Depreciation is the diminution in the value of assets due to use, wear and tear and efflux of time. It is an estimated charge against profit for use of fixed assets. The provision for depreciation is to create funds for replacement of assets. There are various method of depreciation, such as,–
Straight-line method or Fixed Installment method
Diminishing/reducing value method
Unit charging system.
Machine Hour Rate.
Sum of the digits method.
Methods of Calculating Depreciation
There are a number of methods of calculating depreciation on the original cost or on the replacement cost of the assets. Each method adopts one or more of the following principles —
Depreciation is a function of time;
Depreciation is a function of use;
Depreciation is a function of time and use;
Depreciation is a function of time and maintenance; and
Depreciation is a function of time and interest.
Whatever method is applied in the accounts, it must be suitable to the circumstances prevailing in the organisation. The following should be noted for depreciation of the following types of fixed assets:–
Goodwill: No depreciation arises unless the firm’s profits are decreasing. Prudent firms try to write off goodwill over a number of years.
Freehold Land: In this case also no depreciation arises. Amounts written off should be shown separately.
Loose tools, Jigs and Patterns: Depreciation should be calculated on revaluation method.
Patents, Trade Marks, etc: There is a maximum legal life of such assets but the commercial life may be shorter. The asset should be depreciated by straight line method so that it is written off within the legal or commercial life whichever is shorter.
Mines, Oil wells, Quarries, etc.: Depreciation should be charged on depletion method.