Depreciation refers to the decrease in the value of assets of the company over a time period due to use, wear and tear, and obsolescence. Its always charged on the cost price of the asset. It is charged every year to the extent of the depreciable amount. It applies only to tangible fixed assets, such as: Machines, Computers, Furniture, Vehicles, etc.
According to R.N. Carter, "Depreciation is the gradual and permanent decrease in the value of an asset from any cause."
According to William Pickles, "Depreciation may be defined as the permanent and continuing diminution in the quality, quantity or the value of an asset."
Assets can only be depreciated if,
- It is owned by the firm or individual.
- They are used in the business.
- They last for more than one accounting year.
- The useful life of the assets can easily be determined.
Features of Depreciation:
1. Decrease in the Book Value of Fixed Assets: Depreciation is a decline in the book value of a fixed asset and not the market value of the fixed asset, as depreciation is always calculated as a fixed percentage of cost price.
2. Non-Cash Expenses: Depreciation is a non-cash expense because it does not involve any outflow of cash. It is simply a charge to reduce the recorded cost of an asset over its useful life. In the cash flow statement, depreciation is added back to the profit in the operating activities section.
3. Continuous Process: Depreciation is a continuous process of reduction in the value of the fixed assets, as every year depreciation is charged on the fixed assets, and the depreciable amount is deducted from the book value of the asset.
4. Charge Against Profit: Depreciation is a charge against profit, i.e., depreciation is charged even if the firm is at loss. It is done because the asset has to be replaced at the end of its useful life, and actual profit can only be ascertained when depreciation is deducted from operational profit in the income statement.
5. Tax Benefit: It provides a tax benefit to the company, as the depreciation is adjusted to the profit before the payment of taxes. By this, the taxable income is reduced and the firm has to pay less tax on a decreased profit.
Causes of Depreciation:
- Physical deterioration – Wear and tear from usage.
- Time factor – Assets like patents and leases expire over time.
- Obsolescence – New technology makes old machines outdated.
- Accidents – Damage due to unforeseen events.
- Depletion – Use of natural resources (mines, oil wells).
Factors Affecting Depreciation:
- Cost of the Asset – Purchase price plus installation and other expenses.
- Useful Life – Estimated period the asset will be used.
- Residual (Scrap) Value – Estimated value at the end of useful life.
- Method of Depreciation – Chosen method affects the yearly charge.
For example, in 2020, a company purchased a machine for ₹1,00,000. At the time of purchase, the scrap value of the machine was estimated at ₹10,000 at the end of 3 years of use. So depreciation is calculated as:
1,00,000- 10,000 = 90,000
90,000/3= 30,000
Therefore the annual depreciation on that machinery will be ₹30,000.
Need for Depreciation:
- To ascertain the true profit of the business.
- To present the true and fair value of assets in the balance sheet.
- To accumulate funds for asset replacement.
- To comply with legal requirements.
- To distribute dividends only from real profits.