When a specific business is flagged off, an entrepreneur invests a certain monetary amount or any other type of amount and business is carried on the basis of that. Generally, there are two types of assets that are used in business, Fixed Assets and Current Assets.
Whereas, Current Assets are those that can be easily converted to cash, they are the driving force behind working of Fixed Assets. Since, Fixed Assets cannot be converted into cash on an immediate basis; hence they are to be maintained by a company for a long term option.
Types of Fixed Assets:
- Tangible Fixed Assets:This includes physical form of assets as buildings and land.
- Intangible Fixed Assets:This includes non-physical assets as patents, trademarks and goodwill.
Since these assets are directly used in production process hence at times its value is to be reduced which is known as depreciation. This helps in correct utilisation of resources and providing a correct product.
Meaning of Depreciation:
As per the Chartered Accountants of India, Depreciation can be termed as a falling down of value of an asset and its value due to certain changes in technology during a certain time period. It is specifically allocated to charge up a certain amount of depreciable amount within each accounting period during expected usefulness of that period.
Also, according to International Accounting Standard Committee, depreciation is specifically that allocation of a certain amount of depreciation during that time period within which an asset is useful.
However, it should be noted that this depreciation is accounted only on Fixed Assets and never on Current Assets which is why it is charged specifically on Book Value.
Causes of Depreciation:
There are certain specific factors that cause the loss of value of a particular asset over a certain time period.
- Time period:
In most cases, assets lose their value over a certain period of time. However, there are certain legal issues such as lease, copyrights and patents which have a fixed legal period. In such cases, consumption of these assets are taken into consideration known as amortization.
- Economic reasons:
With ever changing technology, it is not unusual for a certain machinery to be termed as out-dated, the moment a business unit gets an alternative for it. Also, it may so happen that a business unit may simply not require machinery due to its internal growth. In this case as well, depreciation takes place.
- Physical aspects:
This is the most important factor that results in depreciation. It causes out of wear and tear of particular machinery and thus it has to be replaced due to value depreciation. Also, certain raw materials are in general of depreciating nature in the sense that with every usage of that machinery, it keeps depreciating in value.
- Untoward incident:
Any type of mishap that may occur in a business unit can result in depreciation of particular machinery, and at a later stage it may be termed as one that is depreciating.
One should have detailed idea regarding these causes for better protection of assets.
Objectives or Need for Providing Depreciation
There are certain specific reasons for which depreciation is required. These are:
- This helps in depicting correct financial position of a country
- It also shows correct profit levels of a company
- With determination of financial position it helps a company make certain important financial decisions
- It shows provisions for asset replacement
- It also determines tax liability of a company in a correct manner
- A detailed presentation of depreciation is required for keeping the capital untouched
- Formulating a depreciation chart is a statutory obligation
Basic Factor for Calculating Depreciation:
Since depreciation is reduction of value over a certain period of time, hence certain factors need to be considered in this case.
- What the actual cost of that asset is
- What is that estimated time period in its life span?
- What is the estimated value at the end of its life or usage?
With these factors in place, calculation becomes easier.
Methods for Providing Depreciation:
Depreciation refers to reduction in value of assets over a certain time period due to excessive wear and tear.
Since in most cases, monetary value or machinery is considered, it is important that a correct decimation be made a singular mistake could result in loss of a huge amount.
- Diminishing Balance Method:
This is calculated on opening balance of a year at a fixed percentage. Since every year opening balance may be decreasing in value, hence this decreasing book value is known as value of asset.
With no chances of reducing this book value to denomination of zero, it can be stated that on application of this depreciation rate, scrap value, as well as removal costs,are completely ignored.
- Annuity Method:
Laying greater interest on the interest factor, in this case, special attention is to be paid to annuity table. In this case on the opening balance, fixed interest rate is charged, while cost of asset with interest is equated with duration of that asset. It is specifically based on constant rate of return and cost recovery upon an asset that is being depreciated.
- Sum of the Year Digits Method:
This is known as accelerated depreciation and fractional amounts are taken for calculation. Since this method provides with decreasing depreciation charge on an annual basis, hence, it is important to note that to obtain depreciation diminishing percentage at an annual level, cost of that asset and salvage value is applied.
Rate of Depreciation: Individual Year/sum of digits representing useful life of an asset.
- Depreciation Fund Method:
This provides details of financial requirement when an old asset is replaced with a new one. With the very opening of this account, amount of depreciation is credited to that and asset account stands for years together at a single value. At the year end, depreciation amount is debited while depreciation fund account is credited with extra money that is being generated to be invested in securities for generating replacement monetary funds.
- Depletion Method:
It is important to note that certain values of economic assets are understood and viewed in regards to geographical space. Total units of resource deposits are counted.
Depletion rates per unit: Total cost of assets/estimated available number of units.
- Repairs Provision Method:
In this case, totality of a certain amount is counted, and this further is categorized to get the actual value. Here total repair, as well as renewal costs,is added on to capital costs, which is divided by estimated life of that particular asset. The result is treated as repair and renewal that has to be charged to profit and loss account per year.
- Revaluation Method:
In this case multiple assets of various forms are considered that range from loose tools to trademarks and livestock. Here depreciation of assets is calculated by differentiating value difference at year end over value at the year beginning.
Method: Book value of the asset – Real value of the asset.
- Insurance Policy Method:
This is an amount that is withdrawn from insurance companies against asset replacement. After a certain time period, insurance companies will pay up that amount that is required for repurchasing that asset.
- Machine Hour Rate Method:
In this case economic life of an asset is determined in terms of working hours.
Hourly Rate = Total Cost of Asset/Total number of hours.
Annual Depreciation = Machine Hour Value x Estimated Hours in a year.
- Fixed Installment Method:
In this case,Depreciation is calculated by the following formula
Depreciation = (Installation Charges + Price of Asset – Removal Cost + Scrap Value)/Approximate life of the Asset.
With these methods, rates of depreciation can be calculated.
Fixed Assets and Depreciation Test Questions
If you are searching for sums on depreciation and fixed assets then here are some of the best mathematical problems with detailed solutions. A complete understanding of concepts is required to ensure that when students are given to do this sum, they do not face any problem in regards to solving these sums.