DEPRECIATION
Depreciation is the reduction in the
value of an asset due to Usage, passage
of time, wear and tear, technological
outdating or Obsolescence, depletion or
other such factors.
A Related term of Depreciation is
Amortization.
Basic Terms
DEPLETION: The physical deterioration by
the exhaustion of natural resources (ore-
deposits in mines, oil-wells etc.)
AMORTIZATION: It refers to the economic
deterioration by the expiration of intangible
assets.
OBSOLESCENCE: It refers to the economic
deterioration by invention of improved
technique or equipment, market decline due
to change in taste and fashion etc and
inadequacy of existing plant due to increased
business.
“Both Depreciation and
Amortization are non-cash
expenses.”
DEFINITION
According to Carter,” Depreciation
is the gradual decrease in the
value of assets from any cause.”
CAUSES OF DEPRECIATION
Physical wear and tear
With the passage of time
Changes in the economic environment
Expiration of legal rights
WHY WE CHARGE
DEPRECIATION?
To ascertain true results of operations.
To present true and fair view of the
financial position.
To comply with legal requirements.
To accumulate funds for the
replacement of assets.
Factors affecting the amount of
Depreciation
HISTORICAL COST
EXPECTED USEFUL LIFE
ESTIMATED RESIDUAL VALUE
DEPRECIATION METHODS
Straight-line Method of Depreciation
Written Down Value Method
Sum of Years’ Digit Method
Annuity Method
Depreciation Fund/ Sinking Fund
Method
Machine Hour Method
STRAIGHT-LINE METHOD
It is the simplest and most often used
technique.
A depreciation method where the
depreciable cost of the asset is spread
evenly over the useful life of the asset.
To calculate the amount of
Depreciation that should be charged
against the asset each year, the cost of
the asset, minus its salvage value, is
divided by the estimated life of the
asset.
The resulting amount is the amount of
depreciation that should be deducted
from the value of the asset each year.
This implies, Under Straight-line Method:
Depreciation =Cost of fixed asset - Salvage
value
___________________________
Life Span (Years)
Rate of Depreciation = Amt of Dep./Original cost X
100
Assume that a company acquires a machine
at the beginning of operations, at Rs. 10,000.
It is expected that the machine will last 10
years and will have no salvage value at the
end of its useful life.
Soln: Depreciation = 10,000-0
___________
10
= Rs. 1,000
Rate of Depreciation = 1,000
__________ X 100= 10%
10,000
Merits of Straight line Method:
1) Easy to understand.
2) Easy to calculate the rate of
depreciation.
Demerits of Straight line Method:
1) The amount of depreciation remains
constant year after year while the total
charge in later years is more as
compared to that in earlier years.
NUMERICAL
Calculate the rate of depreciation under
Straight line Method in each of the
following methods:
Purchase price Residual Life
Value
1. 1,00,000 20,000 4years
2. 20,000 2,000 10 years
On 1st of January, 2008, a machine was
purchased for Rs. 90,000. Rate of
depreciation is 10% p.a. Prepare a
machinery account for 3 years when
depreciation is charged under Original
cost method.
WRITTEN DOWN VALUE
METHOD
Also known as Diminishing Balance
Method/Reducing Installment Method
Depreciation is taken at a certain rate,
and it is applied to the written down
value of the asset as at the beginning
of each year.
Thus, the amount of depreciation
charge every year, is an amount less
than that in the previous year.
MERITS OF WRITTEN DOWN VALUE
METHOD:
1) As the assets grow older, the amount
of depreciation also goes on
decreasing.
DEMERITS:
1) It is difficult to calculate the rate of
depreciation.
NUMERICAL
On 1st of July, 2006, Amar purchased a
second hand machine for Rs. 39,000
and spent Rs. 1,000 on installation. On
30th of June, 2007, the machinery was
disposed off for a sum of Rs. 31,200.
Assuming the books are closed on 31st
of December each year and taking the
rate of depreciation at 10% p.a. on
diminishing balance, show the
Machinery Account.
On 1st of January, 2002, a limited company
purchased machinery for Rs. 12,000 and on
30th of June 2003, it acquired additional
machinery at a cost of Rs. 2,000. On 31st of
March, 2004, one of the original machines
which had cost of Rs. 500 was found to
have become obsolete and was sold as
scrap for Rs. 50. It was replaced on that date
by a new machine costing Rs. 800.
Depreciation to be provided at the rate of
15% p.a. on the Written down value. Show
Machinery Account for the first three years.
SUM OF YEARS’ DIGIT METHOD
Accelerated depreciation Method.
The SYD is found by estimating an
asset’s useful life in years.
For n years, the short cut formula is:
SYD = n(n+1)
2
AN EXAMPLE
Assume that an asset costs $ 1000 and
has an estimated useful life of five
years. The estimated salvage value at
the end of 5 years is $ 100.
The SYD is 5(5+1) = 15
2
The calculations are shown as below:
Year Fraction Depreciation
1 5/15 X $900= $300
2 4/15 X $900= $240
3 3/15 X $900= $180
4 2/15 X $900= $120
5 1/15 X $900= $60
$900