Depreciation is an important concept in finance. Depreciation is the notional loss suffered by fixed assets due to wear and tear and ageing.
The value of the assets is reduced to the extent of depreciation charged, and this value is reflected in the balance sheet. Although it is considered as an expense, there is no cash flow.
The amount charged is generally invested in a “sinking fund” so that money is available for a new asset when the present asset is completely depreciated. For taxable institutions, depreciation works as a “tax shield”.
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There are basically two ways of calculating depreciation.
1. Straight line Method:
In straight line method depreciates an asset by a fixed annual amount for the entire lifespan of the asset.
The disadvantage of this method is that the cost of repair and maintenance is very low during the initial years and the depreciation is disproportionately high, which goes on increasing during later years but the rate of depreciation remains the same.
Also, the replacement cost will always be higher than the initial cost due to inflation and technological changes.
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2. Accelerated Rate:
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In accelerated rate method, a higher rate is charged in the initial year, and the percentage amount of depreciation gradually decreases with passing years.
For high value medical equipments and which have a high rate of obsolescence due to changes in technology, the accelerated rate of depreciation is charged. For assets like buildings, plant, machinery, furnishings, etc. the straight line method can be adopted.
The rates should be decided by the administrator within statutorily laid down ceilings.