Depreciation
Depreciation means a permanent decline in the value of the non-trading assets due to wear and tear and any other reasons. Depreciation is the systematic allocation of the depreciable amount of assets over the life of the assets. Fixed assets are recorded in books of accounts at original cost or acquisition value.
These fixed assets are used for the generation of income for the number of an accounting year in the future with the same cost of acquisition unless they are sold or discarded. Hence the part of the acquisition cost of fixed assets shall be allocated in the books of accounts over the life of the assets which is known as depreciation amount.
J R Batliboi, “depreciation denotes a permanent decline in the value of the assets arising through wear and tear from the use of those assets in business.”
Causes/reasons for providing depreciation:
- Wear and tear due to its use in business
- A decline in Market Value
- Obsolescence due to technological changes
- Expiration of legal right
- Depletion mostly in the case of mines and other reserves.
- Statutory compliance
Now let us discuss each of these points below:
a) Wear and tear due to its use in business :
This is one of the most important reasons for providing for depreciation. Fixed assets when used regularly over a period of time becomes wear and tear. This is due to the continuous use of the assets. Physical wear and tear of the assets decreases assets’ efficiency and hence shall be written off in the books to decrease its value.
b) Decline in Market Value:
Some of the assets have to be depreciated because the market value of these assets falls considerably over the period of time. These assets if not depreciated shall overcast the strength of the balance sheet.
c) Obsolescence due to technological changes:
Due to changes in technologies and changes in fashions, market conditions, government policies machines become obsolete. These machine's value once obsoleted decreases considerably hence depreciation shall be provided in these assets to show the true and fair position of the fixed assets.
d) Expiration of legal right
Some of the fixed assets like patents, copyright, etc. have a fixed period of life as it gets expired after the expiry of the formal agreement to use the assets. Hence these assets need to be depreciated over the life assets.
e) Depletion mostly in case of mines and other reserves:
If an asset is a natural resource, such as an oil or gas reservoir, the depletion of the resource causes depreciation (in this case, it is called depletion, rather than depreciation). The pace of depletion may change if a company subsequently alters its estimate of reserves remaining.
f) Statutory compliance:
Depreciation is often provided for compliance with the provisions of the companies act 2063 as well as the Income Tax Act 2058. The company act directs each company registered in Nepal to provide depreciation as per the provision of the act.
Objectives of providing for depreciation:
a) For ascertaining true profitb) For determination of financial position
c) Funds for replacement
d) Ascertainment of the true cost of production
e) Doesn’t result in cash flows.
a) For ascertaining true profit:
Depreciation amount should be charged for ascertainment of true profit or loss of the firm. If the firm doesn’t account for depreciation of the fixed assets then it will not be considered a loss in value of property plant and equipment (PPE) which is used in the business. Hence actual profit or loss of the firm is not ascertained.
b) For determination of financial position:
PPE shall be disclosed in the financial statements after providing for depreciation in those PPE. If depreciation is not provided in the PPE then they would be disclosed in the financial statements at a value higher than their true value.
c) Funds for replacement:
Depreciation on fixed assets is charged every year. It is a good indication of the amount the enterprise must set aside every year for the replacement of the new fixed assets after the useful life of the existing assets. However, factors like inflation and technological changes might impact replacement costs.
d) Ascertainment of the true cost of production:
Depreciation is charged as an item of cost to ascertain the cost of production. The cost of production of a product includes depreciation. Hence if the cost of production is calculated ignoring depreciation, it gives the wrong result.
e) Doesn’t result in cash flows:
Depreciation is a non-cash item hence it doesn’t impact the cash flows of the organization.
Factors in the measurement of Depreciation
a) Cost of Assets.
b) the Estimated useful life of the assets.
c) Estimated scrap value at the end of useful life.
Now let us discuss the aforementioned points below:
a) Cost of Assets:
Cost of assets includes all the cost incurred for acquisition, installation, and commissioning as well as for additions to or improvement thereof for the purpose of increase in its efficiency. This head includes all the costs incurred for bringing the assets to the necessary condition and location of desired use.
b) the Estimated useful life of the assets:
Useful life is the period during which the depreciable assets are expected to be used or the number of units expected to be produced from the use of the assets. Determination of useful life is the matter of estimation and is usually based on various factors like similar experiences with similar assets, estimated working hours, production capacity, etc.
c) Estimated scrap value at the end of useful life:
Residual value is the value received on the disposition of the assets after their useful life. Determination of the residual value is normally a difficult matter. If the residual value is insignificant it is regarded as nil however if it is significant it shall be estimated at the time of acquisition and installation of the assets.
Once these factors are determined then the depreciable amount is calculated by using different methods of depreciation.
Methods of depreciation
A) Straight Line Method (SLM).
B) Written Down Value Method (WDV).
C) Unit of Production Method.
Now let us discuss each of the above methods of depreciation below:
A) Straight Line Method (SLM):
This is the method of depreciation where the equal amount is written off a year during the life of the asses to bring the value of the assets to nil or its residual value. This method assumes that the particular tangible assets generate equal utility to the organization throughout the year of its life.
While calculating depreciation under this method, the period for which asset is used in the year of the acquisition shall be considered.
Advantages of SLM Method:
a) It is a simple method of depreciation
b) Assets can be written off completely
c) Suitable for small business
Disadvantages of SLM Method:
- Wrong Assumptions that assets perform uniformly over their life
- Difficult to identify the life span of the assets
- Not suitable for fixed assets that have high technological changes.
B) Written Down Value Method (WDV):
Under this system, a fixed percentage of the diminishing value of the asset is written off each year to reduce the asset to its residual value at the end of its life. Under this method, the annual charge for depreciation decreases from year to year, so that the earlier years suffer to the benefit of the later years. Also, under this method, the value of the asset can never be completely extinguished, which happens in the Straight Line Method. However, it is very simple to operate. This method is based on the assumption that the cost of repairs will increase as the asset get old. Therefore, depreciation in earlier years should be high when the repair cost is expected to be low and depreciation in later years should be low when the repair cost is expected to be high.
where n = useful life
Advantages of WDV Method:
a) It assumes that assets perform better in the beginning year of operation and less with every passing year.
b) Amount of depreciation reduces with the reducing value of the assets.
c) This method is recognized by tax and other regulatory bodies.
d) As this method equalizes the total charges of using the asset (i.e., the amount of depreciation plus repair charges) from year to year, it is considered more equitable than the straight-line method. This is because depreciation charges decline each year whereas repair charges increase year by year.
Disadvantages of WDV Method:
a) Under this method, the value of assets is not reduced to zero
b) This method is not suitable for assets having less estimated life of the operation.
c) Calculation of depreciation amount is not as easy as in SLM Method.
d) Difficult to determine the correct rate of depreciation.
Difference between SLM and WDV method of depreciation
Other Method of Depreciation
1) Sum of years of digits method:
It is a variation of the “Reducing Balance Method”. In this case, the annual depreciation is calculated by multiplying the original cost of the asset less its estimated scrap value by the fraction represented by:
2) Annuity Method:
This is a method of depreciation that also takes into account the element of interest on capital outlay and seeks to write off the value of the asset as well as the interest cost over the life of the asset. It assumes that the amount laid out in acquiring the asset if invested elsewhere would have earned interest which must be reckoned as part of the cost of an asset.
On that basis, the amount of depreciation to be annually provided in the accounts is ascertained from the Annuity Tables, to write off each year interest on the capital outlay as well as part of the capital sum at a rate that the whole of the capital sum and interest accruing thereon would be written off over the life of the asset.
3) Machine Hour Method:
Where it is practicable to keep a record of the actual running hours of each machine, depreciation may be calculated based on hours that the concerned machine worked.
The machine hour rate of the depreciation is calculated after estimating the total number of hours that the machine would work during its whole life.
4) Unit Production Method:
Under this method depreciation of the asset is determined by comparing the annual production with the estimated total production. The amount of depreciation is computed by the use of the following method:
5) Depletion Method:
This method is used in the case of mines, quarries, etc. containing only a certain quantity of product. The depreciation rate is calculated by dividing the cost of the asset by the estimated quantity of product likely to be available. Annual depreciation will be the quantity extracted multiplied by the rate per unit.