Fixed Assets are held in business concerns for regular use and not for resale. However a fixed asset cannot render unlimited service to the business. Except Land, all other fixed assets have a limited useful life and benefit from the asset is received by the business throughout its useful life. Thus the price paid for the fixed assets is actually the cost incurred for the ‘series of services’ to be received or enjoyed from it over a number of years and it should be spread over those years.
Depreciation, in common terms, means a reduction in the value of an asset due to wear and tear, efflux of time or obsolescence. However, if we do an in-depth analysis, it is the process of allocating the cost of the asset over its estimated working life in accordance with the matching concept of accounts. It is an accounting estimate and is in the nature of a provision.
Need for Depreciation:
Depreciation is provided for in every accounting period for the following reasons:
- Calculation of correct profits / losses: As per Matching Principle of accounts, all costs incurred for earning revenue in a particular period must be matched against the revenues of the same period. The allocated cost of utilisation of the fixed assets in a particular year (i.e. Depreciation) has to be provided for calculation of correct profits or losses by charging it against the periodic revenues.
- Disclosure of Fixed Assets at a realistic value: Depreciation helps to disclose the fixed assets in the balance sheet at a realistic value as fixed assets are presented in balance sheet at cost less depreciation.
- Accumulation of Fund for Replacement of Assets: Depreciation is a non-cash expenditure. But net profit is calculated after charging depreciation. Through annual depreciation, cash resources are saved and accumulated to provide for the replacement cost at the end of the useful life of the Asset.
- Preventing Capital Erosion: A significant portion of the capital has to be invested for acquiring fixed assets. The values of such assets are gradually reduced due to their regular use and passage of time. Depreciation on the assets is treated as an expired cost and it is matched against revenues by creating a charge against profit. If depreciation is not charged then profits will remain inflated which will cause capital erosion.
- Compliance with legal requirements: Depreciation has to be charged to comply with the relevant provisions of different statutes like Companies Act and Income Tax Act, with make it compulsory to charge depreciation.
Factors on which the Depreciation depends – Measurement factors:
- Historical cost: Also known as the original cost, it includes money spent for acquisition, installation, addition and improvement of a fixed asset. All the costs to bring the asset to its present location and condition and to make it ready for use in the business are included in the historical cost.
- Useful life of the Asset: It is the estimated period over which the services of an asset will be enjoyed. The useful life of an asset depends on many factors such as legal or contractual provisions, level of use of the asset, degree of maintenance and technological developments. Generally the useful life of an asset is shorter than its physical life.
- Estimated residual value or scrap value: It is the value expected to be realised after complete commercial utilisation of a fixed asset.
- Other relevant factors: Some other relevant factors may be considered for deciding the amount to be charged as depreciation such as Replacement Cost of the Asset (that would be incurred if the old as it has to be replaced by a new asset), cost of future additions, alterations or improvements of the existing asset etc.
Watch the video below where we have explained the concept in details in Hindi
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