Depreciation: Meaning, Causes and Factors

1. Why do we need depreciation at all?

The fair way is to spread the cost over the 5 years in which the computer helps to earn revenue: ₹60,000 ÷ 5 = ₹12,000 per year. This yearly share is the depreciation of the computer.

This is the matching principle you learnt in Chapter 2: the expenses of a year must be matched with the revenue of that same year. A fixed asset serves many years, so its cost is matched with the revenue of all those years, a little at a time.

2. Meaning of depreciation

Fixed assets are assets used in the business for more than one accounting year, for example machinery, furniture, buildings, computers, vans and trucks. The moment they are put to use, their value starts to fall: because of use, because time passes, or because a newer and better model comes to the market.

2.1 Which assets are depreciated?

NCERT calls them depreciable assets. An asset is depreciable when it:

• is expected to be used for more than one accounting period;
• has a limited useful life; and
• is held for use in production or supply of goods and services, for renting out, or for office work, and not for sale in the ordinary course of business.

So the refrigerator used in a kirana shop to keep milk cold is depreciated, but the refrigerators kept for sale in an electronics showroom are stock (goods), not depreciable assets. Examples of depreciable assets: machines, plant, furniture, buildings, computers, trucks, vans and equipment.

3. Features of depreciation

1. It is a decline in the book value of a fixed asset (the value shown in the books), not a change in market price.
2. It includes loss of value due to passage of time, usage or obsolescence.
3. It is a continuing process: it goes on every year till the end of the asset’s useful life.
4. It is an expired cost, i.e., an expense, so it is deducted before calculating profit (and taxable profit).
5. It is a non-cash expense: no cash goes out when depreciation is recorded. The cash went out when the asset was bought; depreciation only writes that cost off step by step.

4. Depreciation, depletion and amortisation

Three words describe the same idea (using up the value of an asset) for three different kinds of assets.

Depletion is about exhaustion of a natural resource; depreciation is about use of an asset. Still, both result in the loss of service potential, so they get similar accounting treatment.

5. Causes of depreciation

5.1 Wear and tear due to use or passage of time

A sewing machine in a tailoring shop runs 8 hours a day; its parts rub, heat up and loosen. That is wear and tear from use. A tin shed standing in rain and sun rusts even if nobody uses it. That is physical deterioration from the passage of time.

5.2 Expiration of legal rights

Some assets are useful only as long as a legal agreement lasts: a patent, a copyright, a shop taken on a 5-year lease. When the period ends, the asset is worth nothing to the business, however “new” it looks.

5.3 Obsolescence

Obsolescence means becoming out-of-date. A perfectly working asset loses value because a better one is available. It comes from:

• technological change (a swipe machine replaced by UPI QR soundboxes);
• improvement in production methods;
• change in market demand for the product made with the asset (a DVD-writing machine when nobody buys DVDs);
• legal or other restrictions (old diesel autos banned in some cities).

5.4 Abnormal factors

Accidents, fire, flood or earthquake can damage an asset. Such a loss is permanent but not continuing or gradual. A car repaired after an accident fetches a lower price even if it has hardly been driven.

6. Need for charging depreciation

1. Matching of costs and revenue: the asset helps to earn revenue every year, so a share of its cost is an expense of every year, like salary or rent. Without it, profit is overstated.
2. Consideration of tax: depreciation is a deductible expense for income tax (the tax rules for calculating it may differ from business practice).
3. True and fair financial position: without depreciation, assets would appear in the balance sheet at more than their real worth, and the balance sheet would mislead its readers.
4. Compliance with law: apart from tax laws, some laws (for example for companies) require depreciation to be provided on fixed assets.

7. Factors that decide the amount of depreciation

Three numbers decide how much depreciation is charged: the cost, the estimated net residual value and the estimated useful life. From the first two we also get the depreciable cost.

7.1 Cost of the asset

Cost (original or historical cost) = the purchase price plus every expense needed to bring the asset to working condition: freight and cartage, transit insurance, installation, registration, commission paid on purchase, add-ons like software, and, for a second-hand asset, the initial repair or overhaul done before first use.

7.2 Estimated net residual value

Net residual value (also called scrap value or salvage value) is the amount the business expects to get by selling the asset at the end of its useful life, after deducting the expenses of disposing of it.

7.3 Depreciable cost

7.4 Estimated useful life

Useful life is the economic or commercial life: the period for which the business expects to use the asset profitably. It is usually shorter than the physical life. A machine may still run after 5 years but produce so slowly or expensively that using it is no longer worthwhile. Useful life can be measured in years, in units of output (as for a mine) or in working hours.

Useful life depends on:

• legal or contractual limits (a leased shop: the lease period);
• the number of shifts the asset works;
• the repair and maintenance policy of the business;
• technological obsolescence and improvements in production methods;
• legal or other restrictions.