L 12 - depreciation

Question 1

1. What is depreciation? Write the various objectives of providing depreciation.

Answer 1

Depreciation is an expense charged during a year for the reduction in the value of fixed assets, arising due to:
* Normal wear and tear out of its use and passage of time
* Obsolescence due to change in technology, fashion, taste and other market
conditions.

Following are the objectives of charging depreciation of Assets:
1. If depreciation is not provided, profit and loss A/c will not disclose the true profit made during the accounting period. At the same, the Balance Sheet will not disclose the true Financial position as Fixed assets appearing in the Balance Sheet will be over valued. If depreciation is ignored year after year, ultimately when asset is worn out, the proprietor will not be is a position to continue the
business smoothly.

2. ii) To retain funds in the business for replacement of the asset : Net
   profit is the yield of the capital invested by proprietor and may be wholly withdrawn by him in the form of cash. If depreciation is provided, this figure of net profit will be reduced and the amount withdrawn by the proprietor will also be decreased. As such the cash equivalent to the change for depreciation will be left over the business. This accumulated amount will enable the proprietor to replace a new asset.

Question 2

What are the causes of providing depreciation?

Answer 2

i) Normal wear and tear
(a) Due to usage - Every asset has a life for which it can run, produce or give service. Thus, as we put the asset to use its worth decreases. Like decrease in the efficiency and functioning of a bicycle due to its running and usage.
(b) Due to passage of Time – As the time goes by elements of nature, wind, sun, rain etc, cause physical deterioration in the worth of an asset. Like reduction in the worth of a piece of furniture due to passage of time even when it is not used.

ii) obsolescence - Due to development of improved or superior equipment : Sometimes fixed assets are required to be discarded before they are actually worn out due to either of the above reasons. Arrival of superior equipments and machines etc. allow production of goods at lower cost. This makes older equipments worthless as production of goods with their use will be costlier and noncompetitive. For example, Steam engines became obsolete with the arrival of diesel and electric locomotives.

iii) Due to change in fashion, style, taste or market conditions : Obsolescence may also result due to decline in demand for certain goods and services with a change in fashion, style, taste or market conditions. The goods and services that are no longer in vogue lead to decrease in the value of the assets which were engaged in their production - like factories or machines meant for making old fashioned hats, shoes, furniture etc.

Question 3

What are the two methods of providing depreciation? Explain their
merits and demerits.