Depreciation is defined as the diminution in the value of a fixed asset due to use and/ or lapse of time. That means, depreciation of assets takes place due to the wear and tear of the asset for using as well as for lapse of time. Depreciation may be regarded as fixed, variable or semi- variable depending on the importance given to usage and time factors. Strictly speaking, depreciation is a semi-variable expense.
In financial accounts, depreciation is provided for the purpose of replacement of the asset at the end of its useful life. In cost accounts, the depreciation is considered as a charge to production for utilising assets such as, machinery and equipment. The cost of production will be understated, and profit overstated, if depreciation is not charged for the use of plant and machinery and other assets. Excess profit will be distributed to shareholders, while sufficient funds may not be available for replacement of machinery when required.
There are several methods of calculating depreciation, of which two methods are very common, viz. straight line method and diminishing balance method. Under straight line method, the original cost of the asset as reduced by scrap value at the end of the effective life is divided by the assumed life of the asset, and charged equally every year. For example, if an asset is valued at Rs.12,000, and the scrap value at the end of its effective life of 10 years is Rs.2,000, then during the 10 year period, depreciation will be charged @ Rs.1,000 per year i.e. (12000 2000) divided by 10 years.
Reducing balance method of depreciation is calculated as a constant proportion of the balance of the value of asset after deducting the amount previously employed. For example, if cost of the asset is Rs. 12000, and depreciation percentage is fixed at 10%, then in the first year 10% of Rs. 12000 i.e. Rs. 1200 will be provided. In the second year, 10% will be applied on the reduced balance of the asset i.e. Rs.10,800 (Rs. 12000 less Rs. 1200), and depreciation of Rs. 1080 will be provided. Other methods of depreciation are as follows:
(a) Production unit method. Depreciation is provided by means of a fixed rate per unit of production calculated by dividing the value of the asset by the estimated number of units to be produced during its life.
(b) Production hour method. Depreciation is provided by means of a fixed rate per hour of production calculated by dividing the value of asset by the estimated number of working hours of its life.
(c) Repair provision method. Depreciation along with maintenance cost is provided by means of periodic charges each of which is a constant proportion of the aggregate of the cost of asset depreciated and the expected maintenance cost during its life.
Overheads (d) Annuity method. Depreciation is provided by means of periodic charges, each of
which is a constant proportion of the aggregate of the cost of the asset depreciated and interest at a given rate per period on the written down value of the asset at the beginning of each period.
(e) Sinking fund method. Depreciation is provided by means of fixed periodic charges which, aggregated with compound interest over the life of the asset, would equal the cost of that asset. Simultaneously, with each periodic charge an investment of the same amount would be made in fixed interest security which would accumulate at compound interest to provide, at the end of life of the asset, a sum equal to its cost.
(f) Endowment policy method. Depreciation is provided by means of fixed periodic charges equivalent to the premia or an endowment policy for the amount required to provide, at the end of the life of the asset, a sum equal its cost.
(g) Revaluation method. Depreciation is provided by means of periodic charges each of which is equivalent to the difference between the value assigned to the asset at the beginning and at the end of the period.
(h) Sum of the digits method. Depreciation is provided by means of differing periodic rates computed according to the following formula. If “n” is the estimated life of the asset, the rate is calculated each period as a fraction in which the denominator is always the sum of the series 1, 2, 3 ...n and the numerator for the first period is n, for the second n - 1, and so on.
** Students are advised to study in details and work out problems under each of the above methods from the text books viz. “Cost Accounting Methods and Problems” by B. K. Bhar and Wheldon’s “Cost Accounting”.
Obsolescence
Obsolescence refers to a sudden loss in the value of an assets, because it has to be discarded
before the expiry of its normal life, due to one or more of the following reasons:
i) Change in technology.
ii) Discontinuance of the product line which uses the asset.
iii) Introducing a new and high yielding machine in replacement of existing one for higher productivity and lower cost.
iv) Changes in product specification resulting in change in method.
When obsolescence occurs, the written down value of the asset has to be charged off to costing profit & loss account, as the same will have no relevance with the current production. However, if the amount is too heavy, it can be deferred over next few years. An alternative method is to create an obsolescence reserve by funding every year, and to utilise the same for writing off losses arising out of obsolescence of assets.