This article explains the meaning of Depreciation, Causes of Depreciation, Need for Depreciation, Factors of Depreciation, and revaluation of assets by Accounting Entries
Depreciation is an accounting method that determines the monetary value of an asset over its useful life due to use, wear and tear, obsolescence, and Legal or other limits on its use.
In other words, when the recorded cost of a fixed asset is reduced systematically until its value becomes zero or negligible, this is known as depreciation.
Causes for depreciation accounting:
Some common causes of depreciation include:
Wear and tear: Assets gradually break down over time due to use or the passage of time. This can be caused by excessive use or physical deterioration like rust.
Obsolescence: Assets can become outdated due to technological advancements or changes in business needs. For example, a computer might become obsolete when a newer model is released.
Expiration of legal rights: Some assets, like patents, copyrights, and leases, lose their value when the agreement governing their use ends.
Abnormal factors: Accidents caused by fire, earthquakes, or floods can permanently reduce an asset’s usefulness.
Natural forces: Weather and rain can cause fixed assets to deteriorate.
Expiry of time: Assets’ effective life decreases over time, even if they aren’t used.
Factors for depreciation: The decrease or depreciation of an asset is caused by various factors, such as wear and tear or obsolescence, including unfavorable market conditions.
Need for depreciation: Depreciation in accounting is needed because it allows businesses to spread the cost of physical assets over time. Accounting for depreciation reflects the value of the asset and is required by the accrual method of accounting.
Examples of items that depreciate include:
Tangible assets like Vehicles, office buildings, machines, furniture, computers, printers, fax machines, copiers, etc. Depreciation includes amortisation of intangible assets whose useful life is predetermined.
The purpose of this is to match the cost of the assets to the revenues earned from using the asset. Also, writing off assets allows the owners to lower the tax bills.
Accounting system:
Accounting estimates the decrease in value using the information regarding Accounting estimates the decrease in value using the information regarding the useful life of the asset. Accounting estimates for depreciation can be calculated using a few methods, including ‘the straight-line method’, ‘the value method’ and the sum of the year’s digit method”. (Read: WHAT ARE THE THREE METHODS OF DEPRECIATION AND MEANING OF AMORTIZATION?)
The useful life of a depreciable asset should be estimated after considering the following factors:
(i) Expected physical wear and tear;
(ii) Obsolescence;
(iii) Legal or other limits on the use of the asset.
The method of depreciation is applied steadily to provide comparability of the results of the operations of the business from time to time. A change from one method of providing depreciation to another is made only if the adoption of the new method is required by statute, for compliance with an accounting standard, or if it is considered that the change would result in a more appropriate preparation or presentation of the financial statements of the enterprise.
Whenever the method of depreciation is changed, the depreciation shall be recalculated by the new method from the date of the asset coming into use. The deficiency or surplus arising from retrospective re-computation of depreciation by the new method is adjusted in the accounts in the year in which the method of depreciation is changed. In case the change in the method results in a deficiency in depreciation concerning past years, the deficiency is charged in the statement of profit and loss. In case the change in the method results in a surplus, the surplus is credited to the statement of profit and loss. Such a change is treated as a change in accounting policy and its effect is quantified and disclosed.
Revaluation of assets:
In case the depreciable assets are revalued, the provision for depreciation is based on the revalued amount on the estimate of the remaining useful life of such assets. In case the revaluation has a material effect on the amount of depreciation, the same is disclosed separately in the year in which the revaluation is carried out.
The Securities and Exchange Board of India (SEBI) oversees the development and distribution of revaluation reserves. Revaluation reserves are a part of a company’s general reserves and are accessible for shareholder distribution under Indian GAAP.
Income Tax Act of 1961
The gain from revaluing assets is considered a capital receipt and is not taxed unless it is realized. If the surplus is issued as a dividend, it is subject to a dividend distribution tax.
Revaluation of property, plant, and equipment:
According to the Indian Accounting Standard (Ind AS) 16, revaluations should be made regularly to ensure that the carrying amount does not differ materially from the fair value at the end of the reporting period.
Revaluation of intangible assets
According to the Ind AS 38, the frequency of revaluations depends on the volatility of the fair values of the intangible assets being revalued.
Some methods for revaluing assets include Indexation, Current Market Price (CMP), Appraisal method, and Selective revaluation.
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