Accounting for Depreciation and Related Terms

Accounting for Depreciation

• Depreciation is a systematic and rational allocation of the cost or value of a tangible asset over its useful life.
• It's a process of cost allocation, not valuation.
• Depreciation is a non-cash expense, but it affects the net profit.
• Depreciation is allocated so the cost of an asset is divided across its useful life.

Certain Useful Terms

• Amortization: The systematic write-off of intangible assets like goodwill, trademarks, or patents over their estimated useful lives.
• Depletion: A method to account for the depletion of natural resources like minerals, oil wells, or timber. Cost of the asset is divided by the total workable deposits.
• Obsolescence: The loss of usefulness of an asset due to technological changes, changes in market demand, or other technological limitations.

Nature of Depreciation

• Depreciation is a gradual decrease in the value of assets due to wear and tear, obsolescence, or other factors.
• Assets like plant, building, machinery, furniture, vehicles have a limited useful life.
• During their useful life, these assets help the business generate revenue. Depreciation is the part of the cost of the assets that is treated as an expense.

Causes of Depreciation

• Internal Causes: Wear and tear, depletion (wasting assets), inadequacy (changes in scale of operations).
• External/Economic Causes: Obsolescence (new technology), inadequacy (changes in demand or operations), and abnormal events (accidents, fire, flood).

Characteristics of Depreciation

• Depreciation is a charge against profit.
• It indicates diminution in service potential.
• It's an estimated loss of value, not an actual loss.
• It depends on estimated useful life, residual value, and other factors.
• Depreciation process is allocation, not valuation.

Objective of and Necessity for Providing Depreciation

• Accurately calculate cost of production.
• Accurately calculate profits.
• Accurately value fixed assets in the balance sheet.
• Ensure sufficient funds for replacement of assets at the end of their useful life.

Measurement of Depreciation

• Calculating exact depreciation is complex and depends on many factors like asset cost, additions, estimated useful life of assets, scrap value, obsolescence, renewals, legal regulations, etc.

Methods of Charging Depreciation

• Straight-Line Method: Equal depreciation expense each year.
• Diminishing Balance Method: Higher depreciation in early years, lower in latter years.
• Sinking Fund Method: Accumulate funds to replace assets at the end of their useful life.
• Annuity Method: Allocate depreciation based on consistent payments over the asset’s life.
• Unit of Production Method: Depreciation is calculated according to the number of items produced by the asset throughout its life.

Disposal of an Asset

• Accounting for the sale or disposal of an asset.
• Profit or loss is recorded on the disposal.
• Calculation of profit or loss is determined by WDV minus sale price.

Provision for Depreciation Account

• A provision for depreciation account is kept.
• Useful to determine correct profit and loss for the year.
• Depreciation expenses are accrued over the useful life of the asset.

Change of Method

• Change of method for depreciation should be applied consistently.
• If statute or accounting standards demand, change is possible.
• Prospective effect means the new method is applicable from the date of the change; retrospective effect means the new method is applied from the start of the asset's life.

Application of AS 6 and AS 10

• Accounting standards for depreciation (AS6) and fixed assets (AS10).
• Rules and guidelines to determine and present depreciation and fixed assets in financial statements.

This quiz explores the concepts of depreciation, amortization, and depletion in accounting. Understand how these terms relate to asset valuation, cost allocation, and the impact on net profit. Test your knowledge on the nature and methods of accounting for depreciation.