Here is a detailed explanation of Depreciation and Appreciation, including their meaning, methods of calculating depreciation, and their effects on assets and liabilities, written in paragraph form:
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Meaning of Depreciation and Appreciation
Depreciation refers to the gradual reduction in the value of a tangible fixed asset due to wear and tear, usage, passage of time, or obsolescence. It is a non-cash expense that is charged to the Profit & Loss Account to reflect the true value of assets over time. For example, machinery purchased today will lose value each year as it is used in production.
Appreciation, on the other hand, is the increase in the value of an asset over time due to external factors such as market demand, location advantages, or economic development. For instance, land and property often appreciate in value due to urbanization or development in the surrounding area.
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Methods of Calculating Depreciation
There are several methods used to calculate depreciation, based on the nature of the asset and business policies. The main methods include:
1. Straight Line Method (SLM)
Depreciation is charged evenly over the useful life of the asset.
Formula:
Depreciation = (Cost of Asset – Scrap Value) / Useful Life
2. Written Down Value Method (WDV)
Depreciation is calculated at a fixed percentage on the book value of the asset each year.
The amount of depreciation decreases each year.
Common for assets like vehicles and computers.
3. Units of Production Method
Depreciation is based on the usage or production output of the asset.
Suitable for machines used to produce a specific number of units.
4. Sum of Years’ Digits Method
A more accelerated depreciation method where depreciation is higher in the earlier years.
5. Annuity Method
Considers the cost of capital invested in the asset.
Depreciation and interest are combined.
6. Depletion Method
Used for natural resources like oil, gas, or mines.
Depreciation depends on the quantity extracted.
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Depreciation on Assets and Liabilities
On Assets:
Depreciation is charged only on fixed tangible assets like machinery, furniture, equipment, and buildings (except land). As depreciation is recorded, the book value of the asset decreases, and it is reflected on the asset side of the balance sheet as a deduction.
Example:
If a machine worth ₹1,00,000 depreciates by ₹10,000 per year, after one year, the book value shown in the balance sheet will be ₹90,000.
On Liabilities:
Depreciation does not apply to liabilities. However, appreciation in liability may occur due to interest or currency fluctuations in the case of foreign loans. But depreciation as a concept is specifically applicable to assets, not to liabilities.
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Conclusion
Depreciation is an essential accounting process to allocate the cost of tangible assets over their useful life. It reflects the true and fair value of assets and ensures that profits are not overstated. Appreciation is the opposite concept and applies mostly to non-depreciable assets like land or investments. Understanding depreciation methods is crucial for businesses to maintain accurate financial statements and make informed capital investment decisions.
