Term Paper for "Depriciation of Amotaization"

Chapter 1

1.1 Introduction:

The origin of depreciation is Latin word delphinium. For passing time or in the cause of natural or electrical reason the value of plant assets are reduces. In the concept of accounting depreciation is charged as expense. The asset which can be used for year’s depreciation is charged on those assets. It helps to replace the old asset of an organization. Every large organization keeps depreciation on their assets for replacement when it will be damaged. If any company is unable to keep depreciation on their asset it has to face a lot of problem in the case of replacement of assets when it is damaged. Depreciation is charged on land improvement, buildings, equipments, etc. Because these assets are reduced through years.   Depreciation is that part of the original cost of a fixed asset that is consumed during period of use by the business. The annual charge to profit and loss account/income statement for depreciation is based upon an estimate of how much of the overall economic usefulness of a fixed asset has been used up in that accounting period. an It is expense for services consumed in the same way as expenses are incurred for items such as wages, rent or electricity. Because it is charged as an expenses to the profit and loss account/income statement, depreciation reduces net profit.

For example, if a Machine cost TK.600 and was expected to be used for three years, it might be estimated at the end of the first year that a third of its overall usefulness had been consumed. Depreciation would then be charged at an amount equal to one third of the cost of the PC, i.e. TK.200. Profit would be reduced by TK.200 and the value of the PC in the balance sheet would be reduced from TK.600 to TK.400.

Using an example of a van and the petrol it consumes the only real difference between the expense of depreciation for the van and the expense of petrol incurred in order to use the van, is that the petrol expense is used up in a day or two, whereas the expense for use of the van is spread over several years. Both are expenses of the business. So the cost of productive facility is one of the costs of the services, it renders during its useful economic life. Generally accepted accounting principles require this cost be spread over the expected useful life of facility in such way as to allocate it as equitable as possible to the periods during which service are obtained from the use of facility.

1.2 Main Body:

For using, passing time and for many other reasons the reducing value of plant asset or fixed asset is called depreciation. Plant assets are achieved income through using. Generally fixed assets are not sold but its lifetime is being ended through earning profit. In a particular accounting period the expense of particular assets is omitted from the profit of that asset is called depreciation

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 1.3 Definitions of depreciation:

The value of assets gradually reduces on of use. Such reduction in value is known as depreciation. Different authors have given different definitions of depreciation, such as:

1. According to Pickles - “Depreciation may be defined as the permanent continuous diminution in the quality, quality or value on an asset.”

2. According to Carter - “Depreciation is the gradual permanent decrease in the value of an asset from any cause.”

3. According to Spicer & Pegler -“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. According to Institute of Cost and Management Accountants, England-

 “Depreciation is the diminution in intrinsic value of an asset due to the use and/or the lapse of time.” (By Institute of Cost and Management Accountants, England)

5. According to Northolt & Forsyth- “Depreciation is the reduction in the value of a fixed asset occasioned by physical wear and tear, obsolescence or the passage of time.”

6. According to Cropper “Depreciation is the diminution in the value of assets owing to wear and tear, effusion of time, obsolescence or similar causes.”

7. According to American Institute of Certified Public Accountants (AICPA): The cost of productive facility is one of the costs of the services, it renders during its useful economic life. Generally accepted accounting principles require this cost be spread over the expected useful life of facility in such way as to allocate it as equitable as possible to the periods during which service are obtained from the use of facility.

 8. According to Wygandt, Keiso & Kimmel: Depreciation is the allocation of the cost of a plant asset as expense over its useful life or service life in a rational and systematic manner.

 9. From International Accounting Standard No. 4: Depreciation is the allocation of the depreciable amount of an asset over its estimated useful life.

10. American Accounting Association (A AA): “Depreciation represents the decline in service potential of long term assets and that the decline in service potential may be the result of physical determination consumption through use or loss in economic value because of obsolescence or change in demand.”

11. From GAAP: “depreciation is a systemic and rational process of distributing the cost of tangible assets over the life of assets.”

 From the above definitions, it follows that an asset gradually declines on account of use and passage of time and this causes permanent reduction in the value and utility of asset. Such reduction in the value or utility of asset is called depreciation. In other words, expired cost or utility of asset is

Depreciation.

Chapter 2

2.1 Causes of Depreciation:

 The main causes of depreciation may be divided into two categories, namely:

1.     Internal Cause and

2.     External Causes

Internal Causes:

Depreciation which occurs for certain inherent normal causes, is known as internal depreciation. Some assets physically deteriorate due to wear and tear in use. More and more use of an asset, the greater would be the wear and tear. Physical deterioration of an asset is caused from movement, strain, friction, erasion etc. An obvious example of this is motor car which rapidly wears out. Other assets like this are building, plant, machinery, furniture, etc. The wear and tear is general but primary cause of depreciation.

The main causes of internal depreciation are:

Wear and Tear:

Wear and tear refer to a decline in the efficiency of asset due to its constant use. When an asset losses its efficiency, its value goes down and depreciation arises. This is true in case of tangible assets like plant and machinery, building, furniture, tools and equipment used in the factory.

Effusion of Time:

The value of asset may decrease due to the passage of time even if it is not in use. There are some intangible fixed assets like copyright, patent right, and lease hold premises which decrease its value as time elapse.

Exhaustion:

An asset may loss its value because of exhaustion too. This is the case wasting assets such as mines, quarries, oil-wells and forest-stand. On account of continuous extraction, a stage will come where mines and oil-wells get completely exhausted.

Depletion:

Some assets declines in value proportionate to the quantum of production, e.g. mine, quarry etc. With the raising of coal from coal mine the total deposit reduces gradually and after sometime it will be fully exhausted. Then its value will be reduced to nil.

External Causes:

Depreciation caused by some external reasons is called external depreciation. The main external causes are as follows:

Obsolescence:

Some assets, although in proper working order, may become obsolete. For example, old machine becomes obsolete with the invention of more economical and sophisticated machine whose productive capacity is generally larger and cost of production is therefore less. In order to survive in the competitive market the manufacturers must install new machines replacing the old ones. Again, it may happen that the articles produced by old machine are no longer saleable in the market on account of change of habit and taste of the people. In such a case the old machine, although in good working condition, must be discarded and the new one purchased.

Efflux of Time:

Some assets diminish in value on account of sheer passage of time, even though they are not used e.g., leasehold property, patent right, copyright etc. Suppose we take a lease of a house for 10 years for TK.10,000. Its annual depreciation will be TK.1,000 (10,000/10), irrespective of the the whether the house has been used or not. Because with the end of lease after 10 years, the house will go out of possession.

Accident:

Assets may be destroyed by abnormal reasons such as fire, earthquake, flood etc. In such a case the destroyed asset must be written off as loss and a new one purchased.

Other Causes of Depreciation:

The causes of depreciation can be divided up between physical deterioration, economic factors, the time factor, and depletion. These are briefly explained below:

Physical Deterioration:

Wear and Tear:
When a motor vehicle or machinery or fixtures and fittings are used they eventually wear out. Some last many years, others last only a few year. This is also true of buildings, although some may last for a long time.

Erosion, Rust, Rot and Decay:
Land may be eroded or wasted away by the action of wind, rain, sun and other elements of nature. Similarly, the metals in motor vehicles or machinery will rust away. Wood will not eventually. Decay is a process which will also be present due to the elements of nature and the lack of proper attention.

Economic Factors:

These may be said to be the reasons for an asset being put out of use even though it is in good physical condition. The two main factors are usually obsolescence and inadequacy.

Obsolescence:
This is the process of becoming out of date. For example, over the years there have been great progress in the development of synthesizers and electronic devices used by leading commercial musicians. The old equipment will therefore have become obsolete, and much of it will have been taken out of use by such musicians.

This does not mean that the equipment is worn out. Other people may buy the old equipment and use it, possibly because they cannot afford to buy new up-to-date equipment.

Inadequacy:
This arises when an asset is no longer used because of the growth and changes in the size of the business. For example, a small ferryboat that is operated by a business at a coastal resort will become entirely inadequate when the resort becomes more popular. Then it will be found that it would be more efficient and economical to operate a large ferryboat, and so the smaller boat will be put out of use by the business. In this case also it does not mean that the ferryboat is no longer in good working order, nor that it is obsolete. It may be sold to a business at a smaller resort.

The Time Factor:

obviously time is needed for wear and tear, erosion, etc., and for obsolescence and inadequacy to take place. However, there are fixed assets to which the time factor is connected a different way. These assents which have a legal life fixed in terms of years. For instance, you may agree to rent some buildings for ten years. This is normally called a lease. When the years have passed, the lease is worth nothing to you, us it has finished. Whatever you paid for the lease is now of no value.

A similar asserts is where you buy a patent so that only you are able to produce something when the patent's time has finished it then has no value. Instead of using the term depreciation, the term amortization is often used for these assents.

Depletion:

Other assets are of wasting character, perhaps due to the extraction of the raw materials from them. These materials are then either used by the business to make something else, or are sold in their raw state to other businesses. Natural resources such as mines, quarries and oil wells come under this heading. To provide for the this consumption for an asset of a wasting character is called provision for depletion.

2.2 Objectives of Depreciation:

Buildings, machinery, equipment, furniture, fixtures, computers, outdoor lighting, parking lots, cars, and trucks are examples of assets that will last for more than one year, but will not last indefinitely. During each accounting period (year, quarter, month, etc.) a portion of the cost of these assets is being used up. The portion being used up is reported as Depreciation Expense on the income statement. In effect depreciation is the transfer of a portion of the asset's cost from the balance sheet to the income statement during each year of the asset's life.

Chapter 3

3.1 Method of Depreciation:

There are several methods for calculating depreciation, generally based on either the passage of time or the level of activity (or use) of the asset. Methods of determining Depreciation are given below:

•  Straight Line Method of Depreciation
• Reducing Balance Method
• Double Declining Balance Method 
• Sum of year’s Digits Method 
• Production Unit Method 
•  Machine Hour Rate Method

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