Mrs.Geetha Dasaraty is a commerce graduate with a Masters in Business Administration specialising in finance. Her stint with a Coimbatore based company and later with a consulting firm in Chennai has provided her with a decade of experience in project finance and appraisals, accounting and tax laws. She is a freelance writer and money matters are her forte. She is currently pursuing her final course in Company Secretaryship and is doing a course on Vaishnavism. She has a passion for literature and Carnatic music. She is also a violinist.

About the Class
We bring you an online class titled 'Elementary Finance'. This will have 12 lessons - one a month. Each lesson is further subdivided into 4 chapters. And we will give you one new chapter every week.

Chapter 5 Lesson C - Depreciation
In this lesson we will get to know about depreciation, its meaning and the different types of depreciation.

What is depreciation?
All assets reduce in value with the passage of time. All fixed assets with the exception of land are expected to lose its value upon repeated use. This reduction in value is known as depreciation. As per the definition, depreciation is "the permanent and continuing diminution in the quality, quantity or value of an asset. The loss occurred on the reduction in value is a loss spread out over the period of the asset. This allocation of the cost of the fixed asset is depreciation.

• Depreciation is the reduction in the book value of a fixed asset . It does not imply that the market value is reduced.
• This reduction is gradual unless it is due to technological changes. It cannot be reverted back to its original cost.
• Depreciation is not the process of valuation of assets but the process of allocation of cost over the period of its life.
• Depreciation is applicable only to tangible fixed assets and it does not apply to wasting and fictitious assets like depletion of natural resources.

Causes of depreciation:

• Due to repeated use of the asset there is bound to be some wear and tear
• Some assets have a definite life as in the case of a lease where on the expiry of the lease the asset will cease to exist. Where the asset does not have a definite life period, the period is estimated.
• Depreciation also occurs as a result of obsolescence of machines. New machines invade the markets and as a result old model machines are forced to be discarded in spite of being in good working condition.
• Sometimes, accidents also lead to a loss, which is permanent.
• The value of a machine reduces also due to mere passage of time.

Why is depreciation accounted for?
A certain amount has to be charged as depreciation over the useful life of the asset for the following reasons:

• To show the exact value of the asset: The proper value of the asset has to be shown in the Balance sheet. Where the value of the asset has reduced, due to wear and tear portraying the asset at its cost will not give the true financial picture.
• To ascertain the exact profit or loss: Depreciation is like any other cost of production and hence has to be debited to the profit and loss account. Ignoring depreciation will lead to a heavy loss when the asset actually becomes useless. Hence depreciation is charged.
• Another reason for accounting depreciation is that, a certain portion of the profits is retained by way of depreciation for further replacement of assets. As depreciation does not involve actual cash outflow, the amount shown as depreciation can be used for this purpose.

Factors involved while providing for depreciation

• The original cost of the asset has to be considered. This cost involves freight and erection charges until the asset is ready for use.
• The estimated scrap value or residual value of an asset has to be considered while providing depreciation.
• While providing depreciation the estimated commercial life or the useful life of the asset has to be considered.

The depreciation provided every year should be such that at the end of the useful life of the asset, the value of the asset should be reduced to its estimated scrap value.

METHODS OF PROVIDING DEPRECIATION :
There are two main methods of providing depreciation, namely straight-line method and diminishing balance method.

Straight line method:
Under this method a certain percentage of the original cost of the asset is written off the asset every year. The amount provided for depreciation will be uniform every year. The presumption here is that there will be no residual or scrap value at the end of the estimated life of the asset.

The amount to be written of every year will be:
Cost-estimated scrap value
Number of expected years of life
It is generally stated as a percentage of the original cost.

The entry for depreciation will be
Depreciation a/c Dr
To asset account

Where a provision for depreciation account is opened the amount will be credited to the provision for depreciation account. Here the asset account will appear at its original cost and the amount of depreciation will appear in the provision for depreciation account. In the balance sheet the amount of depreciation is deducted from the cost of the asset and the asset is shown at the reduced value.

Written-down value method or diminishing balance method:
Here, the depreciation is charged at a fixed rate on the reducing balance of the asset every year. The cost of the asset less the estimated scrap value should be written off over its estimated life. The depreciation percentage is applied to the book value of the asset and not the cost.

Distinction between Straight Line and Diminishing balance method:

• Under straight line method the depreciation charged is uniform every year throughout the life of the asset. Under diminishing balance the depreciation charged varies because it is charged on the reduced balance every year.
• Under the straight-line method the asset balance will be zero whereas in diminishing balance the asset balance will not be reduced to zero.
• For Income tax purposes diminishing balance method is preferred over straight-line method.

Effect of non- provision for depreciation

• Under Companies Act, 1956 provision for depreciation is mandatory.
• No Company can declare dividends out of its profits to its shareholders without providing for depreciation.
• Companies desiring to remunerate its directors out of its profits, must provide for statutory depreciation.
• The non-provision for depreciation would mean that the company's accounts do not reflect a true and fair view of its profitability for the period concerned.
• Depreciation being an allowable charge under Income Tax Act, non-provision would mean that the assessee would have to pay higher taxes.

Rates of depreciation:
The following are the general rates of depreciation prescribed under company law:

Questions on Chapter 5 Lesson B
1.What is a funds flow statement?
2.How do you calculate funds from operations?