Depreciation Accounting assignment help 

Depreciation can be described as permanent, continuing and gradual reduction in the book value of the fixed assets due to normal wear and tear, expiration of legal rights or obsolescence. Fixed Assets are the assets which are used in the business for more than one accounting year.  Thatswhy, fixed assets are also known as ‘depreciable assets’.  

It is to be noted that if a business enterprise buys a machine for its production process, it will continue to depreciate when its used rigorously or not used at all. It will depreciate a lot more if a new model comes out and the machine becomes obsolete. 

According to Institute of Cost and Management Accounting (ICMA), London, “Depreciation is the diminution in intrinsic value of the asset due to the use and/or lapse of time”.

Depreciation is allocated so as to charge fair proportion of depreciable amount in each accounting period during the expected useful life of the asset. The useful life of assets is pre-determined. Depreciation has a significant effect in determining and presenting the financial position of the entity effectively. 

Depreciation is only charged on ‘depreciable’ assets. Depreciable assets are assets which-

1. Are expected to be used for more than one accounting period;
2. Have a limited useful life; and
3. Are held by an enterprise for use in production or supply of goods and services, for rental to others, or for administrative purposes and not for the purposes of sale in the ordinary course of the business.

E.g. Plant & Machinery, furniture, buildings, computer and equipment, vehicles, etc.

Features of Depreciation

1. It is a continuous process and it lasts until the asset is sold off or becomes scrap. 
2. It is an expired cost and is deductible from profits before the tax is calculated. Hence, it also helps in tax saving.
3. It is a non-cash expense and doesn’t involve any cash outflow. It is a process of writing-off the capital expenditure that has already incurred.

Depreciation is often replaced with terms like ‘depletion’ and ‘amortisation’. This is because of the similar treatment given to each of them in accounting and because they represent expiry of value and usefulness of the assets.

 The term ‘depletion’ is used in context of the assets which are natural resources which are found on extraction like mines, quarries, etc. The decline in the value of these natural resources is called depletion. 

The term ‘amortisation’ is used to describe the writing-off the cost on intangible assets like patents, copyrights, trademarks, goodwill, franchises, etc. which have utility for a specific period of time. 

Causes of Depreciation

Following are the reasons of for depreciation-

1. Wear and tear due to usage or passage of time
2. Expiration of legal rights
3. Obsolescence (due to technological changes, changes in market demand or production methods or any legal causes)
4. Abnormal factors (e.g. earthquakes, floods, fire or any other accidental happening)

Importance or need for depreciation

The need of depreciation arises due to the conceptual, legal and practical business consideration. These considerations are as follows-

1. Matching costs and revenue: The motive behind acquisition of a fixed asset is to use it in the operations to earn revenue. Fixed assets are huge capital expenditure whose value cannot be determined completely in the period in which it is purchased. Hence, we charge depreciation to allocate the right portion of the cost of the fixed assets used to generate revenue in that particular period. Therefore, depreciation is as much an expense for a business as any other expenses.
   
2. Tax consideration:  Depreciation is a deductible cost for tax purposes. So its also a way for the company to save taxes.
   
3. True and fair performance and financial position: If depreciation is not provided on assets, then the assets will be overvalued and the correct financial position will not be represented to the users. Depreciation is also an expense, so if not charged properly, the profit/loss of the firm will not be correct.
   
4. Compliance with Law: There are legal requirements as well for the enterprises that makes it necessary to provide depreciation on fixed assets.

Factors affecting the amount of depreciation

1. Cost of asset: Cost here refers to the historical cost or original cost. Besides the purchase price, the transportation, registration and installation costs incurred at the time of purchase are also added to the cost of the asset.
2. Estimated net residual value or scrap value: Net residual value or scrap value is the estimated sale value that asset will have at the end of its useful life.
3. Estimated Useful life: Useful life refers to the economic or commercial life of an asset The useful life of an asset is usually pre-estimated to use it as a base for charging depreciation.

Methods of calculating depreciation

There are several methods of calculating and charging depreciation like straight line method, written down method, insurance fund method, depreciation fund method, annuity method, etc. but the most widely used methods are-  a) Straight Line Method; b) Written Down Method

The selection of an appropriate method depends on the following:

1. Type of the asset
2. Nature and use of the asset
3. Circumstances prevailing in the business environment

Straight Line Method: This is the earliest and the most widely used method for charging depreciation. This method is based on the assumption of the equal usage of the assets over its entire useful life. This method is also known as the ‘fixed installment’ method because a fixed and equal amount of depreciation is charged every year.

The depreciation under this method is computed as-

Written Down Value Method: Under this method, depreciation is charged on the book value of the asset and not on the original cost. This method is also called ‘reducing balance’ or ‘diminshing value’ method because the depreciation amount keeps decreasing every year because it is charged on the book value.

The depreciation under this method is computed as-

Here, Book value = [Original cost of the assets – depreciation charged till now]

Comparison of the two methods

Methods of recording depreciation

Charging Depreciation to Asset account: Depreciation is deducted from the depreciable cost of the assets (credited to assets account) and charged to the profit and loss account (debited). 

Journal entries for this method is-

Depreciation A/c      Dr.(with amount of depreciation)

  To Assets A/c

Profit & Loss A/c       Dr.       (with amount of depreciation)

  To Depreciation A/c

Balance Sheet Treatment

The fixed assets appear on the asset side with the net book value (cost less depreciation). 

Creating Accumulated Depreciation Account: A separate account is created to provide for depreciation and every year the depreciation expenses is transferred and accumulated in that account.

Journal entries for this method is-

Depreciation A/c      Dr.(with amount of depreciation)

  To Accumulated Depreciation A/c

Profit & Loss A/c       Dr.       (with amount of depreciation)

  To Depreciation A/c

Balance Sheet Treatment

The fixed assets appear on the asset side with the original cost and the accumulated depreciation account appears on the liabilities side of the balance sheet.

Example: M/s Hannah Pharmas purchased an equipment for $50,000 in January, 2017 and spent $2,000 on its installation. The salvage value of the equipment after its useful life of 10 years is estimated to be $1,000. Pass journal entries if the company follows-

1. Straight Line Method and charges depreciation to asset account
2. Written Down Value Method and charges depreciation to provision account (Rate =10%)

Solution: For case (a)-

For case (b)-

Disposal of Asset

Disposal or sale of assets can take place at either end of its useful life (at scrap value) or during its useful life (at market value). 

Journal entries for this are-

(a)    If the company charges depreciation to asset account

Bank/ Cash   A/cDr.       (with amount of sale price)