Depreciation of Fixed Assets

INTRODUCTION

Fixed assets are assets which are of permanent nature and they create revenue for the business. They can last for a long period of time. Fixed assets of a business lose value or are said to depreciate with usage. Depreciation can be defined as a reduction in the economic service potentials of an asset as a result of wears, tears, usage and passage of time. It can also be defined as the permanent and continuous decrease in the quality,quantity and value of an asset.
The allocation of the cost of a fixed asset over its estimated useful life is a loss and must be taken into consideration when preparing the profit and loss accounts. When fixed assets are sold. the part of cost not recovered is called depreciation.

REASONS FOR CHARGING DEPRECIATION
(1) Since depreciation is a charge against profit, the tax to be paid on the profit by the firm will be reduced.
(2) The amount charged as depreciation can be used for the replacement of the asset at the end of the useful life.
(3) It follows the matching concept, the cost of an asset is spread over its useful life.
(4) To arrive at a profit figure which can be compared with similar business which is not having the advantage of owing the asset as the business charging depreciation.
(5) It enables the business to measure the degree of forecast in relation to estimating the amount of depreciation.

CAUSES OF DEPRECIATION
(1) Wear and Tear
An asset may depreciate as a result of constant usage. Physical factors like erosion, rust and decay can cause an asset to reduce in value.
(2) Obsolescence
An asset can become obsolete due to changes in technology. When this occurs, it is due for replacement. A very good example is the steam engine train which was replaced by diesel engine train.
(3) Passage of time
Depreciation occurs in some assets with the effusion of time e.g Leasehold, patents and copyrights.
(4) Depletion
Some natural resources like gold or oil deposits become worthless when the deposits have been depleted. They are called wasting assets. The more they are extracted, the less the reserve.
(5) Inadequacy
As a result of expansion in the productive capacity of a company, an asset may become inadequate and thus requires replacement for bigger ones.

FACTORS TO BE CONSIDERED IN THE COMPUTATION OF DEPRECIATION
(1) Original Cost: This is the cost incurred in purchasing, installation and cost of cariage.
(2) Estimated Value: This is the scrap value. The amount which can be recovered when the asset is sold at the end of useful life.
(3) Estimated Useful Life: The expected number of ear through which an asset can last.
(4) Method of Depreciation: This is the method that is to be used consistently in depreciating the asset through its life span.

METHODS OF DEPRECIATION
The method to be adopted is a matter of policy on the part of the management of the business. However, consistency must be applied. This means that all similar assets should be depreciated by the sane method and the same method should be used every year. Whatever method is applied, the elements must be taken into consideration.
There are various methods of depreciating fixed assets. These are:

1. Straight line method.
2. Diminishing or Reducing balance method.
3. Revaluation method.
4. Sinking fund method.
5. Retirement and Replacement method.
6. Sum of the year digit method.
7. Depletion unit method.
8. Annuity method.
9. Insurance policy method.

Just the first two methods will be discussed here
STRAIGHT LINE METHOD
This method makes provision for equal amount to be charged as depreciation for each year of useful life of an asset. The formula to be adopted is:

Depreciation = Cost – Estimated value 

                              Years of useful life     

There are two methods for preparing depreciation accounts. They are old and new methods.

Using old method:
Four accounts are involved which are: Assets account, depreciation account,profit and loss account, balance sheet extract.
The procedures are:

1. Debit the asset account with the cost of the asset.
2. Credit the asset account with the depreciation charge.
3. Debit the depreciation account with depreciation charge.
4. Debit the profit and loss account with depreciation charge.
5. Credit the depreciation account with the depreciation charge.

Using new method:
Under this method, there will be a separate account called provision for depreciation account. The assets are always shown at cost price. The following accounts are involved: asset account, provision for depreciation account, profit and loss account and balance sheet extract.

DIMINISHING OR REDUCING THE BALANCE METHOD
By this method, a fixed percentage is written off the diminishing balance of the asset yearly. The total depreciation is spread over the anticipated useful life of the asset by annual installments of diminishing amount. This method is advantageous because depreciation is more scientifically provided for. Here, larger amount of depreciation is deemed to occur in the early years and smaller amount in the late years.
It is computed using the formula:

Depreciation = 1 - N (residual value)^1/2 

                                             cost    

 where N is the estimated useful life