1.0
INTRODUCTION
Fixed assets are
those assets, which are of material value having long life and are held to be
used in business and are not primarily for resale or for conversion into cash.
Usually, with the exception of land, fixed assets have a limited number of
years of useful life. Motor Vans, Machines, Buildings and
Fixtures, for
instance, do not last forever. Even land itself may have all or part of its
usefulness exhausted after a few years. Some types of lands used for quarries,
mines or land of another sort of wasting nature would be examples.
When a fixed asset
bought is put out of use by the firm, that part of the cost that is not
recovered on disposal is called depreciation.
It is obvious, that
the only time that depreciation can be calculated accurately is when the fixed
asset is disposed off and difference between the cost of its owner and the
amount received on disposal is then ascertained.
If a motor van was
bought for N300,000.00 and was sold five years later for N6,000.00, then the
amount of depreciation is N300,000.00 — N6,000.00 = N294,000.00.
Depreciations thus
that part of cost of the fixed asset consumed during its period by the firm.
Therefore, it has been a cost for services consumed in the same way as costs
for items as wages, rent, lighting and heating, etc.
Depreciation is,
therefore, an expense and will need charging to the Profit and Loss Account
before ascertaining Net Profit or Net Loss.
2.0
OBJECTIVES
At the end of this note,
you should be able to:
• define
Depreciation;
• explain the main
causes of depreciation
• explain the need
for providing depreciation
• explain the
provision for depreciation as apportionment of cost.
3.0
MAIN CONTENT
3.1
Depreciation - Meaning and Causes
3.2
Definition of Depreciation
Some definitions
given by prominent authors or Institutes of Accountancy are given below:
1) Depreciation may
be defined as the permanent and continuous
diminution in the
quality, quantity or value of an asset.
2) Depreciation is
the gradual and permanent decrease in the value of an asset from any cause .
3) Depreciation may
be defined as a measure of the exhaustion of
the effective life of an asset from any cause during a given period.
4) Depreciation is
the diminution in intrinsic value of asset due to use or the lapse of time.
5) Depreciation
represents that part of the cost of a fixed asset to its owner, which is not
recoverable when the asset is finally put out of use by him. Provision against
this loss of capital is an integral cost of conducting the business during the
effective commercial life of the assets and is not dependent upon the amount of
profit cleared.
Institute
of Chartered Accountants in Austria
In simple words, we
can define depreciation as a permanent, continuing and gradual shrinkage in the
book value of a fixed asset.
3.3
Main Causes of Depreciation
The following are the
main causes of depreciation:
1. Physical
deterioration
2. Economic Factors
3. Time Factor
4. Depletion
Explanation
1. Physical
Deterioration
This is caused mainly
from wear and tear when the asset is in use and from erosion, rust and decay
from being exposed to wind, rain, sun and other elements of nature.
2. Economic
Factors
These may be said to
be those that cause the asset to be put out of use even though it is in good
physical condition. These arise due to obsolescence and inadequacy.
Obsolescence means the process of becoming obsolete or out of date. An old
machinery though in good physical condition may be rendered obsolete by the
introduction of new machinery, which produces more than the old machinery.
Inadequacy refers to the termination of the use of an asset because of growth
and changes in the size of the firm. But obsolescence and inadequacy do not
necessarily mean that the asset is scrapped. It is merely put out of use by the
firm. Another firm will often buy it.
3. Time
Factors
There are certain
assets with a fixed period of legal life such as lease, patents and copyrights.
For instance, a lease can be entered into for any period while a patent's legal
life is for some years but on certain grounds this can be extended.
4. Depletion
Some assets are of a
wasting character perhaps due to the extraction of raw materials from them.
These materials are then either used by the firm to make something else or are
sold in their raw state to other firms. Natural resources such as mines,
quarries and oil wells come under these headings.
3.4
Need for Providing Depreciation
You should note that
the need for depreciation arises because of the following reasons:
1.
To know the correct Profit
We have seen that
depreciation like other expenses is an expense. Thought it is not visible
expense like other expenses and never paid to the outside party. Yet it is
desirable to charge depreciation on the reasoning that since assets are used
for earning purposes so its depreciation must be deducted out of the income,
which has been earned from its use in order to calculate Net Profit or Net
Loss.
2.
To Show Correct Financial Position
Financial condition
can be studied from the balance sheet and for the preparation of the balance
sheet, fixed assets are required to be shown at their correct and true value.
If assets are shown in the balance sheet without any charge made for its use or
depreciation, then their value must have been overstated in the balance sheet
and will not reflect the true financial condition, it is necessary that the
depreciation must be deducted from the assets and then at such reduced value
these may be shown in the balance sheet.
3.
To make Provision for Replacement of Assets
If deprecation is not
provided, the profits of the concern will be overstated and can be distributed
to the shareholders as dividend. After the end of the working life of the
asset, there will be no provision or funds at the disposal of the concern and
has to borrow for purchasing new assets.
Provision for
depreciation is a source of fund as fund is created by charging depreciation to
Profit and Loss Account, but actually, depreciation is not paid and the amount
of depreciation thus accumulated during the working life of the asset provides
funds at the end of the working life of the asset for its replacement.
4.0
CONCLUSION
Depreciation is a
part of the cost of fixed asset employed in the business. It is charged against
the revenue of the accounting period during which the asset is employed so that
the revenue of each period is charged in proportion to the benefit from the
assets, which are consumed in earning that revenue.
In short,
depreciation is the gradual reduction in the value of a fixed asset from the
following causes:
• Wear and tear due
to use
• Decay - in case of
assets made of wood being exposed to rain.
• Obsolescence -
Machine becomes obsolete as new and more efficient machine is invented and
brought into use
• Passage of time and
• Sinking
You should note that
Accountants lay great emphasis on depreciation because of the above causes so
as to ascertain the true value of the assets at the end of an accounting
period, and also provide sufficient funds for the replacement of the assets and
to know the amount to be charged in the case if such asset is to be sold in
future.
5.0
SUMMARY
In this note, we have
dealt with some definition of depreciation. We also discussed the cases of
depreciation and the need for providing depreciation, that is:
(i) to know the
correct profits;
(ii) to show correct
financial position of the business; and
(iii) to make
provision for replacement of assets.
If depreciation is
not provided, the profits of the concern will be overstated and can be
distributed to the shareholders as dividend.
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