Depreciation Concepts and Methods

Depreciation Concepts

• Depreciation: Reduction in cost of a fixed asset due to wear and tear over its useful life. It reflects the period during which the asset is productive.
• Depletion: Reduction in the value of natural resources (e.g., oil wells, mines) as they are extracted.
• Wear and Tear: Deterioration and decrease in an asset's value from its use in generating revenue.
• Expiration of Legal Rights: Loss of asset value when the agreement allowing its use expires.
• Obsolescence: Asset becomes outdated due to newer, better assets becoming available.
• Abnormal Factors: Accidental losses (e.g., fire, flood) leading to permanent but non-recurring asset value reductions.
• Useful Life: Estimated time an asset functions efficiently. Estimated by vendor or professional based on current condition and usage.

Depreciation Methods

• Straight-Line Method: Fixed depreciation amount charged annually throughout the asset's life. Based on original cost. Also known as original cost method or fixed instalment method.
• Written-Down Value Method: Depreciation charged on the asset's book value (cost - depreciation) each year. Book value decreases, and depreciation also decreases annually. Also known as diminishing balance method or reducing installment method.

Asset Valuation

• Scrap Value: Salvage value of an asset at the end of its useful life when it's no longer functional.
• Book Value: Estimated value shareholders would receive if the company liquidated the asset. Calculated by total assets minus intangible assets and liabilities. An important metric for evaluating whether stock is undervalued or overvalued.
• Salvage Value: Estimated value of an asset at the end of its useful life. Used in depreciation calculations and for tax deductions.
• Depreciable Cost: Asset's worth minus accumulated depreciation.
• Disposal of Assets: Complete removal of an asset from business operations and accounting records.

Reserves and Provisions

• Provisions: Amounts set aside for probable future expenses or asset value reductions, even if the amount is uncertain.
• Reserves: Retained earnings used to strengthen financial position, clear debt, fund expansion, or meet legal requirements. Not restricted in use.
• General Reserves: Profit set aside without a specific purpose. Used to meet contingencies, offset losses, enhance capital, or pay dividends.
• Specific Reserves: Created for a specific business purpose; cannot be used for other purposes unless allowed by articles of association and board approval.
• Revenue Reserves: Created from net profit for meeting future business needs. Not distributed as dividends.
• Capital Reserves: Created from capital profits, often for inflation, expansion, or new projects. Permanently invested; not usable for other purposes.
• Secret Reserves: Undisclosed reserves (hidden or internal) often used by insurance companies or banks. Illegal for most other companies because of accounting/reporting obligations.

Specific Accounting Items

• Provision for Doubtful Debts: Amount set aside to cover expected bad debts.
• Original Cost: Price and related expenses (installation, testing, commissions) involved in purchasing and putting asset into use.