Q.1. Depreciation in accounting is neither the recording of physical deterioration nor of decline in market value of tangible properties or assets.
Ans. This statement emphasises that in accounting the purpose of depreciation is to recognise the expiration of asset cost through use. Its primary purpose is cost allocation.
According to American Institute of Certified Public Accountants (AICPA), "Depreciation in Accounting is a system which aims to distribute the cost or other basic value of a tangible capital asset, less its salvage value, if any, over the estimated useful life of the unit (which may be a group of assets) in a systematic and rational manner, it is a process of allocation and not of valuation. Depreciation for the year is portion of the total charge under such a system that is allocated to the year."
Depreciation accounting treats the original cost of the asset as deferred expenses and the original cost of the asset is therefore charged against the income of various accounting periods by allocating it over its useful life in a systematic manner.
The following points may be emphasised to explain depreciation accounting:
(i) It is concerned with allocation of depreciable amount (i.e., cost less residual value) of an asset over its estimated useful life in a systematic manner.
(ii) Depreciation is used on cost of the asset and not on the market value of the asset. Thus it is a process of allocation of cost, not of valuation of assets.
(iii) Portion of depreciation amount, which is allocated to an accounting year and is charged to Profit & Loss Account of that year, is called depreciation.
Depreciation is a measure of fall in the value of an asset during an accounting year.
(i) Depreciation does not provide funds for*replacing the asset when its useful life ends.
(ii) Depreciation accounting is not concerned with the decline in the value of current assets like inventories.
(iii) Land is not subject to depreciation.
Is mainly caused by the normal wear and tear of the asset because of the asset being used in business. Any other deterioration in the value of an asset because of factors such as obsolescence, destruction, accident etc. is not called depreciation. But in case of assets like leases, patents, copy rights etc., even loss in the value of the asset because the asset is just not used is or may be called depreciation. Decrease in value of the asset in such cases arises just because of passage of time even. Further, depreciation not only relates to the fixed assets, it arises even in cases of other non-fixed assets such as motor vehicles, furniture etc.
Q.2. Need for providing depreciation.
Ans. The need for depreciation arises because of the following reasons:
TO KNOW THE TRUE PROFITS.
Depreciation is an expense and becomes an important element of the cost of production. Though it is not visible like other expenses and never paid to the outside party, yet it is desirable to charge depreciation on fixed assets as these are used for earning purposes. So their depreciation must be deducted out of the income earned from their use in order to calculate net profit or loss.
TO SHOW TRUE FINANCIAL POSITION
Financial position of a business can b studied from the Balance Sheet and for the preparation of Balance Sheet, fix assets are required to be shown at their true value. If depreciation is no provided, the assets will appear in the Balance Sheet at a value higher
than their real value and will not reflect the true financial position. So, forth purpose of reflecting true financial position, it is necessary that depreciation must be deducted from the assets
TO MAKE PROVISION FOR REPLACEMENT OF ASSETS
Assets used in the business need replacement after the expiry of their service. If depreciation is no charged against the profit during its lifetime, it will be difficult to find case to replace the asset. If depreciation is not accounted for, the profit of the business is overstated. Such a firm would have distributed not only profit but a part of capital also.
TO COMPUTE TAX LIABILITY
Depreciation is a chargeable expense from income tax point of view. By calculating depreciation as per tax laws and charged it to Profit and Loss Account, taxable income can be calculated.
TO DETERMINE PRODUCT-COST FOR MANAGERIAL DECISION MAKING
Depreciation though a non-cash expense, is very important for calculation of cost o production. Therefore, deduction of depreciation is necessary to determine real product cost for decision-making.
Q.3. What is "Depreciation"? Explain.
Ans. Many assets are used in a business. No business can be carried on without assets. Some of these assets are current assets, the ones which are created or get created in the course of the ordinary business cycle, i.e., inventories, debtors, bills receivables. These are always short-term or short life assets and do not depreciate. However, all other non current assets that are used in business, get depreciated except assets like land.
INDIAN ACCOUNTING STANDARD-6 (REVISED) DEFINES DEPRECIATION AS:
"A measure of wearing out, use or consumption or even other loss of value of a depreciable asset arising from use, passing of time or even obsolescence through changes in technology and market changes."
Amount of depreciation is allocated so as to charge a fair proportion of the value of asset in each accounting period over the expected useful life of an asset. Depreciation is related to only the cost of the asset and has nothing to do with the current market value of the asset. It is so because of the historical cost concept. It reduces the value of the asset and is charged on a continuous basis year after year till the asset is used in business.
DEPRECIABLE ASSETS ARE THOSE WHICH
(i) Are expected to be used during more than one accounting periods,
(ii) Have a limited useful life, and
(iii) Are held by an enterprise for use in the production or supply of goods and services, for rental to others, or for administrative purposes and not for the purpose of sale in the ordinary course of business.
Q.4. Annuity method and depreciation fund (sinking fund) method of depreciation.
Ans. Differences between Annuity Method and Depreciation Fund Method:
— Under Annuity Method, annual charges are not set aside and the amount remains in the business. Hence this method does not provide funds for replacement of an asset.
Whereas in Depreciation Fund Method, the annual instalments are invested outside the business. Hence this method makes provision for the replacement of an asset.
— Under Annuity Method, money spent on purchasing an asset is considered as an investment and interest lost on this investment is regarded as opportunity cost and is debited to cost of purchasing the asset.
But under the Depreciation Fund or Sinking Fund Method (S.F. method) an amount equal to the amount of depreciation is invested by the firm in some outside investments, called S.F. Investments and the amount of interest earned (actually) on these S.F. Investments is also credited to the Sinking Fund Account.
— Under the Annuity Method, total amount of depreciation provided over the life of the asset is more than the original cost of the asset. However under the Sinking Fund Method, total amount of depreciation over the life of the asset is much less than the original cost of the asset. Rather, the total amount of depreciation and the amount of interest actually earned on the Sinking Fund Investments are equal to the original cost of asset.