Depreciation and Amortization in Mining Industry


By

Harpreet Sandhu
Lecturer
College of Management & Economic  Studies
University of Petroleum & Energy Studies
Dehradun
 


DEPRECIATION

Objectives of the chapter:

- Understanding the significance of depreciation in accounting
- Various methods of depreciation

Depreciation is an important aspect of expense incurred in running business where the company uses several types of fixed assets. Plant and machinery, furniture and fixtures, vehicles, electric fittings etc deteriorate in quality and value over the years due to constant use, wear and passage of time called depreciation. There are several methods of providing for depreciation.

Depreciation

Meaning of depreciation

In simple words, depreciation means a fall in the value of an asset The net result of an asset's depreciation is that sooner or later the asset will become useless. Every fixed asset is liable to lose its value, once it begins to be used for production purposes. Some important definitions by various authorities on the subject of depreciation are:

Pickles defined depreciation as "The permanent and continuing diminution in the quality, quantity or value of an asset"

According to Spicer and Pegler, "Depreciation may be defined as the measure of the exhaustion of the effective life of an asset from any cause during the given period.

According to Chartered Institute of Management Accountant (CIMA), London, "Depreciation is the diminution in intrinsic value of the asset due to use and/or lapse of time".

Depreciation can be defined as a part of the cost of a fixed asset which has expired on account of its usage and/or the lapse of time. In other words, it is, thus, a reduction in the value of a fixed asset.

Here, it is important to note that depreciation is charged on almost all fixed assets except land. Usually the value of land appreciates over a period. The reason is that unlike other fixed assets like machinery, it does not have a finite economic life.

Characteristics of Depreciation

The following are some salient characteristics of depreciation:

1. Depreciation is a reduction in the book value of fixed assets (with exception of land).
2. It reduces the book value of the asset but not its market value:
3. The reduction in the book value of an asset is permanent, gradual and of continuing nature. When the book value is reduced, it is not possible to restore it to its original cost.
4. Depreciation is a continuing process because the book value is reduced either with the use of the asset or with a passage of time.
5. It takes place gradually unless there is a quick physical deterioration or obsolescence due to technological developments.
6. It is not the process of valuation of asset; it is a
process of allocation of cost of the asset to the period of its life.
7. The term depreciation is used only for tangible fixed assets. This term is not used in the case of wasting and fictitious assets such as depletion of natural resources and amortization of goodwill, respectively.

Depreciation and Other Related Concepts

Sometimes the terms depletion, obsolescence, amortization, etc., are used interchangeably with depreciation. But, these terms are used in different contexts. Therefore, let us understand the basic distinction between depreciation and such other related concepts.

Depreciation and Depletion: In fact, the term 'depletion' is used in respect of the extraction of natural resources like quarries, and mines, that reduces the availability of quantity of the material or asset. But, depreciation refers to a reduction in the value of all kinds of fixed assets arising from their wear and tear.

Depreciation and Obsolescence: Obsolescence refers to decrease in usefulness caused on account of the asset becoming out of date, old fashioned, etc. Depreciation, as stated earlier, is a loss in value of an asset generally arising on account of wear and tear. The fact remains that obsolescence is regarded as one of the causes of depreciation.

Depreciation and Amortization: The clear-cut distinction between depreciation and amortization is that 'amortization' refers to writing off the proportionate value of the intangibles such as goodwill, copyright, patents, etc., while 'depreciation' refers to the writing of the expired cost of the tangible assets like machinery, building, furniture, etc.

Causes of Depreciation

The main causes of depreciation are:

(1) Wear and Tear: Wear and tear is an important cause of depreciation in the case of tangible fixed assets. It is mainly due to use of the asset.

(2) Afflux of Time: Some assets have a definite life period like a lease; on the expiry of the life, the asset will cease to exist. Other assets, like plant and machinery, may not have a definite life; in their case, the useful life is estimated.

(3) Obsolescence: If a better machine comes on the market, the old machines may have to be scrapped even though they are capable of being run physically. It is a reduction in usefulness of the asset.

(4) Accidents: Accidental loss may be permanent but is not continuing and gradual.

(5) Fall in Market Prices: Market conditions may change the market prices of the current assets but not the book values of the fixed assets. Of the above, only the first two factors are considered as relevant to depreciation. Factors (3) and (4) are considered only when they occur; they do not happen to all assets. In case of fixed assets, a fall in prices is ignored; only current assets are affected by this factor. It should be noted that when we talk of depreciation, we think only of fixed assets.

Only in a few cases do fixed assets appreciate. Land may go up in value. But usually the value of fixed assets diminishes continuously. This is even if an asset is not used. Mere passage of time is sufficient to reduce the value of the asset.

One unfortunate thing about depreciation is that it is not visible like other expenses till the very end. In case of other expenses, the expenditure is obvious and, hence, everybody provides for such expenses while calculating loss or profit. It is not so with depreciation. Many people do not deduct depreciation from the gross earning to ascertain their net profit simply because there is no payment for it. This is fallacious. Let us clear it by an example. Suppose:

1. A starts a small manufacturing business and buys machinery worth Rs. 20,000;

2. He does not realize that this machinery is depreciating and, therefore, uses up all 'profits' which his business gives; By the end of ten years, he has earned a net income of Rs. 30,000, without considering depreciation; and

4. The machinery bought by A is useless at the end of  10th year. It is clear that A's net income is not Rs. 30,000 but only Rs. 10,000, because out of Rs.30,000,he must deduct the loss of machinery worth Rs. 20,000. Would it not have been better if he had deducted  every year a due proportion of his expenditure on the machinery before ascertaining his profit?

Further, if A has already used up Rs. 30,000, which according to his mistaken idea is his profits for the 10 years, he cannot continue to run his business for his machinery is no longer serviceable unless he raises funds say, as a loan. If  he had provided proper depreciation he would have  retained sufficient funds to buy new machinery when  the old one became useless. Provision of depreciation, therefore, is necessary first for ascertaining the true  profit, and secondly, for retaining funds in the business so that the asset can be replaced (when its life is over) by a new one.

Accounting Concept of Depreciation

Accounting concept of depreciation means to distribute the cost of fixed assets over its estimated life in a reasonable manner. Annual depreciation in the value of assets is like an expense. This expense is due to use of assets in business functions. This is a charge on profits. Therefore, this is an expense like other expenses. Its provision is not optional but compulsory. If we do not deduct any expense from the income of an accounting period, the ascertained profit will be wrong and will not disclose correct result of the business. Because depreciation is also an expense which refers to cost of use of fixed assets, it is compulsory to deduct the cost of depreciation of that period from the incomes of the accounting period.

OBJECTIVES OF CHARGING DEPRECIATION:

The above discussion shows that the need for charging a reasonable amount of depreciation over the useful life of the asset arises for following purposes:

(1) To Ascertain the Profit or Loss Properly: The first objective is to ascertain the profit or loss properly. If depreciation is ignored, the loss that is occurring (though not being paid for in cash) in respect of fixed assets will be ignored. The loss will suddenly loom large when the asset becomes useless or valueless. Looking at it from another point of view, when goods are produced it involves use of fixed assets – the reduction in their value should be treated like another cost for production of the goods. Depreciation should, therefore, be debited to the Profit and Loss Account before profit is ascertained.

(2) To Show the Asset at its Proper Value: The second objective is to show the fixed assets in the Balance Sheet at their proper value. To continue to show them at cost, when their value has fallen because of wear and tear will be improper – it will tantamount to painting a financial picture better than it is. If depreciation is not allowed, the balance sheet would fail to show the true financial position. Therefore, depreciation must be accounted for in order to present the assets at their proper value.

(3) To retain (out of Profits) Funds for Replacement: The third objective of depreciation is to retain (out of profits) funds for replacement of assets. The amounts debited in the Profit and Loss Account are retained in the business (no payment is made like other expenses). These are available for replacement of the asset when its life is over. Funds would not be collected for this purpose without accounting for depreciation.

One can see that depreciation has an important role to play in ascertaining the profit, in portraying the correct financial position and in ensuring continuity of business.

Basic Factors or Basis of Providing Depreciation: For calculating the amount of depreciation, the most important factors are the following:

(i) Original cost of the asset: Cost will include all expenses incurred like freight and erection charges up to the point the asset is ready for use.

(ii) The estimated residual or scrap value at the end of its life: Residual value is an estimated sale value of the asset at the end of its economic life to the firm. Suppose, a machine is purchased at a cost of Rs. 50,000. It is expected that it will be used for I5 years at the end of which period it will have a scrap value of Rs. 5,000. We must provide a total "depreciation" of Rs. 45,000 in 15 years.

(iii) Estimated effective or commercial life or the legal life whichever is shorter: Physical life is not important—an asset may still exist physically but may not be capable of producing goods at a reasonable cost. If, for instance, an asset can work for twenty years but is likely to lose its commercial value within ten years life for the purpose of accounting should be considered as only ten years.

So much depreciation should be provided each year, that the book value of the asset is reduced to its estimated scrap value at the end of its useful life.

Methods for Providing Depreciation

There are various methods used to change the amount of depreciation from year to year. In fact, different methods are adopted to suit the nature of each asset. Nonetheless, the following are the two main methods for providing depreciation:

1. Fixed percentage on Original Cost or Fixed Installment or Straight Line Method (SLM)

2. Fixed Percentage on Diminishing Balance or Reducing Installment Method or Written-down Value Method (WDV). These methods are discussed below:

1. Straight Line Method: In this method, a suitable percentage of original cost is written off the asset every year. Thus, the amount of depreciation is uniform from year to year. Suppose, if an asset costs Rs. 20,000 and 10 per cent depreciation is thought proper, Rs. 2,000 would be written off every year. The assumption in this case is that the life is 10 years and that at the end of 10 years, there will be no scrap or residual value. In this method, the amount to be written off every year is arrived at as under:

Cost – Estimated scrap value/
Number of years of expected life

In the first year, the asset may not have been used for the whole of the year. In that case only the proportionate amount will be provided as depreciation. Suppose, the asset is installed on 1st April and the accounts are closed on 31st December. In that, case, the depreciation for the year will be Rs. 1,500, i.e., Rs. 2000´9/12.

The entry for the depreciation is:

Depreciation Account   …Dr.
To Asset (by name) Account

Instead of crediting the asset, the credit may be placed in the Provision for Depreciation Account. In that case, the asset account will continue to appear at the original cost and the total amount of depreciation provided so far will be apparent from the provision for Depreciation Account.

The entry in this case is:

Depreciation Account    ...Dr.
To Provision for Depreciation Account

In the Balance Sheet the amount of the Provision for Depreciation will be deducted from the cost of the asset and only the balance is shown in the outer column.

Merits of Straight Line Method: The various merits of this method are:

(i) This is a simple method of calculating depreciation.

(ii) In this method, asset can be depreciated up to the estimated scrap value or zero value.

(iii) In this method, it is easy to know the amount of depreciation.

(iv) Every year, the profit and loss account is debited by the same amount of depredation, so there is same effect on profit and loss account every year.

Demerits of Straight Line Method: The following are the demerits of this method:

(i) There is no arrangement of interest on capital invested in assets in this method.

(ii) By the passage of time, work efficiency of assets decreases and repair expenses increase. Thus in later years in comparison to earlier years, there is more weight age on profit and loss account.

(iii) Sometime in this method, book value of assets becomes zero but yet the assets are used in this business.

2. Written-Down Value Method: Under this method, depreciation is charged at fixed rate on the reducing balance (i.e., cost less depreciation), every year. In other words, the cost of the asset less estimated scrap value has to be written off over its estimated useful life. A certain percentage is applied to the book value and not the cost of the asset.

Suppose, the cost of the asset is Rs. 20,000 and the percentage to be written off each year is 10. In the first year the amount of the depreciation will be Rs. 2,000; this will reduce the book value to Rs. 18,000. Next year, the amount of the depreciation will be Rs. 1,800, i.e., 10% of Rs. 18,000. Thus, every year the amount of the depreciation will go on reducing.

Merits of Written Down Value Method: The following are the main merits of this method:

(i) There is same weight age on profit and loss account of depreciation and repair expenses.

(ii) Practically, this method is easier.

(iii) On the expansion and increase in assets, the depreciation can be computed easily in this method.

(iv)  This method is certified by the Income-tax Act:

Demerits of Written Down Value Method: The following are the demerits of this method:

(i) In this method, the book value of assets can never be zero.

(ii) There is a difficult task to ascertain the proper rate of depreciation.

(iii) In this method, there is also no provision of interest on capital invested in use of assets.

Depreciation in the Indian Context

In India, Section 350 of The Companies Act of 1956 deals with depreciation. It states that:

The amount of depreciation to be deducted in pursuance of clause (k) of sub-section (4) of Section 349 shall be the amount calculated with reference to the written down value of the assets as shown by the books of the company at the end of the financial year expiring at the commencement of this Act or immediately thereafter and at the end of each subsequent financial year at the rate specified in Schedule XIV:

Provided that if any asset is sold, discarded, demolished or destroyed for any reason before depreciation has been provided for in full, the excess if any, of the written down value, shall be written off in the financial year in which the asset is sold, discarded, demolished or destroyed'.

Section 205 of the Act dealing with dividends also provides for depreciation before paying dividends. It is done in Depreciation shall be provided either:

(a) To the extent specified in Section 350; or

(b) in respect of each item of the depreciable asset, for such an amount as is arrived at by dividing ninety five per cent of the original cost thereof to the company specified by the period in respect of such asset; or

(c) on, any other basis approved by the Central Government which has the effect of writing off by way of depreciation ninety-five per cent of the original cost to the company of each such depreciable asset on the expiry of the specified period; or

(d) as regards any other depreciable asset for which no rate of depreciation has been laid down by this act or the rules made there under on such basis as may be approved by the Central Government by any general order published in the Official Gazette or by any special order in any particular case.

Rates of depreciation


SUMMARY:

1. To understand the significance of depreciation

With the passage of time various assets will deteriorate in value and quality due to constant use, wear and tear, etc and this deterioration is termed as depreciation. In accounting parlance, it is the fall in value of the asset. This will reduce the book value of asset and it is a permanent and continuing process. Depreciation is related to the reduction in value of the assets due to wear and tear and depletion is due to the reduction of the availability of assets, like availability of minerals in mines.

2. To understand the accounting concept of depreciation

Depreciation is the distribution of the cost of assets over a period of time with an intention of replacement at the end of the useful life of the asset. Hence it is charged on the profits deductible at the end of every year and it is compulsory. The objectives are to ascertain profit and loss properly, to show the asset at proper value and to retain the profit for replacement.

3. To understand the methods of depreciation

There are two Methods – Straight Line Method and Written Down Value Method. In the straight-line method a constant percentage is written off the asset every year. Hence in this method the depreciation is uniform every year. The amount is determined by the following formula

(Cost-Scrap value)/(No. Of years of expected life of assets)

In the written down value method, the depreciation is charged at  a fixed rate on reducing balance. Thus, every year the depreciation charge will go on reducing.

Review Questions

1. What is depreciation provided?

2. What are the popular methods of depreciation? Which method will you adopt and why?

3. Distinguish between depreciation and depletion.
 


Harpreet Sandhu
Lecturer
College of Management & Economic  Studies
University of Petroleum & Energy Studies
Dehradun
 

Source: E-mail September 22, 2006

     

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