UPSC APFC

General Accounting
Principles
DEPRECIATION

By: CA Anurag Kahol

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 DEPRECIATION
Property, plant and equipment are tangible items that:
(a) are held for use in the production or supply of goods or services, for rental
to others, or for administrative purposes; and
(b) are expected to be used during more than a period of twelve months.
These are also called fixed assets in common parlance.

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 DEPRECIATION
Depreciation may be described as a permanent, continuing and gradual
shrinkage in the book value of fixed assets. It is based on the cost of assets
consumed in a business and not on its market value.

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 REASONS OF DEPRECIATION
Value of such assets decreases with passage of time mainly due to
following reasons.
Depletion
Obsolesce
Wear and Efflux of mainly in
nce due to
tear due time even Decrease case of
technologi
to its use when it is in market mines and
cal or
in not being value other
other
business used natural
changes
reserves
As per Schedule II under the Companies Act, 2013, Depreciation is the
systematic allocation of the depreciable amount of an asset over its
useful life. The depreciable amount of an asset is the cost of an asset or
other amount substituted for cost, less its residual value

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 TERMS (OBSOLESCENCE)
Obsolescence is another factor leading to depreciation of fixed
assets. In ordinary language, obsolescence means the fact of being
―out-of-date”. Obsolescence implies to an existing asset becoming
out-of-date on account of the availability of better type of asset. It
arises from such factors as:
• Technological changes;
• Improvements in production methods;
• Change in market demand for the product or service output of the
asset;
• Legal or other description.

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 TERMS (ABNORMAL FACTORS)
Decline in the usefulness of the asset may be caused by abnormal
factors such as accidents due to fire, earthquake, floods, etc.
Accidental loss is permanent but not continuing or gradual. For
example, a car which has been repaired after an accident will not fetch
the same price in the market even if it has not been used.

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 OBJECTIVE OF DEPRECIATION
Correct True financial
income position
Ascertainmen
measurement statement by Funds for
t of true cost
by matching showing PP&E replacement
of production.
the charge for at their
the year current value

Matching of Costs and Revenue

The rationale of the acquisition of fixed assets in business operations is that these are
used in the earning of revenue. Every asset is bound to undergo some wear and tear,
and hence lose value, once it is put to use in business.
Therefore, depreciation is as much the cost as any other expense incurred in the
normal course of business like salary, carriage, postage and stationary, etc. It is a
charge against the revenue of the corresponding period and must be deducted before
arriving at net profit according to ̳Generally Accepted Accounting Principles‟.

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 Important Factors of Computing
Depreciation
Estimated Residual
Estimated useful life Historical Cost of value of the asset at
of the asset the asset the end of the of its
estimated useful life

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 Inclusion in cost
Examples of costs directly attributable costs are:
(a) cost of employee benefits arising directly from acquisition or
construction of an item of property, plant and equipment.
(b) cost of site preparation
(c) initial delivery and handling costs
(d) installation and assembly costs
(e) cost of testing whether the asset is functioning properly, after
deducting the net proceeds from selling the items produced while
testing (such as samples produced while testing)
(f) professional fees e.g. engineers hired for helping in installation of a
machine

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 Exclusion in cost
Thus all the expenses which are necessary for asset to bring it in
condition and location of desired used will become part of cost of
the asset. However, following expenses should not become part of
cost of asset:
(a) costs of opening new facility or business, such as inauguration
costs;
(b) cost of introducing new product or service (for example cost of
advertisement or promotional activities).
(c) cost of conducting business in a new location or with a new class of
customer (including cost of staff training); and
(d) administration and other general overhead costs.

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Method of Providing Depreciation
1. Straight line method
2. Reducing balance method
3. Sum of years of digits method
4. Machine hour method
5. Production units’ method
6. Depletion method
7. Annuity Method

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 Method of Providing Depreciation

The Income Tax Rules, however, prescribe the Diminishing Balance

Method except in the case of assets of an undertaking engaged in
generation and distribution of power.

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 Advantages of Straight line
Straight Line method has certain advantages which are stated below:
1. It is very simple, easy to understand and apply. Simplicity
makes it a popular method in practice;
2. Asset can be depreciated upto the net scrap value or zero
value. Therefore, this method makes it possible to distribute full
depreciable cost over useful life of the asset;
3. Every year, same amount is charged as depreciation in profit
and loss account. This makes comparison of profits for different
years easy;
4. This method is suitable for those assets whose useful life can be
estimated accurately and where the use of the asset is consistent
from year to year such as leasehold buildings.

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 Disadvantages of Straight line
Although straight line method is simple and easy to apply it suffers
from certain limitations which are given below.

This method is based on the faulty assumption of same amount of the

utility of an asset in different accounting years. With the passage of
time, work efficiency of the asset decreases and repair and maintenance
expense increases. Hence, under this method, the total amount charged
against profit on account of depreciation and repair taken together, will
not be uniform throughout the life of the asset, rather it will keep on
increasing from year to year.

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 Advantages of WDV
Written down value method has the following advantages:
• This method is based on a more realistic assumption that the
benefits from asset go on diminishing (reducing) with the passage of
time. Hence, it calls for proper allocation of cost because higher
depreciation is charged in earlier years when asset‘s utility is higher as
compared to later years when it becomes less effective.

• It results into almost equal burden of depreciation and repair

expenses taken together every year on profit and loss account

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 Disadvantages of WDV
Although this method is based upon a more realistic assumption it
suffers from the following limitations.
• As depreciation is calculated at fixed percentage of written down
value, depreciable cost of the asset cannot be fully written-off. The
value of the asset can never be zero;

• It is difficult to ascertain a suitable rate of depreciation.

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STRAIGHT LINE and WDV

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SUM OF YEAR DIGIT

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MACHINE HOUR

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PRODUCTION UNIT METHOD

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 DEPLETION
Depletion is the allocation of the cost of wasting natural resources such
as oil, gas, timber, and minerals to the production process. This method
is used in case of mines, quarries etc. containing only a certain quantity
of product.

Substance Over Form

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 DEPLETION

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 ANNUITY METHOD

JUST REMEMBER IN ANNUITY METHOD

DEPRECIATION IS SAME IN EVERY YEAR IS
SAME

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 Profit and Loss on Sale of Asset
The resulting profit or loss on sale of the
tangible asset is ultimately transferred to
profit and loss account.

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