Life span of an asset to a business rests primarily, on the purpose of its acquisition and secondary, on its nature. An item acquired for immediate consumption or sale is a short-lived asset and that meant for prolonged use, is long lived asset, though both produce revenues. Whereas the former asset expires within one year of its acquisition, the latter asset lasts longer. Hence almost entire expenditure on a short lived asset becomes an expense and is matched against current year’s revenue.
But the position is otherwise with a long-lived asset which wears out or depreciates over a long period. Accordingly, the outlay of a fixed asset is spread over several years and annually only a fraction thereof expires. Simply, this fraction, called expired cost or depreciation, is charged against current revenues and the rest, termed un expired cost, is carried forward for future expiration.
“Depreciation may be defined as the permanent decrease in the value of an asset due to use and/or the lapse of the time.” -Terminology of Institute of Cost and Management Accountants, England
“Depreciation is the permanent and continuous diminution in the quality, quantity or value of an asset.” -Pickles
“Depreciation may be defined as measure of the exhaustion of effective life of an asset from any cause during a given period.” -Spicer and Pegler
“Depreciation is’ the gradual and permanent decrease in the value of an asset from any cause.”-Carter
Objects of making provision for depreciation
For attaining following objects, depreciation accounting is a must for every business:
(1) Recovery of cost incurred on fixed assets over their useful life so as to keep owner’s capital intact;
(2) Provision is for replacement cost on the retirement of original assets ;
(3) to include the depreciation in the cost of production to find out the correct cost of production;
(4) to find out correct profit for the year ;
(5) to find out the correct financial position through balance sheet.
Causes of Depreciation
Depreciation may be of two types :-
(1) Internal-Depreciation which occurs for certain inherent normal causes is known as internal depreciation. The causes of internal depreciation are :
(1.1) Wear and Tear-An asset declines on account of continued use e.g. building, plant,
machinery etc. such decline depends upon quantum of use of an asset. If a factory works double-shift instead of single shift, depreciation on plant and machinery will be doubled. It is obvious that such loss is unavoidable. An asset may be kept in proper working conditions
through repairs for the time being, but it can not be done so permanently: At one time the asset will become unfit for repairs, when it will no longer be suitable.
(1.2) Depletion-Some assets decline in value proportionate to the quantum of production, e.g. mines, quarry etc. With the raising of coal etc. from coal mine, the total deposit reduces gradually and after some time it will be fully exhausted. Then its value will be nil.
(2) External-Depreciation caused by some external reasons is called external
depreciation.
The causes of external depreciation are:
(2.1) Obsolescence
Some assets, though 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 higher and cost of production is lesser. In order to survive in the competitive market the manufacturer must install new machine replacing the old one.
(2.2) Passage of time
Some assets diminish in value on account of sheer passage of time, even though they are not used e.g. lease hold property, patent rights, copy rights etc.
(2.3) Accidents
Assets may be destroyed by abnormal reasons such as fire, earth quake, flood etc. In such a case the destroyed asset may be written-off as loss and a new one purchased.
Need for Provision of Depreciation
The need for provision for depreciation arises for the following reasons:
(1) Ascertainment of true profit or loss-Depreciation is a loss. So unless it is considered like all other expenses and losses, true profit/loss cannot be ascertained. In other words, depreciation must be considered in order to find out true profit/loss of a business.
(2) Ascertainment of true cost of production-Goods are produced with the help of plant and machinery which incurs depreciation in the process of production. This depreciation must be considered as a part of the cost of production of goods. Otherwise, the cost of production would be shown less than the true cost. Sale price is normally fixed on the basis of cost of production. So, if the cost of production is shown less by ignoring depreciation, the sale price will also be fixed at a low level resulting in loss to the business;
(3) True Valuation of Assets-Value of assets gradually decreases on account of depreciation. If depreciation is not taken into account, the value of asset will be shown in the books at a figure higher than its true value and hence the true financial position of the business will not be disclosed through Balance Sheet.
(4) Replacement of Assets-After some time an asset will be completely exhausted on account of use. A new asset then be purchased requiring large sum of money. If the whole amount of profit is withdrawn from business each year without considering the loss on account of depreciation, necessary sum may not be available for. buying the new assets. In such a case the required money is to be collected by introducing fresh capital or by obtaining loan by selling some other assets. This is contrary &0sound commercial policy.
(5) Keeping Capital’ Intact-Capital invested in buying an asset, gradually diminishes on
account of depreciation. If loss on account of depreciation is not considered in determining profit/ loss at the year end, profit will be shown more. If the excess profit is withdrawn, the working capital will gradually reduce, the business will become weak and its profit earning
capacity will also fall.
(6) Legal Restriction-According to Sec. 205 of the Companies Act, 1956 dividend cannot be declared without charging depreciation on fixed assets. Thus in “Case of joint stock companies charging of depreciation is compulsory.