MBA – ONLINE FINANCIAL ACCOUNTING

LAQ – 3
QUESTION: BRIEFLY EXPLAIN VARIOUS METHODS OF PROVIDING FOR DEPRECIATION OF FIXED
ASSETS.
Depreciation is the process of spreading the cost of fixed assets over the different accounting
periods which derive the benefit from their use. The cost of fixed assets apportioned to a given
period forms part of the overall cost to be matched with the revenues generated in that period. So,
depreciation is of great significance in the concept of income measurement. It measures the service
potential of the fixed assets.
Fixed Assets: They include all assets whose benefits is derived by a businessman for a long period of
time, usually more than one year period. Examples: Machinery, Furniture, Buildings, Leases, etc.
Land is a fixed asset but not subject to depreciation because it has infinite lifetime.
Meaning and Definition of Depreciation:
Depreciation can be defined as the systematic allocation of the cost of a tangible asset over its
expected useful life. It recognizes that assets undergo a decline in value due to physical deterioration,
technological advancements, changes in market demand, or other factors that render them less
productive or relevant.
From a conceptual standpoint, depreciation refers to the reduction in the book value of an
asset, which represents its historical cost less the accumulated depreciation. While the asset may
continue to have some residual value, depreciation is a way to capture its declining worth over time.
According to the Institute of Chartered Accountants of India, “Depreciation is a measure of the
wearing out, consumption or other loss of value of a depreciable asset arising from use, effluxion of
time or obsolescence through technology and market changes”.
The following important terms from these definitions are important.
i) Depreciable Assets: Depreciable assets are tangible assets that have a finite useful life and are
expected to lose their value over time due to wear and tear, obsolescence, or other factors. These
assets are recognized in a company's financial statements and are subject to depreciation, which is
the systematic allocation of their cost over their useful life. Depreciable assets include items such as
machinery, buildings, equipment, vehicles, and furniture. Land is typically not considered a
depreciable asset, as it is not subject to wear and tear or obsolescence.
ii) Useful Life: The useful life of an asset refers to the estimated period during which the asset is
expected to be economically useful to the business. It is the duration over which the asset will
contribute to revenue generation and production activities. The useful life is a critical factor in
determining the depreciation expense for the asset. Companies use historical data, technical
analysis, industry norms, and expert judgment to estimate the useful life of assets. Depreciation is
typically charged over this useful life, and it affects the asset's carrying value on the balance sheet.
iii) Depreciable Amount: The depreciable amount of an asset is the portion of its historical cost or
initial acquisition cost that is subject to depreciation. It is calculated by subtracting the estimated
residual value of the asset (its value at the end of its useful life) from its original cost. The
depreciable amount represents the part of the asset's cost that will be allocated as an expense over
its useful life. The formula for calculating depreciation expense is: Depreciation Expense =
(Depreciable Amount / Useful Life).
iv) Realisable Value: Realisable value, also known as the net realizable value or fair value, is the
estimated amount a company expects to receive from the sale of an asset in an open market, less
any selling expenses. It represents the asset's market value at a specific point in time and is relevant
when determining impairment losses or evaluating the recoverability of an asset's carrying amount.
For impaired assets or assets held for sale, realizable value is a critical factor in assessing their
recoverable amount in comparison to their carrying value.

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LAQ – 3
v) Effluxion of Time: Effluxion of time refers to the passage or elapse of time. In the context of
depreciation, it signifies the gradual consumption of an asset's economic benefits over its useful life.
Depreciation expense is charged to the income statement over time, reflecting the asset's declining
value due to factors such as wear and tear, technological advancements, and obsolescence. The
concept of effluxion of time plays a significant role in recognizing depreciation as it indicates the
progressive nature of asset value reduction.
vi) Obsolescence: Obsolescence refers to the state of being outdated or no longer relevant due to
technological advancements, changes in market demands, or evolving industry practices. In the
context of depreciation, obsolescence can lead to a decline in an asset's value over time, impacting
its useful life and economic utility. Technological obsolescence, for example, can render certain
machinery or equipment less efficient or effective in comparison to newer models. As a result,
obsolescence is one of the causes of depreciation and an important factor to consider when
assessing an asset's useful life and depreciation method.
CHARACTERISTICS OF DEPRECIATION :
Depreciation exhibits several key characteristics that differentiate it from other accounting entries:
a) Non-Cash Nature: Depreciation is a non-cash expense, meaning it does not involve any cash
outflow. It represents the allocation of an asset's cost over its useful life rather than an actual
expenditure.
b) Systematic Allocation: Depreciation is allocated systematically over the asset's estimated useful
life. Various depreciation methods, such as straight-line, declining balance, and units-of-production,
distribute the cost differently over time.
c) Impact on Profitability: Depreciation directly affects a company's profitability by reducing the
reported net income. As an expense, it lowers the earnings for the accounting period in which it is
recognized.
d) Bookkeeping Entry: Depreciation is recorded through journal entries, ensuring proper
documentation and adherence to accounting principles.
CAUSES OF DEPRECITATION
The following are the main causes of depreciation:-
1) Use: Depreciation due to use is one of the primary causes of asset value reduction. As tangible
assets are utilized in the regular course of business operations, they undergo wear and tear, resulting
in a decrease in their physical condition and functionality. Frequent usage and exposure to
operational activities lead to a natural deterioration of the asset's components, affecting its efficiency
and productive capacity. This reduction in value due to wear and tear is systematically recognized
through depreciation in financial accounting. The more intensively an asset is used, the higher the
depreciation expense over its estimated useful life. Proper maintenance and regular servicing can
mitigate the impact of use-related depreciation, ensuring that assets continue to contribute
optimally to business operations.
2) Lapse of Time: The mere passage of time is also a significant cause of depreciation. As assets age,
their value decreases due to factors beyond use or wear. Over time, technological advancements
may render an asset less efficient or outdated, leading to reduced demand and value in the market.
Additionally, the effects of aging may become more apparent, impacting an asset's appearance,
condition, and overall worth. Depreciation due to the lapse of time is often associated with the
asset's decreasing economic relevance and is a crucial aspect considered while estimating the asset's
useful life. Companies must assess the impact of time-based depreciation to accurately present the
asset's true value and allocate the cost over its remaining useful life.

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MBA – ONLINE FINANCIAL ACCOUNTING
LAQ – 3
3) Obsolescence: Obsolescence arises when technological advancements or changes in market
demands render an asset outdated or non-competitive. As industries progress, newer and more
innovative assets may replace existing ones, making the latter less efficient or less capable of
meeting modern requirements. Technological obsolescence can affect a wide range of assets, from
machinery and equipment to software and communication systems. Depreciation resulting from
obsolescence reflects the reduced demand and value of the asset, as newer alternatives offer
enhanced features and improved performance. To stay competitive, businesses must recognize and
plan for obsolescence-related depreciation, and consider timely upgrades or replacements of assets
to maintain operational efficiency.
4) Accidents: Accidents or unexpected events can also cause depreciation of assets. Physical damage
resulting from accidents, such as collisions, fires, floods, or natural disasters, can significantly reduce
an asset's value. In such cases, repairs or replacements may be necessary to restore the asset's
functionality, but even after repair, the asset's market value may still be impacted due to its history of
accidents. Insurance claims and provisions for impairment losses may be relevant considerations in
such situations. Accidents-induced depreciation serves as a reminder of the importance of risk
management and insurance coverage to safeguard against potential financial losses.
5) Disuse: When assets are not used for an extended period, they can suffer from disuse-related
depreciation. Lack of operation and maintenance can result in deterioration, rust, or malfunctioning
of the asset's components. Disuse can particularly affect assets that require regular usage or specific
environmental conditions to remain functional. For instance, machinery left idle for an extended
duration may experience reduced performance when put back into operation. Regular inspection
and periodic usage of assets can help mitigate the impact of disuse-related depreciation, ensuring
their readiness when required.
6) Inadequacy: Depreciation due to inadequacy occurs when an asset is no longer suitable or
sufficient for the company's operational requirements. This can happen when a business experiences
growth or changes in production demands, rendering the existing asset inadequate in terms of
capacity or capability. Inadequacy-induced depreciation may prompt the need for upgrading to larger
or more technologically advanced assets to support the business's evolving needs. As companies
expand or modify their operations, they must carefully assess the adequacy of their existing assets to
avoid potential disruptions and operational inefficiencies.
7) Depletion: Depletion is a cause of depreciation specifically related to natural resources such as
minerals, oil, and timber. As these resources are extracted and consumed, their reserves deplete,
leading to a decrease in their value. Depletion is recognized as an expense over time and reflects the
reduction in the available quantity of the resource. For companies engaged in industries that rely on
the extraction of natural resources, depletion-related depreciation is an essential aspect of
accurately reporting the cost of resource utilization and its impact on profitability.