Depreciation Methods and Principles

Lecture Overview

• Lecture Name: Depreciation
• Coverage: Approximately 5 marks in exams
• Related to 11th-grade concepts but more complex in 12th grade

Definition of Depreciation

• Reduction in the value of assets over time
• Happens due to wear and tear, outdated technology, time passage

Reasons for Depreciation

1. Wear and Tear: Physical usage decreases asset value (e.g., a used mobile phone).
2. Obsolescence: Newer technology makes older technology outdated.
3. Passage of Time: Time naturally reduces asset value.

Terms and Concepts

• Tangible Assets: Depreciation (e.g., machinery).
• Intangible Assets: Amortization (e.g., patents, goodwill).
• Natural Resources: Depletion (e.g., coal mines, oil refineries).

Principles Governing Depreciation

1. Matching Principle: Income should match expenses within the same period.
2. Prudence Principle: Recognize losses as soon as they are foreseeable.
3. Historical Cost Principle: Relates to the original cost of an asset.
   • Provisions for depreciation created to satisfy the historical cost principle.

Methods of Depreciation

1. Straight Line Method (SLM)

   • Fixed amount of depreciation each year.
   • Depreciation = (Acquisition Cost - Scrap Value) / Useful Life

2. Reducing Balance Method (RBM) / Diminishing Balance Method (DBM)

   • Higher depreciation in the earlier years, lesser in later years.
   • Depreciation calculated on the book value of the asset.

3. Sum of the Digits Method (SOD)

   • Combination of SLM and RBM
   • Applicable in scenarios involving taxations

Cost of Acquisition

• All expenses necessary to bring the asset to its usable state (e.g., purchase cost, import duty, transport costs).

Depreciation Accounts

• Maintained to track depreciation for financial record-keeping.
• Machine Account, Depreciation Account, and if applicable, Provision for Depreciation Account.

Calculation Example

• If a machine is bought for ₹10,00,000 with a useful life of 5 years and no scrap value, it is depreciated as follows (SLM): ₹2,00,000 per year.

Asset Sale and Depreciation

• When an asset is sold, its depreciation is calculated up to the sale date.
• Any remaining book value vs. sale price reflects profit or loss.

Change in Depreciation Method

• When switching from one method to another, recalculation is needed.
• Recalculation ensures alignment with both current and new principles.

Special Depreciation Rules for Natural Resources

• Depletion method used for mining and resource extraction industries.

Conclusion

• Understanding depreciation methods is crucial for accurate financial reporting
• Aligns with principles like matching, prudence, and historical cost
• Helps in maintaining accurate records for valuation and tax purposes.