Depreciation
Depreciation may be defined as the permanent and continuing diminution in the quality or the value of an asset. William Pickles
Depreciation is the gradual and permanent decrease in the value of an asset from any cause. R.N. Carter.
- Depreciation is fall in the value of the fixed assets (except Land).
- Depreciation is charged as an expense in the Profit and Loss Account in order to spread the cost of a fixed asset over the asset’s useful life.
- Depreciation is charged on a continuous basis. Once the depreciation is charged, it must be charged on regular basis in the succeeding period also.
Calculation of Depreciation
Straight line or Fixed Installment Method
A fixed or equal amount is to be charged as depreciation every year during the life time of the asset. The amount of depreciation remains equal from year to year. The expected lifetime of the asset is calculated and the cost of the asset is spread over its lifetime.
Depreciation expense per annum=Original cost/number of years of useful life
If the fixed asset is expected to have a scarp value at the end of its useful life, then
Depreciation expense per annum= (Original cost-Estimated scrap value)/Number of years of useful life
Reducing Balance or Diminishing Balance Method
The value of asset goes on diminishing year after year, the amount of depreciation charged every year also goes on declining. Every year a fixed percentage of the net book value of the asset is reduced. For example 20% depreciation is charged. If the asset has a value of $10000, the depreciation for the first year will be 20% of $10000 i.e. $4000. The book value for the next year will be now $6000. This year the depreciation will be again 20% of the remaining value i.e. 20% of 6000=$1200. So the remaining value of the asset is now $6000-$1200=$4800.
Revaluation Method
Under this method, the fixed asset is valued at the end of every accounting period. The difference between its value at the end of the period and the beginning of the period will be the depreciation for that period.
Depreciation expense=Value of asset at the end-Value of asset at the beginning + Any new purchase
Recording Depreciation in the Books
Once the depreciation expense is calculated, the adjusted entry would be:
Method 1
Depreciation Account Dr.
Provision for Depreciation Account
The nominal account is closed and the balance transferred to the Profit and Loss Account by:
Profit and Loss Account Dr.
Depreciation Account
The Provision for Depreciation Account shows the accumulated depreciation on the fixed asset. Like other liability accounts, it is closed by bringing its balance down. The Fixed Assets account is always maintained at its original cost. In the Balance Sheet, the fixed asset is shown at it book value, thus is, cost minus the provision for depreciation.
Method 2
In this method, depreciation expense is directly credited into the fixed asset itself. In this case, the book value of the fixed asset is the balance in the Asset Account.
The entries are:
Depreciation account Dr.
Fixed asset Account
Depreciation account is closed and its balance is transferred to the Profit and Loss account.
Profit and Loss Account Dr.
Depreciation Account
The effect on the Profit and Loss account and the Balance Sheet remains unchanged.
When no Provision for Depreciation Account is set up to record all the accumulated depreciation, the Fixed asset is brought down to its book value at the close of each accounting period after depreciation is written off.