Chapter 12: Depreciation
Written Exam Master Guide • Extracted strictly from Module IV, Lesson 12 (224en12)
1. Meaning, Nature and Core Objectives of Depreciation
Core Textbook Definition:
Depreciation is an expense charged during a year for the reduction in the value of fixed assets, arising due to:
• Normal wear and tear out of its use and passage of time.
• Obsolescence due to change in technology, fashion, taste and other market conditions.
Accounting Concept & Distinction
Expenditure on assets of the business like furniture, fixtures and fittings of the shop, motor vans, machines, and equipments are neither goods nor expenses of a single year. Expenditures of this nature give services to the business for many years and therefore are called fixed assets (also termed long-term assets). Assets in accounting are broadly divided into two categories: Current Assets (cash, debtors or customers balances, stock of materials and goods) and Fixed Assets (buildings, furniture and fixtures, machinery and plant, motor vehicles).
If the expenditure on fixed assets were deducted from the profit of any one single year, it would be conceptually and practically wrong, since their benefit is enjoyed by the enterprise across multiple operating periods. The correct accounting procedure is to distribute their total cost over the years of their useful life to the business. The portion of the cost of fixed assets charged each year as an operating expense is named depreciation.
Textbook Core Illustration (Office Chair):
An office chair is purchased for ₹2,500 and it is estimated that after 10 years it will be scrapped. The useful life of the chair is 10 years over which the cost of ₹2,500 will be distributed:
Thus, ₹250 is the depreciation expense charged to the Profit and Loss Account for each year.
Two Main Objectives of Providing Depreciation
Fixed assets have an effective working life during which they can be economically operated. Depreciation represents the gradual loss in the value of fixed assets. If depreciation is not provided:
- The Profit and Loss Account will not disclose the true profit made during the accounting period (profit will be overstated).
- The Balance Sheet will not disclose the true financial position because fixed assets will be shown at an over-valued figure.
- If ignored year after year, when the asset is finally worn out, the proprietor will not be in a position to continue business operations smoothly.
Net profit is the yield of capital invested by the proprietor and may be wholly withdrawn in the form of cash/drawings. When depreciation is provided as a non-cash operating expense:
- The reported net profit is legitimately reduced, thereby decreasing the amount that can be withdrawn by the owner.
- Cash equivalent to the annual depreciation charge remains preserved within the business.
- This accumulated liquid amount enables the proprietor to purchase a replacement asset without depleting working capital when the existing asset finishes its useful life.
2. Causes of Depreciation and Four Determining Factors
The textbook explicitly identifies five fundamental causes for which depreciation is provided in accounts, and highlights the difference between physical deterioration and economic obsolescence:
- Due to Usage: Every asset has an operational capacity. Constant use leads to loss of physical efficiency, such as the decrease in functioning and efficiency of a bicycle through continuous running.
- Due to Passage of Time (Efflux of Time): Even if an asset is not actively used, elements of nature like rain, wind, sun, and temperature cause physical deterioration (e.g., reduction in the worth of furniture lying idle).
- Superior Equipment Development: Discarding assets before they are physically worn out because newer equipment produces goods at a much lower cost. For example, steam locomotives became obsolete upon the arrival of diesel and electric engines.
- Shifts in Market Conditions: Changes in fashion, style, or consumer taste decrease the value of specialized machines producing old-fashioned hats, shoes, or outdated garments.
Four Factors Affecting the Amount of Depreciation (Section 12.4)
A generator was purchased for ₹5,00,000. Crane loading charges were ₹1,500; transportation to factory was ₹7,000; unloading at site was ₹2,000. Useful life is 10 years, and estimated scrap value is ₹60,000:
3. Straight Line Method (SLM / Fixed Installment / Original Cost Method)
Under the Straight Line Method (SLM), an equal and uniform amount of depreciation is written off every accounting period throughout the useful working life of the asset. Because the amount charged per installment is fixed, this method is also termed the Fixed Installment Method or the Original Cost Method.
Example: Machine ₹1,20,000, 10 years life, scrap ₹20,000 → (₹1,20,000 - ₹20,000)/10 = ₹10,000/year. If scrap is nil → ₹1,20,000/10 = ₹12,000/year.
Example (Illustration 3): Machine ₹1,00,000, life 10 years, scrap ₹10,000. Annual Dep. = ₹9,000. Rate = (₹9,000 / ₹1,00,000) × 100 = 9% p.a.
Merits & Limitations of the Straight Line Method
1. Simplicity: The computation is extremely straightforward. Once determined, the identical amount is credited to the asset account year after year without recalculation.
2. Complete Write-off: The book value of the asset can be reduced completely to zero or to its exact residual scrap value at the end of its estimated operating lifespan.
1. Difficulty in Computation: When an enterprise operates multiple machines acquired at different dates with varied useful lives, computing individual depreciation amounts becomes complicated.
2. Illogical Burden on P&L: Physical efficiency and output are highest in early years while repair costs are low. In later years, repairs escalate while productivity declines. Charging identical depreciation produces an unfair combined burden (depreciation + repairs) that is significantly higher in later years.
4. Diminishing Balance Method (WDV / Reducing Balance Method)
Under the Diminishing Balance Method, the amount of depreciation charged every year steadily declines as the book value of the asset diminishes. The annual charge is calculated as a fixed percentage on the written down value (opening book value) of the asset at the beginning of each successive accounting period.
Textbook Numerical Mechanism (₹40,000 Asset @ 10% p.a.):
Note: Under this method, the book value of the asset never reduces to zero, regardless of how long depreciation is provided.
Merits & Demerits of Diminishing Balance Method
1. Equal Combined Burden on Profit & Loss: In initial years, depreciation is high and repair costs are minimal. In later years, depreciation declines while repairs increase. Consequently, the combined annual cost (depreciation plus repairs) remains relatively uniform across all years.
2. Recognized by Tax Authorities: The diminishing balance method is accepted under statutory income tax frameworks due to its realistic match with asset earning power.
1. Value Never Completely Zero: The mathematical curve never touches zero, even if the asset is entirely discarded or obsolete without any scrap value.
2. Computational Complexity: Determining the precise rate of depreciation required to write off an asset to its residual scrap value over a specified term involves complex algebraic roots.
5. Accounting Treatment, Proportionate Time Rule & Asset Disposal
In the double entry system, the recording of depreciation and subsequent sale of fixed assets follows systematic journal entries and ledger balancing:
Depreciation A/c ... Dr.
To Asset A/c
(Being depreciation charged on asset)
Profit & Loss A/c ... Dr.
To Depreciation A/c
(Being depreciation transferred to P&L)
Bank / Cash A/c ... Dr.
To Asset A/c
Profit & Loss A/c (Loss on Sale) ... Dr.
To Asset A/c
Asset A/c ... Dr.
To Profit & Loss A/c (Gain on Sale)
When an asset is acquired or sold during the financial year, depreciation must be calculated strictly for the fraction of the year during which the asset was held in the business:
For example, in Illustration 4 (Salman & Usman Bros), the machine costing ₹75,000 was acquired on July 1 with books closing on December 31. Depreciation for that first period was charged for exactly 6 months: ₹75,000 × (10/100) × (6/12) = ₹3,750.