Depreciation is a measure of the wearing out, consumption or other loss of value of a depreciable asset arising from use, effusion of time or obsolescence through technology and market changes. Depreciation is allocated so as to charge a fair proportion of the depreciable amount in each accounting period during the expected useful life of the asset. Depreciation includes amortisation of assets whose useful life is predetermined.
Depreciable assets are assets which:
- are expected to be used during more than one accounting period. Dies and blocks are written off on first year itself as their useful life ends within one year.
- have a limited useful life. Depreciation is not charged on land as the useful of land cannot be determined, it is endless.
- are held by an enterprise for use in the production or supply of goods and services, for rental to others, or for administrative purposes and not for the purpose of sale in the ordinary course of business. Depreciation is not charged on assets purchased for the purpose of resale but could not be sold till the end of the accounting year.
Depreciable amount of a depreciable asset is its historical cost, or other amount substituted for historical cost in the financial statements, less the estimated residual value.
Depreciable Amount = Historical Cost – Residual Value.
Assessment of depreciation and the amount to be charged in respect thereof in an accounting period are usually based on the following three factors:
- Historical cost or other amount substituted for the historical cost of the depreciable asset when the asset has been revalued;
- Expected useful life of the depreciable asset; and
- Estimated residual value of the depreciable asset.
Historical cost of a depreciable asset represents its money outlay or its equivalent in connection with its acquisition, installation and commissioning as well as for additions to or improvement thereof.
For example, Mr. Seth imported machine from Japan on the condition that machine will be run on trail basis for 15 days. If machine works satisfactorily, it will be purchased or else it will be rejected. Since the trial run is the necessary condition for acquisition of the machinery, the cost incurred for trail run net of any revenue generated will be capitalized i.e. added to the historical cost of the machine.
The historical cost of a depreciable asset may undergo subsequent changes arising as a result of increase or decrease in long term liability on account of exchange fluctuations, price adjustments, changes in duties or similar factors.
Useful life of a depreciable asset is shorter than its physical life. Useful life depends upon the following factors
- Pre-determined by legal or contractual limits. Example- Asset given on lease, the estimated life is period of lease.
- Depends upon the number of shifts for which the asset is to be used.
- Repair and Maintenance policy of enterprise.
- Technological obsolescence
- Innovation/ improvements in the production method.
- Change in demand of output.
- Legal or other restrictions.
Useful life is either
- the period over which a depreciable asset is expected to be used by the enterprise;
- the number of production or similar units expected to be obtained from the use of the asset by the enterprise.
Additions to Existing Assets
Any addition or extension to an existing asset which is of a capital nature and which becomes an integral part of the existing asset is depreciated over the remaining useful life of that asset.
As a practical measure, however, depreciation is sometimes provided on such addition or extension at the rate which is applied to an existing asset. Any addition or extension which retains a separate identity and is capable of being used after the existing asset is disposed of, is depreciated independently on the basis of an estimate of its own useful life.
For example, the engine of an aircraft is replaced. Since the life of engine is not dependent on the life of the aircraft body, depreciation charged on both is recorded separately.
Amount of Depreciation
The quantum of depreciation to be provided in an accounting period involves the exercise of judgment by management in the light of technical, commercial, accounting and legal requirements and accordingly may need periodical review. If it is considered that the original estimate of useful life of an asset requires any revision, the unamortised depreciable amount of the asset is charged to revenue over the revised remaining useful life.