Methods of Depreciation
- Straight Line Method
Under this method, depreciation is charged at a fixed rate on the original cost of the asset for its whole life span. This method is also known as Original Cost Method, Equal Installment Method, and Fixed Installment Method. This method can be easily applied for those assets whose useful life can be estimated accurately. To calculate the value of depreciation through this method, the following formula is used:
Deprecation = (Original Cost of Asset - Estimated Scrap Value) / Estimated Life Span of the Asset
- Reducing-balance Method
Under this method, the value of asset diminishes every year, and the value of depreciation also decreases every year. This method is also known Reducing Installment Method or Diminishing Balance Method. This method is suitable to use for the assets with long life span which losses more value when used, such as plant, machinery, motor vehicles etc.
Depreciation on this method is calculated on the net carrying amount or net book value. This mean that the net book value has to be first calculated before calculating depreciation.
Net book value = Cost less Accumulated depreciation.
- Revaluation Method
It is one of the easiest methods to calculate the depreciation. Under this method, the assets are revalued at the end of the financial year and then this balance is compared with the initial value of the assets at the beginning of the financial year. The difference between the values is considered as the amount of depreciation. It can be understood as:
Depreciation = Opening value of asset less closing value of asset.
It is mostly use on assets that cannot be depreciated using the other methods such as Spares tools, kitchen utensils etc.Depreciation
Non- current assets are initially recognized at their historic cost i.e. actual cost price and any cost incurred in bringing asset in a ready-to-use state. They are recorded in subsidiary books such as cash book when bought cash and general journal when bored on credit.
They are then debited in the asset account on it cost price. Any additions are debited and should any of it or part of it be sold, a credit entry is created. The balance on this account will mean the value of the assets at historical cost at that particular time. Historical costs are used because they can be proven through the use of source documents.
Non-current asset cost cannot be treated the same as expense. This is simply because benefits from the asset is gained over the useful life of the asset which is more than a year. Matching concept states that expenses (costs) must be recorded in the same financial year as the income (benefit) to which it has been obtained from it. In short, revenue earned in a financial year must be matched with costs incurred in the same financial year. The concept implies that expenditure incurred during an accounting period should be matched with revenue collected during that time frame.
This is where depreciation fits in.
What is depreciation?
Depreciation is an estimate loss in value of a non-current asset as it is being put into use to generate income for the business over its useful life. With appreciation, we are trying to allocate the cost of an asset over it useful life after considering the fact that, the benefit of that asset is for more than one year.
It is an accounting method used to allocate the cost of asset over its useful life. It represents the value of the asset used up.
Causes of Depreciation- Constant UseThe value of a fixed asset can be reduced due to its constant use. This is because there is the possibility of normal wear and tear while using an asset for the business operations.
- Expiry of TimeGenerally, the value of an asset decreases with the passage of time even if they are not used for the once. Their values can get deteriorate due to natural factors such as rain, winds, weather, etc.
- Expiry of Legal RightsThere are certain assets which have a limited life span and after expiry of that span the value of the asset automatically get reduced. For example, lease. If a lease is obtained for 15 years for E6,00,000 then the value of lease will reduce every year whether the company uses it or not. So, at the end of the 15th year, the value of the lease will get reduced to zero.
- ObsolescenceThe inventions and improved technology are also a major cause of depreciation. With the innovation in the market, the old assets became obsolete and to remain in the market and face the market competition, the companies have to discard and replace these assets with the new one even if those assets can be put to use physically. Other than this, change in the customers' taste and preference also cause an obsolescence of the assets.
- AccidentSometimes, there can be loss of the machinery occur due to an accident or a natural calamity such as fire, theft, earthquake, flood, etc.
- DepletionThe continuous use of the certain assets also causes a reduction in the value of wasting assets such as mines, oil wells, etc. This is because these are the non-renewable resources, i.e., once they are finished can't be get or produced again.
Revenue and Capital Expenditure
The main purpose of financial reporting is to provide financial information about a business that is useful to existing and potential investors, lenders and other creditors in making decisions relating to providing resources (capital) to the business. Information about business expenditures is useful to users and might influence the decision of the users with regard to providing capital in the business. This information may also enhance fair presentation of financial statements. An expenditure is any cost incurred by the business whether when acquiring a good or a service that has benefitted or that in the future will benefit the business.
Revenue expenditure
These are costs incurred by the business on it normal day to day operations. They include (not limited to) cost of purchasing costs (purchases of goods, carriage inwards, import duties) and all expenses. They are recognized (recorded) in the income statement and reduces the value of profit.
Capital Expenditure
These are cost incurred by the business when acquiring non-current assets and all other costs bringing the non-current asset to a ready-for-use state. They include (not limited to) cost incurred when purchasing the non-current asset, cost of transporting it to the business premises, legal cost incurred, installation costs, rights to use the assets etc. They are initially recognized at cost price in the statement of financial position, applying the historical cost concept.
Subsequently, depreciation expense is charged in the income statement and recognized at COST - ACCUMULATED DEPRECIATION = NET BOOK VALUE in the statement of financial position.
Effect of wrongful recognition on profit and assets.
If an item of Revenue expenditure was wrongfully recognized as item of capital expenditure, Profits will be overstated, and the total of non-current assets will be overstated.
If an item of Capital expenditure was wrongfully recognized as item of revenue expenditure, Profits will be understated, and the total of non-current assets will be understated.