Depreciation reduces the value of assets on a residual basis. It also reduces the profits of the current year.
Depreciation indicates reduction in value of any fixed assets. Reduction in value of assets depends on the life of assets. Life of assets depends upon the usage of assets.
There are many deciding factors that ascertain the life of assets. For example, in case of a building, the deciding factor is time. In case of leased assets, the deciding factor is the lease period. For plant and machinery, the deciding factor should be production as well as time. There can be many factors, but the life of assets should be ascertained on some reasonable basis.
Here is why we need to provide depreciation:
To ascertain the true profit during a year, it is desirable to charge depreciation.
To ascertain the true value of assets, depreciation should be charged. Without calculating the correct value of assets, we cannot ascertain the true financial position of a company.
Instead of withdrawal of overstated profit, it is desirable to make provisions to buy new assets to replace old asset. The accumulated value of depreciation provides additional working capital.
Depreciation helps in ascertaining uniform profit in each accounting year.
Depreciation allows to take the advantage of tax benefit.
Let us see the accounting entries related to assets and depreciation:
|1||Purchase of Fixed Assets||
|2||Expenses on purchase of Fixed Assets||
|3||For Providing depreciation||
|4||Transfer of depreciation to Profit & Loss a/c||
|5||Sale of Assets||
Depreciation can be calculated using any of the following methods, however the most popular methods remain (a) Straight Line Method and (b) Written Down Value Method.
|Desc.||Opening Value||Addition during the year||Sale||Balance||Rate of Depreciation||Value of Depreciation||Closing Value|
|25-06-13||To Bank||xxx||31-03-2014||By Depreciation||xx|
|By Balance c/d||xx|
|01-04-2014||To Balance||xx||By Depreciation||xx|