DEPRECIATION (ACCOUNTING STANDARD 6)(For HSC Students)

Introduction:

Fixed assets are required in a business in the process of providing goods and services to customers. Expenditure on fixed assets is capital expenditure. Fixed assets are utilized during operation of business for a number of successive accounting periods. Value of fixed assets decreases with passage of time and its utilization.

Value of the portion of asset utilized for generating revenue must be recovered during that accounting year to ascertain real income. Portion of the cost of a fixed asset allocated to a particular accounting year is called “depreciation”.

Definition

Depreciation can be defined as “reduction in the value of fixed assets due to wear and tear, effluxion of time and obsolescence of technology”.

What are depreciable assets?

Depreciable assets are those assets that fulfill the following conditions.

1) Assets should have been purchased for the purpose of production and not for sale.

2) Asset should be of limited life.

3) Asset should be used for more than 1 year.i.e if used for less than 1 year than it should be charged to revenue.

What are exclusions from accounting standard 6?

1) Forest plantations.

2) Mineral and natural gas asset.

3) Research and development expenditure.

4) Live stock.

5) Goodwill.

6) Land.

How can we calculate amount of depreciation?

Cost: Cost of an asset includes invoice price (purchase price) and other costs which are necessary to put the asset in operation. Besides payment to vendor other costs include legal charges, transportation cost, insurance, registration cost, installation expenses, commission paid on purchase, etc. However cost does not include interest paid or payable on amount raised to finance the purchase of asset. In case of purchase of second hand asset, cost of initial repair is also capitalized.

Scrap value OR Net residual value: It is the recoverable value of an asset at the end of its useful life. It is also called as salvage value. Difference between cost of the asset and its residual value is termed as depreciable cost of the asset. Total depreciation charged must be equal to depreciable cost. If it is less than the depreciable cost than the business enterprise would not be able to replace the existing asset out of internally generated funds. Charging of less depreciation is clearly a violation of “going concern” concept. If depreciation charged is more than the depreciable cost than it results in creation of “secret reserves”. Charging of excess depreciation is clearly a violation of “full, fair and adequate disclosure”. Hence depreciation should be charged equal to depreciable cost only.

Estimated Life: To estimate useful life of an asset is a very difficult job. It depends upon number of complex factors such as use of an asset, maintenance of an asset, replacement policy, technological changes, market changes, etc.

Methods of depreciation:

1) Straight line method

2) Reducing balance method

Straight line method:

• It is also known as fixed installment method.
• According to this method, an equal amount is written off every year during the working life of an asset so as to reduce the cost of the asset to nil or its residual value at the end of its useful life.
• The assumption of this method is that the particular asset generates equal utility during its lifetime. But this cannot be true under all circumstances. The expenditure incurred on repairs and maintenance will be low in earlier years, whereas the same will be high as the asset becomes old. Apart from this the asset may also have varying capacities over the years, indicating logic for unequal depreciation provision. However, many assets have insignificant repairs and maintenance expenditures for which straight line method can be applied.
• Formula:

Depreciation = Cost of the asset-Scrap value

Estimated life

Reducing balance method:

• It is also known as diminishing balance method.
• Under this system, a fixed percentage of the written down value of the asset, is written off each year.
• Under this method, the annual charge for depreciation decreases from year to year.
• Also, under this method, the value of asset can never be completely extinguished, which happens in the case of fixed installment method.
• For example: Depreciation amount @ 20%p.a according to diminishing balance method on an asset costing Rs.100000 is calculated as under:

Cost of asset 100000

Less: depreciation for 1^st year (20% of Rs.100000) 20000

Written down value in the beginning of second year 80000

Less: depreciation for 2nd year (20% of Rs.80000) 16000

Written down value in the beginning of third year 64000

Less: depreciation for 3rd year (20% of Rs.64000) 12800

Written down value in the beginning of fourth year 51200

• As the amount of depreciation is based on written down value of the asset, it is also referred to as “written down value method”.

Points to remember:

1) Total cost includes purchase cost and incidental charges.

2) Depreciation amount is charged every year.

3) Under FIM, amount of depreciation is calculated on original cost.

4) Under RBM, the amount of depreciation is calculated on opening balance of asset every year.

5) When the asset is purchased in middle of the year, the depreciation is calculated from the date of purchase to the date of financial year.

6) Every year amount of depreciation is transferred to profit and loss A/c.

7) Duration of financial year is 12 months i.e. from 1^st April to 31^st March.