Depreciation is a gradual change in the cost of an asset into revenue expense to be accounted for in the accounts of a particular accounting period. Accounting Standard– 6 has made it mandatory for all commercial organizations. Depreciation should be taken into account in order to ascertain the correct picture of profit or loss. It has to be calculated from the date the asset comes into use. When assets are disposed of or destructed, the net surplus or deficit is disclosed separately.
Depreciation is based on the following three factors:
- Historical cost
- Expected useful life
- Estimated salvage/residual value
Accounting treatment of depreciation is done either by charging directly to Asset Account or by creating provision for depreciation
- Straight Line Method: According to this method annual depreciation is calculated on the historical cost of the asset and hence remains uniform. This method is suitable for asset depreciate for lapse of time, such as patents.
- Diminishing Value Method: In this method annual depreciation is calculated on the opening balance of the Asset Account and it reduces year by year. This method is suitable for exhausting and costly assets like plant and machinery.
- Depletion Method: This method is applicable for assets of wasting nature and also for intangible assets such as mines, patents, copyrights etc.
- Revaluation Method: In this method depreciation is calculated as the difference between the revalued opening balance of assets account and closing balance of the asset account. It is suitable for assets such as packages, loose tools etc.
- Sinking Fund Method: According to this method the amount of depreciation is invested in interest earning securities.
- Insurance policy method: In this method annual depreciation amount is invested as the payment to an insurance policy as premium.
- Machine Hour Rate Method: This method is used for machines where productivity is relevant in their performance and in the case of machines with high cost.