The useful life of an asset for a company is based primarily on the purpose of its acquisition, and secondly, on its nature. An item purchased for immediate consumption or sale is a short-lived asset and an item that is intended for long-term use is a long-lived asset, although both generate income. While the first asset expires within a year of its acquisition, the second asset lasts longer. Therefore, almost all spending on a short-lived asset becomes an expense and is compared to income for the current year.
But the situation is different with a long-lived asset that wears out or depreciates over a long period. Consequently, the disbursement of a fixed asset is distributed over several years and only a fraction of it expires annually. Simply, this fraction, called past due cost or depreciation, is charged against current income and the rest, called unexpired cost, is carried forward to future maturities.
“Depreciation can be defined as the permanent decrease in the value of an asset due to use and / or the passage of time.” -Terminology from the Institute of Management and Cost Accountants, England
“Depreciation is the permanent and continuous decline in the quality, quantity, or value of an asset.” -Pickles
“Depreciation can be defined as the measure of the depletion of the effective life of an asset for any reason during a given period.” -Espicer and Pegler
“Depreciation is’ the gradual and permanent decrease in the value of an asset for any reason.” Sump
Objects of the provision for depreciation
To achieve the following goals, depreciation accounting is a must for all businesses:
(1) Recovery of the cost incurred in fixed assets during their useful life to keep the owner’s capital intact;
(2) The provision is for the replacement cost in the retirement of the original assets;
(3) include depreciation in the cost of production to find the correct cost of production;
(4) to find out the correct profit for the year;
(5) know the correct financial situation through the balance sheet.
Causes of depreciation
Depreciation can be of two types: –
(1) Internal depreciation that occurs from certain inherent normal causes is known as internal depreciation. The causes of internal depreciation are:
(1.1) Wear and tear: An asset decreases due to continuous use, for example, building, plant,
machinery, etc. such decrease depends on the amount of use of an asset. If a factory works double shifts instead of one shift, depreciation of plant and machinery will double. It is obvious that such a loss is inevitable. An asset can be kept in proper working condition.
through repairs for the time being, but it cannot be done permanently: in a moment the asset will cease to be suitable for repairs, when it will no longer be suitable.
(1.2) Depletion: the value of some assets decreases proportionally to the amount of production, for example, mines, quarries, etc. With the raising of coal, etc. from the coal mine, the total deposit is gradually reduced and after some time it will be completely depleted. Then its value will be null.
(2) External depreciation caused by some external reasons is called external
The causes of external depreciation are:
Some assets, while working properly, can become obsolete. For example, the old machine becomes obsolete with the invention of a more economical and sophisticated machine, whose productive capacity is generally higher and the production cost is lower. To survive in the competitive market, the manufacturer must install a new machine to replace the old one.
(2.2) Passage of time
Some assets decrease in value due to the passage of time, even if they are not used, for example, rental property, patent rights, copyrights, etc.
Assets can be destroyed by abnormal reasons such as fire, earthquake, flood, etc. In such a case, the destroyed asset can be written off as a loss and a new one purchased.
Necessity of provision for depreciation
The need for a provision for depreciation arises for the following reasons:
(1) Determination of actual gain or loss: depreciation is a loss. So unless it is considered as all other expenses and losses, the actual profit / loss cannot be determined. In other words, depreciation must be considered to know the true profit / loss of a business.
(2) Determination of the real cost of production: goods are produced with the help of plants and machinery that incur depreciation in the production process. This depreciation should be considered as part of the cost of production of the goods. Otherwise, the production cost would show less than the actual cost. The selling price is normally set on the basis of the cost of production. So if the cost of production is shown less by ignoring depreciation, the selling price will also be set at a low level, resulting in losses for the business;
(3) Actual valuation of assets: The value of assets gradually decreases due to depreciation. If depreciation is not taken into account, the value of the asset will be shown on the books at a higher figure than its real value and, therefore, the true financial situation of the business will not be revealed through the Balance Sheet.
(4) Asset replacement: After some time, an asset will be completely depleted due to use. Then a new asset will be purchased that requires a large sum of money. If the full amount of profit is withdrawn from the business each year without considering the depreciation loss, the required amount may not be available. buy the new assets. In such a case, the required money must be raised by introducing fresh capital or by obtaining a loan by selling other assets. This is a strong and contrary trade policy.
(5) Keep the capital intact: the capital invested in the purchase of an asset gradually decreases
depreciation account. If the depreciation loss is not considered in determining the profit / loss at the end of the year, the profit will be shown further. If the excess profit is withdrawn, the working capital will gradually decline, the business will weaken and its profitability
the capacity will also drop.
(6) Legal restriction: according to Sec. 205 of the Corporation Law of 1956, the dividend cannot be declared without charging the depreciation of the fixed assets. Thus, in the case of public limited companies, the collection of depreciation is mandatory.