Why is Depreciation Charged on Assets

Posted in Accounting, Financial Accounting on Aug 24th, 2014 | 0 comments

What is meant by Depreciation?

It means reduction in the value of a fixed asset used in the business due to #wear and tear and effluxion of time.

Need for Depreciation — What is depreciation?

Internal and External Causes of depreciation:

i. Wear and tear: Caused mainly due to constant use, erosion, rust etc.

ii. Efflux of time: Mere passage of time will cause a fall in the value of an asset, even if it is not used.

iii. Obsolescence: A new invention or change in fashion or a permanent change in demand may render the asset useless.

iv. Depletion: When raw materials or natural resources like mines, quarries and oil wells are extracted continuously, they deplete.

v. Accident: An asset may reduce in value because of meeting with an accident, like fire accidents.

vi. Fall in the market price.

Watch this video on What Is Depreciation – How It Affects Profit And Cash Flow

What is the necessity for providing depreciation?

According to International Accounting Standard Committee (IASC) “Depreciation is the allocation of the depreciable amount of an asset over its estimated useful life.

Depreciation for the accounting period is charged to income either directly or indirectly.”

The need for depreciation arises because of the following reasons:

To ascertain the true profit of the business for a particular period
To show the asset at its true value in the balance sheet
To provide funds for replacement of the old asset with a new one

Objectives of providing depreciation:

To recover the cost incurred on fixed assets over its life
To facilitate the purchase of new asset, when the old asset is disposed
To find out the correct profit or loss for the particular period
To find out correct financial position through balance sheet

Factors to be considered while determining the amount of depreciation:

I. The total cost of the asset including all freight, insurance and installation charges

II. The estimated residual or scrap value at the end of its life

III. Estimated number of years of its usefulness

It is concerned with charging the cost of fixed assets to operations. But the term depletion refers to the cost allocation for natural resources, whereas the term amortization relates cost allocation for intangible assets.

What are the various methods for depreciation?

Fixed installment or Straight line or Original cost method.
Diminishing Balance Method or Written down value method or Reducing Installment method.
Annuity Method.
Depreciation fund method or Sinking fund amortization fund method.
Insurance policy method.
Revaluation method.
Sum of the year’s digits method (SYD).
Double declining balance method.
Depletion method.