Question 1: Explain the concept of depreciation. What is the need for charging depreciation and what are the causes of depreciation?
Answer:
Depreciation may be described as a permanent, continuing and gradual shrinkage in the book value of fixed assets. It is based on the cost of assets consumed in a business and not on its market value.
Every business acquires fixed assets for its use in the business over a period of time. As the benefits of these assets can be availed over a long period of time (due to their regular use), there exists continuous wear and tear and consequently fall in their value. This fall in the value of fixed assets (due to regular use or expiry of time) is termed as depreciation. A machinery that costs Rs 1,00,000 and its useful life of 10 years, its depreciation will be calculated as:
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To ascertain true net profit or net loss: Correct profit or loss can be ascertained when all the expenses and losses incurred for earning revenues are charged to the profit and loss account. Assets are used for earning revenues and its cost is charged in the form of depreciation from profit and loss accounts.
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To show a true and fair view of financial statements: If depreciation is not charged, assets are shown at higher value than their actual value in the balance sheet; consequently, the balance sheet does not reflect the true view of financial statements.
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For ascertaining the accurate cost of production: Depreciation on plant and machinery and other assets, which are engaged in production, is included in the cost of production. If depreciation is not included, cost of production is underestimated, which will lead to low sale price and thus lead to low profit.
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Distribution of dividend out of profit: If depreciation is not charged, which leads to over estimating of profit & consequently more profit is distributed as dividend, out of capital instead of the profit. This leads to the flight of scarce capital out of the business.
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To provide funds for replacement of assets: Unlike other expenses, depreciation is not a cash expense. So, the amount of depreciation charged will be retained in the business and will be used for replacement of fixed assets after its useful life.
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Consideration of tax: If depreciation is charged, then the profit and loss account will disclose less profit as to when the depreciation is not charged. This depicts reduced profit and thus the business will be liable for lesser tax amount.
The causes for depreciation:
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Constant use: Due to constant use of the fixed assets there exists normal wear and tear that leads to fall in the value of fixed assets.
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Expiry of time: With the passage of time, whether assets are used or not, its effective life decreases. The natural forces like rain, weather, etc. lead to deterioration of the fixed assets.
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Obsolescence: Due to the fast technological innovations and inventions today’s assets may be outdated by tomorrow’s sophisticated assets. This leads to the obsolescence of fixed assets.
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Expiry of legal rights: If an asset is acquired for a specific period of time, then, whether the asset is put to use or not, its value becomes zero at the end of its useful life.
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Accident: An asset may lose its value and damage may happen to it due to mishaps such as a fire accidents, theft or a natural calamity. The loss due to accidents is permanent in nature.
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