Chapter 2 Definition, Explanation and Characteristics of "Depreciation" or "Accounting Depreciation":

The value of assets gradually reduces on account of use. Such reduction in value is known as depreciation. Different authors have given different definitions of depreciation, such as: "Depreciation may be defined as the permanent continuous diminution in the quality, quantity or value on an asset." (By Pickles) "Depreciation is the gradual permanent decrease in the value of an asset from any cause." (By Carter) "Depreciation may be defined as a measure of the exhaustion of the effective life of an asset from any cause during a given period." (By Spicer & Pegler) Depreciation is the diminution in intrinsic value of an asset due to use and/or the lapse of time." (By Institute of Cost and Management Accountants, England) "Depreciation is the reduction in the value of a fixed asset occasioned by physical wear and tear, obsolescence or the passage of time." (Northcott & Forsyth) "Depreciation is the diminution in the value of assets owing to wear and tear, effluscion of time, obsolescence or similar causes." (Cropper) From the above definitions, it follows that an asset gradually declines on account of use and passage of time and this causes permanent reduction in the value and utility of asset. Such reduction in the value or utility of asset is called depreciation. In other words, expired cost or utility of asset is depreciation.

Characteristics of Depreciation:
Depreciation has the following characteristics: 1. Depreciation is charged in case of fixed assets only. e.g., building, plant and machinery, furniture etc. There is no question of depreciation in case of current assets - such as stock, debtors, bills receivable etc. 2. Depreciation causes perpetual, gradual and continual fall in the value of assets. 3. Depreciation occurs till the last day of the estimated working life of the asset. 4. Depreciation occurs on account of use of asset. In certain cases, however, depreciation may occur even if the assets are not used, e.g., leasehold, property, patent, copyright etc. 5. Depreciation is a charge against revenue of an accounting period.

6. Depreciation does not depend on fluctuations in market value of assets (see

difference between depreciation and fluctuation page). 7. The amount of depreciation of an accounting year cannot be determined precisely - it has to be estimated. In certain cases, however, it may be ascertained exactly, e.g., leasehold property, patent right, copyright etc. 8. Total depreciation of an asset cannot exceed its depreciable value (cost less scrap value).

Causes of Depreciation:
The main causes of depreciation may be divided into two categories, namely:

1. Internal Cause and 2. External Causes

Internal Causes:
Depreciation which occurs for certain inherent normal causes, is known as internal depreciation. The main causes of internal depreciation are:

Wear and Tear:

Some assets physically deteriorate due to wear and tear in use. More and more use of an asset, the greater would be the wear and tear. Physical deterioration of an asset is caused from movement, strain, friction, erasion etc. An obvious example of this is motor car which rapidly wears out. Other assets like this are building, plant, machinery, furniture, etc. The wear and tear is general but primary cause of depreciation.

Depletion:
Some assets declines in value proportionate to the quantum of production, e.g. mine, quarry etc. With the raising of coal from coal mine the total deposit reduces gradually and after sometime it will be fully exhausted. Then its value will be reduced to nil.

External Causes:
Depreciation caused by some external reasons is called external depreciation. The main external causes are as follows:

Obsolescence:
Some assets, although in proper working order, may become obsolete. For example, old machine becomes obsolete with the invention of more economical and sophisticated machine whose productive capacity is generally larger and cost of production is therefore less. In order to survive in the competitive market the manufacturers must must install new machines replacing the old ones. Again, it may happen that the articles produced by old machine are no longer saleable in the market on account of change of habit and taste of the

people. In such a case the old machine, although in good working condition, must be discarded and the new one purchased.

Efflux of Time:
Some assets diminish in value on account of sheer passage of time, even though they are not used e.g., leasehold property, patent right, copyright etc. Suppose we take a lease of a house for 10 years for $10,000. Its annual depreciation will be $1,000 (10,000/10), irrespective of the the whether the house has been used or not. Because with the end of lease after 10 years, the house will go out of possession.

Accident:
Assets may be destroyed by abnormal reasons such as fire, earthquake, flood etc. In such a case the destroyed asset must be written off as loss and a new one purchased.

Depreciation Methods:
Fixed assets differ from each other in their nature so widely that the same depreciation methods cannot be applied to each. The following methods have therefore been evolved for depreciating various assets: 1. Fixed installment or Straight line or Original cost method. 2. Diminishing Balance Method or Written down value method or Reducing Installment method.

Fixed Installment Method or Straight Line Method or Original Cost Method of Depreciation:
Fixed installment method is also know as straight line method or original cost method. Under this method the expected life of the asset or the period during which a particular asset will render service is the calculated. The cost of the asset less scrap value, if any, at the end f its expected life is divided by the number of years of its expected life and each year a fixed amount is charged in accounts as depreciation. The amount chargeable in respect of depreciation under this method remains constant from year to year. This method is also know as straight line method because if a graph of the amounts of annual depreciation is drawn, it would be a straight line.

Formula:
The following formula or equation is used to calculate depreciation under this method: Annual Depreciation = [(Cost of Assets - Scrap Value)/Estimated Life of Machinery]

Journal Entries:
The journal entries that will have to be made under this method are very simple. The journal entries will be as under:

1. Depreciation account
To Asset account
(Being the depreciation of the asset)

2. Profit and loss account

To Depreciation account
(Being the amount of depreciation charged to Profit and Loss account)

These entries will be passed at the end of each year so long as the asset lasts. In the last year, the scrap will be sold and with the amount that realised by the sale the following entry will be passed:

3. Cash account
To Asset account
(Being the sale price of scrap realised.)

Advantages:
1. Fixed installment method of depreciation is simple and easy to work out 2. The book value of the asset can be reduced to zero.

Disadvantages:
1. This method, in spit of its being simplest is not very popular because of the fact that
whereas each year's depreciation charge is equal, the charge for repairs and renewals goes on increasing as the asset becomes older. The result is that the profit and loss account has to bear a light burden in the initial years of the asset but later on this burden becomes heavier. 2. Interest on money is locked up in the asset is not taken into account as is done in some other methods. 3. No provision for the replacement of the asset is made. 4. Difficulty is faced in calculation of depreciation on additions made during the year.

Scope of Application:
On account of the above mentioned advantages and disadvantages of fixed installment method, it is generally applied in case of those assets which have small value or which do not require many repairs and renewals for example copyright, patents, short leases etc.

Example:

On 1st January 1991 X purchased a machinery for $21,000. The estimated life of the machine is 10 years. After it its break up value will be $1,000 only. Calculate the amount of annual depreciation according to fixed installment method (straight line method or original cost method) and prepare the machinery account for the first three years. Machinery Account Debit Side $
1991 Jan. 1

Credit Side $
1991 Dec. 31 1991 Dec. 31

To Bank account

21,000

By Depreciation account By Balance c/d

2,000 19,000 21,000

21,000
1992 Jan. 1

To Balance b/d

19,000

1991 Dec. 31 1991 Dec. 31

By Depreciation account

2,000 17,000 15,000

15,000
1993 Jan. 1

To Balance b/d

17,000

1991 Dec. 31 1991 Dec. 31

By Depreciation account By Balance c/d

2,000 15,000 17,000

17,000

Diminishing Balance Method of Depreciation:

Definition and Explanation:
Diminishing balance method is also known as written down value method or reducing installment method. Under this method the asset is depreciated at fixed percentage calculated on the debit balance of the asset which is diminished year after year on account of depreciation.

Journal Entries:
The entries in this case will be identical to those discussed in the case of the fixed installment method. Only the amount will be differently calculated.

Advantages of Diminishing Balance Method:

1. The strongest point in favor of this method is that under it the total burden imposed
on profit an loss account due to depreciation and repairs remains more or less equal year after year since the amount after depreciation goes on diminishing with the passage of time whereas the amount of repairs goes on increasing an asset grow older. Separate calculations are unnecessary for additions and extensions, though in the first year some complications usually arise on account of the fact that additions are generally made in the middle of the year.

2.

Disadvantages of Diminishing Balance method:

1. This method ignores the question of interest on capital invested in the asset and the
replacement of the asset.

2. This method cannot reduce the book value of an asset to zero if it is desired. 3. Very high rate of depreciation would have to be adopted other wise it will take a very
long time to write an asset down to its residual value

Scope of Application:
Diminishing balance method of depreciation is most suited to plant and machinery where additions and extensions take place so often and where the question of repairs is also very important. Written down value method or reducing installment method does not suit the case of lease, whose value has to be reduced to zero.

Example:
On 1st January, 1994, a merchant purchased plant and machinery costing $25,000. It has been decided to depreciate it at the rate if 20 percent p.a. on the diminishing balance method (written down value method). Show the plant and machinery account in the first three years. Plant and Machinery Account Debit Side Date
1994 Jan. 1

Credit Side $ Date

1994 Dec. 31 "

$ By Depreciation By Balance c/d 5,000* 20,000

To Cash

25,000

25,000

25,000

1995 Jan. 1

To Balance b/d

20,000

1995 Dec. 31

By Depreciation

4,000**

"

By Balance c/d

16,000

20,000

20,000

1996 Jan. 1

To Balance b/d

16,000

1996 Dec. 31

By Depreciation

3,200***
12,800

By Balance c/d

16,000

16,000

Formula or equation for the depreciation calculation may be written as follows:

*First year: 25,000 20% = 5000 **Second Year: (25000 - 5000) 20% = 4,000 ***Third Year: [25000 - (5,000 + 4,000)] 20% = 3,200