrap (residual) value

---

Methods of Depreciation

• Straight Line Method (SLM)
• Written Down Value Method (WDV)

---

Difference Between SLM and WDV

Straight Line Method (SLM): Depreciation is charged evenly over the asset's useful life, with the same amount each year.

Written Down Value Method (WDV): Depreciation is charged at a fixed percentage on the reducing book value each year, resulting in decreasing depreciation amounts annually.

---

Advantages of SLM

• Simple to understand and apply.
• Asset value can be completely written off.
• Asset value can be reduced to zero at the end of useful life.
• Facilitates easier profit comparison due to equal depreciation charges.
• Suitable for assets with constant usage.

---

Advantages of WDV

• Simple and easy to operate.
• Annual depreciation reduces with the asset's reducing balance.
• Higher depreciation in earlier years when the asset is more efficient and repair costs are low.

---

Methods of Recording Depreciation

• Charging depreciation directly to the Asset Account.
• Creating a Provision for Depreciation account.
• Treatment of depreciation on disposal of asset.

---

Key Terms

Depletion: Physical deterioration due to exhaustion of natural resources like mines or oil wells. Depreciation is charged based on quantity produced.

Amortisation: Writing off the cost of intangible assets such as patents, copyrights, trademarks, franchises, and leasehold mines over their useful life.

Obsolescence: Loss of asset value due to technological advancements making assets outdated.

Provisions and Reserves

---

Provisions

Provisions are amounts set aside from profits to meet known liabilities whose exact amount is uncertain. Examples include:

• Provision for bad and doubtful debts
• Provision for depreciation
• Provision for taxation
• Provision for discount on debtors

---

Reserves

Reserves are created from profits to strengthen the financial position and support future growth. They are classified as:

(i) Revenue Reserve

Created from revenue profits earned from normal business activities. It can be general or specific.

• General Reserve: Created without any specified purpose.
• Specific Reserve: Created for a specific purpose, e.g., Debenture Redemption Reserve, Investment Fluctuation Reserve, Dividend Equalisation Reserve, Workmen Compensation Fund.

---

(ii) Capital Reserve

Created from capital profits arising from non-operating activities such as sale of fixed assets. Examples include:

• Premium on issue of shares
• Premium on issue of debentures
• Profit on redemption of debentures
• Profit on sale of fixed assets
• Profit on reissue of forfeited shares
• Profit prior to incorporation

---

Difference Between Capital and Revenue Reserve

Revenue Reserve: Created from regular business profits, can be used for general or specific purposes, and may be distributed as dividends.

Capital Reserve: Created from capital profits, used only for specific purposes, and cannot be distributed as dividends.

---

Key Terms

Open Reserves: Reserves shown on the liabilities side of the balance sheet.

Secret Reserves: Reserves not shown in the balance sheet and kept confidential.

Reserve Fund: Reserves invested outside the business in securities.