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Explain the concept of depreciation in accounting.
Depreciation means gradual decrease of value of a tangible asset over a period of time. All tangible assets tend to depreciate. Machinery, equipment, furniture etc. except land.
Land tends to appreciate over the years than depreciate. The amount which is depreciated or carrying value of an asset is called salvage value.
Criteria in depreciation is as follows −
- Cost of the asset.
- Residual/salvage value of the asset.
- Useful life of the asset.
- Appropriate method.
The main purpose of depreciation is to measure income generated from assets, determine real value of assets, tax benefits and deductions, expenditure incurred in the production. Main causes for depreciation are wear and tear of machinery, market changes, using outdated technology, effluxion of time etc.
Depreciation in accounting − Cost of asset is matched with its useful life. Depreciation in accounting is based on matching principle.
Depreciation in taxation − Income Tax Act 1961, allows depreciation cost is deducted from tax liabilities.
Types of depreciations include −
Straight line method − It is an easiest way to calculate depreciation. In this, constant amount is deducted from principle cost of an asset over the lifespan of the asset.
Double-declining balance method − In this, high amount is deducted initially and reduced over lifespan of the asset.
Diminishing balance method − In this, fixed percentage is deducted from principle amount and same is reduced from asset value in every accounting year.
Units of production method − In this total number of units produced or working hours are calculated for depreciation.
Some of the advantages are as follows −
- Tax deductions.
- Asset valuation.
- Cost recovery.
Some of the disadvantages are as follows −
- Determination of life of an asset.
- Replacement of asset.
- Currency depreciation.
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