What is Depreciation in Accounting
Depreciation in the context of accounting methods is the determination of the cost incurred in the life expectancy or usage of a particular tangible asset.
The characteristics of depreciation are mentioned below:
Depreciation is a loss of value that takes place for tangible assets due to the passage of time.
It is primarily the decrease that is recorded in fixed assets’ book value.
Depreciation is necessarily a continuous process until it reaches the conclusion of the lifespan of the assets.
Causes for Depreciation
There are a host of different causes that lead to the depreciation of physical assets.
The passage of time and regular wear and tear leads to deterioration which in turn causes a decrease in the asset value. Such deterioration may also arise from revenue-generating activities of the asset as well as business operations.
In a few instances, with the expiry of legal rights which are inherent to a certain class of assets, the latter loses its value with the expiry of the pre-determined period.
The tangible asset may also become out-of-date, causing its value to go in a downward spiral. In this case, the particular asset becomes outdated, and usually, newer substitutes are made available.
Depreciation Methods
The types of depreciation calculation owing to its methods are indicated below:
1. Straight-Line Method
In case of straight-line depreciation calculation, the amount of expense is the same for each year of the asset lifespan.
The depreciation formula is –
2. Units of Production Method
An asset is depreciated on the basis of the total number of units that are generated by utilizing the asset or the total number of hours for which it has been used across its lifespan.
The depreciation formula is –
3. Double Declining Balance Method
Double declining balance depreciation method causes a higher amount of expenses in the previous years when compared to the latter years of the lifespan of a particular asset. It shows that such classes of assets are significantly more productive in its earlier years.
The depreciation formula is –
4. Sum-of-Years Digits Method
The sum-of-years digits method of depreciation is accelerated when compared to other methods. In the early years of the lifespan of an asset much higher expense is incurred, and as the years’ progress, the expenses reduce. For this calculation, the asset’s remaining life is divided by the aggregate of years and subsequently multiplied by the depreciating base.
The depreciation formula is –
Explain Accumulated Depreciation
Accumulated depreciation is the total depreciation recorded for a fixed asset over its useful life up to a specific date. It represents the reduction in the asset’s value due to wear, tear, or obsolescence.
Accumulated Depreciation = Annual Depreciation × Number of years
It is shown as a contra-asset account on the balance sheet, reducing the asset's original cost to reflect its net book value.
Different Aspects of Straight Line Method of Depreciation
The benefits of the straight-line method of depreciation are –
Given that it is a relatively simple method for calculation of depreciation, asset depreciation can go up to zero value which is also the net scrap value.
In the profit and loss account, pursuant to this method, the same is charged as the depreciation amount.
The limitations of the straight-line method of depreciation are –
Even though the depreciation of assets under this calculation can go up to zero, assets’ book value can never be zero.
A suitable rate of depreciation becomes difficult to be ascertained.
Written Down Value Method of Depreciation
Written down value essentially indicates the asset value after accounting amortization or depreciation. It shows what is the present worth of an asset that has already been purchased.
(The term, amortization is mostly used with respect to intangible assets. The concept of amortization includes the measure of writing off certain intangible assets such as copyrights, patents, franchises, trademarks, etc. It can be understood that those aspects are also covered under the written down value method of depreciation)
The calculation of the written-down value is done by subtracting the amortization or the accumulated depreciation from the original value of the asset. The depreciation becomes a fixed percentage of the asset’s original cost. The written-down value figure will reflect on the balance sheet.
Comparison between the Straight-Line Method and Written Down Value Method
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How Depreciation affects the Selling Price of Assets?
Machines and tools are the physical objects that help in performing various functions that are essential for developing a product or getting work done. To illustrate an example: Vehicles help in transportation of goods and people, packaging machines in industrial setups perform the function of packaging of final products. Electronic devices such as computers and smartphones help in conducting various tasks and communication. Because all these physical or tangible objects add value to the product they deal with, they are known as assets in general terms. The value of the materials and effort used in the making of these assets constitute the value of these assets. According to this value, the cost of the assets is determined to be sold in the market.
Anybody who needs the service performed by these assets can buy it and use it. With time the value of the asset also decreases with time as they are used up worn and torn down gradually. So after each year, the value of the equipment or asset will decrease. This decrease in value determines the selling price of the equipment each year. As the balance sheet of a business also includes the values of every equipment and asset the effect of depreciation is also reflected in it. It sometimes benefits the owner of the asset or business to cut down his tax expenses during accounting.
There are various methods and formulas derived and established for the calculation of depreciated value during accounting. To name some are straight-line methods, declining balance methods, fixed percentage methods. Often the law of attraction determines the use of anyone method for the computation of depreciation.
Depreciation Rate Chart
A depreciation rate chart is a table or graph that outlines the rate at which an asset loses its value over time, typically based on its useful life and the method of depreciation being applied. Depreciation is the process by which businesses allocate the cost of an asset over its useful life. The rate can vary depending on the asset type, accounting methods (such as straight-line or declining balance), and industry standards.
Key elements in a depreciation rate chart may include:
Asset Type: The kind of asset (e.g., vehicles, machinery, buildings).
Useful Life: The estimated period the asset is expected to be in service.
Depreciation Method: The method used to calculate depreciation (e.g., straight-line, double-declining balance).
Depreciation Rate: The percentage of the asset's value that is depreciated each year.
Explanation of the chart
Asset Type: Refers to the type of asset being depreciated.
Useful Life: The expected duration for which the asset will be used.
Depreciation Method: The method used to allocate depreciation (e.g., straight-line or declining balance).
Annual Depreciation Rate: The percentage of the asset’s value that is depreciated each year. It is based on the asset’s useful life and the depreciation method.
This is a general guideline, and specific depreciation rates and methods might vary based on country regulations, industry practices, or company policies.
NCERT-Based Solved Questions
Multiple Choice Questions (MCQs)
1. Which method of depreciation calculates an equal expense over the asset’s useful life?
a) Double declining balance method
b) Straight-line method
c) Sum-of-years digits method
d) Units of production method
Answer: b) Straight-line method
2. Depreciation is primarily applied to:
a) Intangible assets only
b) Tangible assets only
c) Both tangible and intangible assets
d) None of the above
Answer: b) Tangible assets only
3. In the written-down value method, the depreciation is calculated based on:
a) Original cost
b) Salvage value
c) Book value
d) Market value
Answer: c) Book value
4. Which of the following is not a cause of depreciation?
a) Wear and tear
b) Obsolescence
c) Appreciation in asset value
d) Expiry of legal rights
Answer: c) Appreciation in asset value
5. What is the formula for calculating depreciation using the straight-line method?
a) (Cost + Salvage Value) / Useful Life
b) (Cost – Salvage Value) / Useful Life
c) Cost / Useful Life
d) Salvage Value / Useful Life
Answer: b) (Cost – Salvage Value) / Useful Life
Short Answer Questions
6. Define depreciation in accounting.
Answer: Depreciation is the systematic allocation of the cost of a tangible asset over its useful life. It represents the decrease in the asset's value due to wear and tear, obsolescence, or the passage of time.
7. What is the main difference between amortization and depreciation?
Answer: Depreciation applies to tangible assets, while amortization pertains to intangible assets such as patents, copyrights, and trademarks.
8. Why is depreciation considered a non-cash expense?
Answer: Depreciation is considered a non-cash expense because it does not involve any actual cash outflow. It is an accounting entry that allocates the cost of an asset over time.
9. Explain the concept of salvage value in depreciation.
Answer: Salvage value is the estimated residual value of an asset at the end of its useful life. It is the amount the asset is expected to be sold for after being fully depreciated.
10. Mention two limitations of the straight-line method of depreciation.
Answer:
It does not account for the varying productivity of an asset over time.
It may not accurately reflect the true wear and tear or usage pattern of the asset.
Long Answer Questions
11. Discuss the causes of depreciation with suitable examples.
Answer: Depreciation occurs due to:
Wear and Tear: Physical deterioration from usage, e.g., machinery in a factory.
Obsolescence: Outdated technology, e.g., older computer models replaced by newer ones.
Expiry of Legal Rights: Loss of value after the expiration of a patent or lease.
Natural Factors: Damage caused by environmental factors, e.g., corrosion in equipment due to humidity.
12. Compare the straight-line method and written-down value method of depreciation.
Answer:
Depreciation Charge: SLM uses original cost, WDV uses book value.
Annual Depreciation: Constant in SLM, declining in WDV.
Repairs and Cost: Lower in early years for SLM; constant for WDV.
Tax Recognition: WDV is recognized by Indian tax authorities, but SLM is not.
13. Explain the significance of depreciation in accounting.
Answer: Depreciation helps allocate the cost of an asset systematically, matching the expense with the revenue generated during the asset's useful life. It also aids in determining the true value of assets, provides tax benefits, and helps in budgeting for future replacements.
14. Describe the double declining balance method of depreciation with an example.
Answer: This accelerated method calculates higher depreciation in the early years.
Example: Asset cost = ₹10,000; Useful life = 5 years; Depreciation rate = 40%.
Year 1: ₹10,000 × 40% = ₹4,000
Year 2: ₹6,000 × 40% = ₹2,400, and so on.
15. How does depreciation affect the selling price of assets?
Answer: Depreciation reduces an asset's book value over time, which directly impacts its selling price. The more an asset depreciates, the lower its market value becomes, reflecting its reduced utility and condition.
Value-Based Questions
16. Why is it important for businesses to account for depreciation accurately?
Answer: Accurate depreciation accounting ensures fair valuation of assets, compliance with legal requirements, and realistic financial reporting, enabling businesses to make informed decisions.
17. Discuss the ethical implications of underestimating or overestimating depreciation.
Answer:
Underestimating: Inflates profits and misleads stakeholders.
Overestimating: Reduces profits, potentially affecting investor confidence.
18. A company decides to replace its machinery after five years. How should it plan for this using depreciation?
Answer: The company can allocate the machinery’s cost over its useful life and set aside funds equivalent to the depreciation expense annually. This ensures enough reserves for replacement.
19. How does the concept of depreciation align with the matching principle in accounting?
Answer: Depreciation aligns with the matching principle by allocating the cost of an asset over its useful life, ensuring that the expense matches the revenue generated during the same period.
20. A business uses outdated machinery due to financial constraints. How can depreciation impact its decisions for upgrades?
Answer: Depreciation reflects the declining value of machinery, signaling the need for upgrades. Proper accounting helps assess the financial feasibility of replacements or repairs, ensuring operational efficiency.
The concept of 'Depreciation' has been explained in detail above, specifically tailored for Class 11 Commerce students. For more insights, stay connected with Vedantu.
FAQs on Depreciation: Methods, Causes, and Accounting Treatment
1. What exactly is depreciation in accounting, and can you give a simple example?
Depreciation is an accounting method used to allocate the cost of a tangible asset over its useful life. It represents how much of an asset's value has been used up. For example, if a company buys a delivery truck for ₹10,00,000 and expects it to last for 10 years, it might record ₹1,00,000 in depreciation expense each year. This is not a cash payment but an entry to show the asset is gradually losing value as it's being used.
2. What are the main causes of depreciation for a business asset?
The primary causes of depreciation are:
- Wear and Tear: This is the physical deterioration of an asset due to its constant use in business operations.
- Passage of Time: Some assets lose value simply because they get older, even if they aren't used much.
- Obsolescence: An asset becomes outdated or obsolete when a newer, more efficient technology becomes available.
- Depletion: This applies to natural resources (like mines or quarries) and refers to the exhaustion of the resource.
3. What are the main methods for calculating depreciation that students learn about?
While there are several methods, the two most common ones taught in the CBSE/NCERT syllabus are:
- Straight-Line Method (SLM): This method spreads the cost of the asset evenly over its useful life. The depreciation amount is the same every single year.
- Written Down Value (WDV) Method: Also known as the Diminishing Balance Method, this method applies a fixed depreciation rate to the asset's book value each year. The depreciation amount is highest in the first year and decreases over time.
4. How does a business decide whether to use the Straight-Line Method or the Written Down Value Method?
The choice depends on the asset's nature and how it's used. The Straight-Line Method is suitable for assets that provide consistent benefits over their lifetime, like furniture or buildings. The Written Down Value Method is more realistic for assets like machinery or vehicles, which are more productive in their early years and lose value faster at the beginning.
5. Why is depreciation referred to as a 'non-cash' expense in accounting?
Depreciation is called a non-cash expense because recording it doesn't involve any actual outflow of cash. When a company records depreciation, no money leaves its bank account. It is purely an accounting entry to match the cost of using an asset with the revenue it helps generate during a period, following the 'matching principle' of accounting.
6. How is the accounting treatment for depreciation handled in financial statements?
Depreciation has a dual effect on financial statements:
- On the Profit and Loss Account (Income Statement), it is shown as an operating expense, which reduces the net profit.
- On the Balance Sheet, the annual depreciation is added to an account called 'Accumulated Depreciation,' which is then subtracted from the original cost of the asset to show its current book value.
7. What is the difference between Depreciation, Amortisation, and Depletion?
These three terms all refer to allocating the cost of an asset, but they apply to different types of assets:
- Depreciation is for tangible assets like machinery, vehicles, and buildings.
- Amortisation is for intangible assets like patents, copyrights, and trademarks.
- Depletion is used for the extraction of natural resources like oil, coal, and timber.
8. What is the importance of 'salvage value' in calculating depreciation?
Salvage value, also known as scrap value or residual value, is the estimated amount an asset will be worth at the end of its useful life. It is important because it directly affects the total amount that can be depreciated. The depreciable amount of an asset is calculated as its original cost minus its estimated salvage value.
