Depreciation | Causes of Depreciation | Factors Affect Depreciation
Arjun EP
Concept of Depreciation
Depreciation is taken from Latin word ‘Depretium’. De means to decrease and pretium means price.
Therefore, depreciation means decrease in price of asset.
Depreciation is charged on tangible assets except land gold biscuits.
Tangible assets are depreciated but intangible assets are written off or amortized.
Examples of tangible assets are machines, plants, furniture, buildings, computers, vehicles, equipment etc.
Examples of intangible assets are patents, trademarks, copyrights, goodwill etc.
Depreciation reduces profit of an organization. It is non-cash expenses.
It is debited in profit and loss account.
Definition of depreciation |
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According to ICMA, England, “Depreciation may be defined as permanent decrease in the value of assets due to use and/or the lapse of time.” According to R.N. Carter, “Depreciation is the gradual and permanent decrease in the value of asset from any cause.” According to Nepal Income Tax Act 2064 BS, section 19, “Depreciation is the depletion in the value of assets by tear and wear, obsolescence or the passing of time.” |
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Causes of Depreciation
There are different causes of depreciation; out of them, some causes are as follows:
Wear and tear
Regular using, the value and working capacity of asset is decreased.
The values of some assets are automatically decreased after purchasing such as vehicles, computer, machinery, furniture etc.
To maintain or control more wear and tear, repairs and maintenance is needed.
Obsolescence
Here, obsolescence means NOT in use.
To compare with new technology or invention, old technology asset does not work efficiently.
In such a condition, it becomes old fashioned or out dated.
The value of old asset naturally goes-on decrease.
Passing or lapse of time
The value of patent and lease asset decreases due to time passing.
These assets are taken for fixed period.
As well as time passes, it becomes zero value.
The legal right of using asset comes to end.
Exhaustion
Here, exhaustion means empty something.
Some natural asset has limited output capacity.
They are coal-mine, oil well, forest etc.
After dig-out or consumption these assets, their value comes end.
Accident
Accident may be natural or manmade.
Accident may damage partial or complete.
But it decreases the value of asset.
Some accidents are fire, earthquake, flood, short circuit, tsunami etc.
Fall in market value
Investment is also asset.
Investment can be made in shares, debentures, land, gold, commodities business etc.
Generally investments are not depreciated.
The value of investment is decreased or depreciated due to heavy price fall in the market.
Factors that Affect the Amount of Depreciation
There are different factors that affect depreciation; out of them, some important factors are given below:
Cost or purchase price
It is the purchase price of the asset.
Installment, transportation, erection expenses are added with asset.
When cost is more, depreciation is also more.
If cost is less, depreciation is also less.
Estimated life of asset
Generally asset has its life. After some times, asset does not work properly.
The life of the asset is depended on its speed, daily use, repairs and maintenance etc.
More life of asset has less depreciation but less life of asset has more depreciation.
Scrap value
It is assumed that most of assets have scrap value at the end of their life.
But some assets do not have scrap value.
When there is more scrap value, depreciation is less.
But, when there is less scrap value, depreciation is more.
Interest on invested capital
Asset needs more capital to investment.
To collect capital, interest or dividend should be paid.
This interest or dividend affects depreciation rate.
Obsolete of asset
New technology makes absolute of assets.
When technology changes depreciation rate will be high.
Advantages of Depreciation
True profit
When fixed assets are purchased, large amount of cash is needed.
After using asset, its value is decreased.
Depreciation is the using cost of fixed assets.
To determine true profit, depreciation should be treated as revenue expenses.
Therefore, depreciation is debited to profit and loss account.
True financial position
The value of asset decreases over a period due to various factors.
In-order-to present true statement of affairs, fixed assets are shown in assets side of balance sheet.
Depreciation is deducted from related asset in balance sheet.
Replacement of assets
After using assets, their life will be decreased. After some years, assets must be replaced.
To replace assets, large amount is needed.
Sinking fund or depreciation fund method helps to replace assets.
For this purpose, depreciation amount is invested into financial institutions.
Tax saving
Every business organization should pay tax or VAT to government.
Tax authority allows depreciation limit for tax saving.
Tax is paid on profit. Depreciation deducts net profit.
Thus, depreciation helps to tax saving.
Depreciation Terminologies
Book value
Long-term assets is also known as fixed assets or property, plant and equipment (PP&E)
When a company acquires long-term assets, it initially records at the purchase price.
This purchase price is known as book value.
Book value is the amount of before accounting for depreciation.
Cost price or purchase price
It is the purchase price of fixed assets.
Installation charge, transportation, erection charge etc are added with cost price.
Net value = Purchase value + Transportation + Installation charge + Erection charge – Scrap
Estimated life of asset
Generally, asset has its life.
After some time (year), it cannot work properly.
It is depend on its speed, daily operating, repairs, maintenance etc.
Scrap value
Scrap value is also known as fetch values, residual value, terminate value, breakup value or phase out value.
It is assumed that most of fixed assets have their value at their ending life.
However, some assets have zero scrap value at their ending life.
· Plant will have scrap value.
· Building may has been scrap value.
· Furniture may have been scrap value.
· Leasehold property does not have scrap value.
Depreciation
Depreciation means decrease in price of asset.
Depreciation is charged on tangible assets except land and gold biscuits.
Tangible assets are depreciated but intangible assets are written off or amortized.
Book salvage value
The amount that somebody may pay for something/asset that no longer useful is book value.
It is the remaining value after deducting depreciation from purchase value.
When asset is not need to sale, it is called book value.
When company wants to sell its assets after deducting depreciation is called book salvage value.
Book value = Purchase value – Depreciation
Book salvage value = Purchase value – Accumulated depreciation
Cash salvage value
It is also known as sold value or disposed of value.
It is cash value when company sells its assets.
While selling asset, there may be capital profit or capital loss.
Cash salvage value – Book salvage value = Profit
Book salvage value – Cash salvage value = Loss
Retrospective
It is applying to past events.
It applies for past as well as present.
When the company wants to change depreciation methods from straight line to diminishing balance or diminishing balance to straight line, this method is applied.
Annual depreciation
There are two types to calculation depreciation amount.
First, when depreciation rate is given and second when depreciation rate is not given.
(A) When depreciation rate is given
Annual depreciation
Depn = (Purchase value + Transportation + Installation charge + Erection charge – Scrap) x (% ÷ 100)
(B) When depreciation rate is not given
Annual depreciation
Depn = (Purchase value + Transportation + Installation charge + Erection charge – Scrap) ÷ Life
Net value = Purchase value + Transportation + Installation charge + Erection charge – Scrap
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