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Special Features of Depreciation :

 

  1. Depreciation is loss in the value of assets.
  2. Loss should be gradual and constant.
  3. Depreciation is the exhaustion of the effective life of business.
  4. Depreciation is the normal feature.
  5. Maintenance of assets is not depreciation.
  6. It is continuing decrease in the value of assets.
  7. It is the allocation of cost of assets to the period of its life.

 

Accountants have developed certain specific words to denote the loss in the value of particular assets, other than depreciation. These words are as under :

 

1. Obsolescence

 

Sometimes new inventions throw away the existing machines and equipments as obsolete (useless) although the old machines and equipments are not completely useless. The firm will have to replace the old machine and equipment with the latest, up-to-date and newly invented machine and equipment. Loss-due to the obsolescence of the old machine and equipment is known as ·obsolescence’.

 

2. Depletion

 

The film may possess certain mineral wealth such as coal, oil, iron ore etc. The more we extract mineral wealth from these mines the more mines are depleted. Decrease in mineral wealth of the mines is termed as depletion.

 

3. Amortisation

The word ‘amortisation’ is used to show loss in the value of intangible assets. These assets are goodwill, patents and preliminary expenses etc. These assets are written off over certain period.

 

4. Fluctuation

 

Increase and decrease in the market value of assets is knovm as fluctuation. As we record the value of these assets on historical basis. we do not pass any entry for the fluctuations in the market value of assets. In case of permanent fall in the value of investments fluctuation may be recorded.

 

Causes for Depreciation

 

1. By constant use. The loss in the value, efficiency and utility of fixed assets due to its constant use is termed as depreciation.

 

2. By expiry of time. The effective life of assets goes on decreasing with the passage of time. It certain lease has been obtained for 20 years for $ 1,00,000. it will lose its 2~ th. i.e., c~ x I, 00,000) = $ 5,000 value at the end of the first year and so on. At the end of 20th year it will become valueless.

 

3. By obsolescence. The old assets will become obsolete due to new inventions, improved techniques

and technological advancements.

 

4. By depletion. Loss of mineral wealth due to constant working of mines is also depreciation, but specifically known as ‘depletion·. Suppose a particular mine has got 1,00,000 tons of coal during lst year coal worth 5,000 tons have been extracted. The loss of 5.000 tons of coal from mines is loss due to depletion. This is why. we charge depreciation on these mineral wealth according to depletion method.

 

5. Permanent fall in price. Though fluctuations in the market value of fixed assets is not recorded in ·the books. Sometimes we have to account for this loss such as permanent fall in the value of investments.

 

6. By Abnormal factors. Depreciation may also be due to the loss in the value of assets by accidents and damage.

 

Depreciation in the value of assets in all the above cases is accounted for in the books of accounts.

 

Objectives of Charging Depreciation

 

Recording depreciation in the books of accounts is essential due to the following reasons :

 

1. For determination of net profit or net loss. Loss in the value of assets is undoubtedly a business expense. It must be recorded and shown at the debit side of the profit and loss account for the correct calculation of net profit or net loss. The ultimate objective of accounting is to determine the correct net income. This objective will not be achieved, unless we account for depreciation in the books of accounts.

 

2. For showing assets at fair and true value in the Balance Sheet. If depreciation is not charged, the assets will be shown at value more than its actual value. The purpose of recording assets is to show them a true value. Provision for depreciation reduces the value of assets with the amount of depreciation and assets are shown at their true and fair value.

 

3. Provision of funds for replacement of assets. The assets acquired and used. in the business will become useless after expiry of its estimated life or even before that, we will have to replace the obsolete assets with another fresh asset. The replacement will require funds. Proper method of depreciation will make the funds available for the purchase of fresh assets.

 

4. Ascertaining accurate cost of production. Depreciation on factory plant and machinery is factory overhead. It will increase the cost of production and the price of the commodity will be fixed at higher rates.

 

In the absence of provision for depreciation, the sales price of the commodity will be fixed at lower rates, because cost of production will also be lower due to ignorance of depreciation. Profit will thus be reduced.

 

5. Distribution of dividend out of profit only. Depreciation is charged out of Profit and loss account, so the profit after charging depreciation will be lesser. Shareholders will get dividend out of this profit. If depreciation is not charged, the profit will be more and the excess dividend will be paid out of capital, which should have been paid out of profit.

 

6. Avoiding over payment of income-tax. If depreciation is not charged, profit and loss account will show more profit. We will have to pay more income-tax on this profit. In this way, the payment of tax will be definitely more than what it should have actually been. The profit will reduce with the amount of depreciation, so lesser or the actual income tax due will be paid. Provision for depreciation in this way, avoids over payment of income-tax.

Factors Affecting the Amount of Depreciation

 

It is quite impossible to calculate the actual and accurate amount of depreciation. It can always be estimated, though we try our best to be more accurate and correct. Following factors have to be considered before estimation of the amount of depreciation.

 

1. Total cost of the assets. Value of assets is determined after adding all expenses of acquiring, installing and constructing the assets. We should take into consideration the total cost of assets for determining the rate and the amount of depreciation.

 

2. Estimated useful life of assets. The estimated working life of the assets may be measured in terms of years, months, hours, output (units) or kilometers (for trucks). In case of depreciation the value of assets is allocated over the estimated useful life of the asset. If expected life is more, the rate of depreciation will be lesser and vice-versa.

 

Useful life of asset depends upon the following factors

(a)    Predetermined by legal or contractual limits e.g., in case of leasehold asset, the useful life is the period of lease.

(b)   The number of shifts for which asset is to be used.

(c)    Repair and maintenance policy of the business organization.

(d)   Technological obsolescence.

(e)    Innovation/improvement in production method.

(f)    Legal or other restrictions.

 

3. Estimated scrap value. It is the residual value, which is expected to be realized even if the asset becomes obsolete. We shall have to make provision of the amount which is the value of assets less its scrap value. Suppose we purchase a machine for $ 10,000, whose expected life is ten years. If the scrap value is $1,000, we will have to arrange $ 9,000, i.e., 10,000- 1,000 in ten years. Every year will bear a depreciation of $ 900, i.e., 9,000/10. If the scrap value in the above case is $ 2,000 depreciation to be charged will be $ 800 only.

 

4. Chances to obsolescence. If the asset acquired is expected to be obsolete within 5 years, we will have to split its value over 5 years. If it will be obsolete within four years the value will be split over four years.

 

It shows that the amount of depreciation charged every year will decrease with comparatively remote chances of obsolescence.

 

5. Addition to assets. Depreciation should be charged on the additions to the assets also. If book value of furniture on Jan. 1, 2006 is $  10,000 and additions worth $ 5,000 are made on July I. 2006. Depreciation is to be charged @ 10%. We shall be calculating depreciation on $ 10,000 for the whole year and on 5,000 for six months.

 

6. Legal provisions. The rate and method of depreciation being used must be subject to legal provisions. Companies have to honour the legal provision with regard to depreciation.