Depreciation of fixed assets is an example of

Correct — D, (d) revenue expenditure/expense. Depreciation is the systematic allocation of the depreciable amount of a fixed asset over its useful life, and the portion allocated to a year is an expense of that year, charged to the statement of profit and loss.

The cleanest way to see it is to follow the money. Buying a machine is capital expenditure: an asset comes into the business and appears in the balance sheet. But the machine was not bought to be admired; it was bought to be used up in earning revenue, a little each year, until it is exhausted. Depreciation is the accounting device that measures how much of it was used up this year, so that this year's revenue can be matched against the cost of the resources that produced it. In other words, depreciation is the mechanism by which a capital expenditure is converted, year by year, into revenue expense. The capital character belongs to the purchase; the revenue character belongs to the annual charge.

Three properties of that charge are worth fixing, because every EPFO question on depreciation tests one of them. First, it is a non-cash expense: nothing leaves the bank when depreciation is debited, because the cash left when the asset was bought. Second, it is a charge against profit and not an appropriation of profit — it must be provided whether the year has been profitable or not, since the object is to ascertain the true profit or loss, and an enterprise that omits it is reporting a profit it has not earned. Third, it is a process of allocation and not a process of valuation: the written-down figure that results is the unallocated remainder of a cost, and it is not a statement about what the asset would fetch if it were sold.

The causes of depreciation are the reasons an asset has a finite life at all — wear and tear through use, the mere passage of time, obsolescence as better technology arrives, and depletion in the case of a wasting asset. The measurement methods follow from the pattern in which the benefit is consumed: the straight line method spreads the depreciable amount evenly, the written down value method charges a fixed percentage on the diminishing book value and so front-loads the expense, and a units-of-production method ties the charge to output.

One reading point specific to this pair of questions. The four option texts here are the same four that appeared at question 58, printed in a different order, so the letters do not correspond between the two items. A candidate who has just marked (c) for preliminary expenses and reaches for (c) again out of momentum will land on 'capital gain'. Read the options afresh on the second item of any such pair.

Why the others are wrong

• (a)deferred revenue expenditure — This is the answer to the previous question, not to this one, and the two categories are genuinely close enough to need separating. Deferred revenue expenditure is an actual outlay — money that went out of the business once — which acquired no asset but bought a benefit lasting several years, so the charge is spread forward. Depreciation is not an outlay at all: nothing is spent in the year it is charged, and it presupposes an asset, which deferred revenue expenditure by definition does not create. The test that separates them is whether an asset exists to be written down. A machine exists; the cost of drafting a memorandum of association does not.
• (b)capital expenditure — Capital expenditure is the purchase of the asset, not the annual charge for using it, and the two must not be run together. If depreciation were treated as capital expenditure it would be added to the asset instead of being written off from it, the asset's book value would rise every year that it was used, and the profit reported would be permanently overstated because the cost of the resource consumed would never reach the statement of profit and loss. The relationship between the two is sequential: capital expenditure goes into the balance sheet, and depreciation takes it out again in instalments.
• (c)capital gain — A capital gain is income arising on the transfer of a capital asset — the excess of the consideration over the cost of acquisition — and it is a credit, not a charge. Depreciation is the opposite in every respect: it is an expense, it arises from use rather than from transfer, and it reduces profit rather than adding to it. The two do meet at one point, which is worth knowing: when a fixed asset is sold, the difference between the sale proceeds and the written-down value produces a profit or loss on sale, and that figure is a consequence of how much depreciation has been charged. But the annual charge itself is never a gain.

Depreciation is the systematic allocation of the depreciable amount of a tangible fixed asset over its useful life, the depreciable amount being cost less the estimated residual value. It exists because the matching concept requires the cost of a long-lived resource to be spread across the periods that benefit from it rather than charged wholly to the year of purchase. It is a non-cash charge, a charge against profit rather than an appropriation of it, and a process of allocation rather than of valuation — the written-down value is an unallocated cost, not a market price. Its causes are wear and tear from use, efflux of time, obsolescence, and depletion in the case of wasting assets. The common methods are the straight line method, which charges an equal amount each year, the written down value or diminishing balance method, which charges a fixed percentage on the reducing book value and therefore more in the early years, and output-based methods that tie the charge to units produced. In Indian company law, Schedule II of the Companies Act, 2013 prescribes useful lives for classes of assets, replacing the rate-based approach of the earlier legislation, and leaves the enterprise to choose a method consistent with the pattern in which the asset's benefits are consumed. In the accounting standards, depreciation accounting was dealt with by AS 6 and now sits within the revised AS 10 on property, plant and equipment. Depreciation on an asset begins when it is available for use and continues until it is derecognised, and a change of method or of estimated useful life is dealt with prospectively as a change in an accounting estimate.

Key facts

• Depreciation is the systematic allocation of the depreciable amount of a fixed asset over its useful life.
• The depreciable amount is the cost of the asset less its estimated residual value.
• It is a revenue expense, charged to the statement of profit and loss in the year to which it relates.
• The purchase of the asset is capital expenditure; depreciation converts that capital expenditure into revenue expense over time.
• It is a non-cash expense — no cash moves in the year the charge is made.
• It is a charge against profit and not an appropriation, so it must be provided whether or not there is a profit.
• It is a process of allocation, not of valuation; the written-down value is an unallocated cost, not a market price.
• Its causes are wear and tear, efflux of time, obsolescence, and depletion in the case of wasting assets.
• The common methods are straight line, written down value or diminishing balance, and output-based methods.
• Schedule II of the Companies Act, 2013 prescribes useful lives for classes of assets.
• Depreciation accounting was covered by AS 6 and now sits within the revised AS 10 on property, plant and equipment.
• The four option texts here are the same as those at question 58, in a different order, so the letters do not correspond between the two items.

Common traps

• Carrying the answer letter across from the previous question when the same options have been reprinted in a different order.
• Treating depreciation as capital expenditure because the asset it relates to was a capital purchase.
• Confusing depreciation with deferred revenue expenditure; the second involves an actual outlay and no asset.
• Describing depreciation as a process of valuing the asset — it allocates cost, and the written-down value is not a market value.
• Assuming depreciation need not be charged in a loss-making year; it is a charge against profit, not an appropriation of it.
• Believing that charging depreciation sets money aside for replacement; no cash is reserved unless a separate fund is created and invested.

• practice — not a real PYQ

  Depreciation is best described as

  • (a)a process of valuing an asset at its current market price
  • (b)the systematic allocation of the depreciable amount of an asset over its useful life
  • (c)a fund of cash set aside for replacing the asset
  • (d)an appropriation of profit made after the profit has been ascertained

  Answer(b) the systematic allocation of the depreciable amount of an asset over its useful life

• practice — not a real PYQ

  Which one of the following statements about depreciation is correct?

  • (a)It is charged only in the years in which the enterprise earns a profit
  • (b)It involves an outflow of cash in the year in which it is charged
  • (c)It is a charge against profit and must be provided whether or not there is a profit
  • (d)It is charged on current assets as well as on fixed assets

  Answer(c) It is a charge against profit and must be provided whether or not there is a profit