Depreciation Methods


METHODS of Depreciation

Bahaudin Zakriya Universty

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Depreciation Methods Bahaudin Zakriya Universty Page 2 PREFACE .

Depreciation Methods TABLE OF CONTENTS Depreciation Methods of depreciation Straight-line method: Declining-balance method (or Reducing balance method) Double Declining Method Activity depreciation Sum-of-years' digits method Units-of-production depreciation method Bahaudin Zakriya Universty Page 3 .

and 2. The latter affects net income. Example: a depreciation expense of 100 per year for 5 years may be recognized for an asset costing 500. The former affects values of businesses and entities. Generally the cost is allocated. among the periods in which the asset is expected to be used.Depreciation Methods Group depreciation method Composite depreciation method Tax depreciation Depreciation Depreciation refers to two very different but related concepts: 1. straight line. Methods and lives may be specified in accounting and/or tax rules in a country.D. as depreciation expense. is C0 + I . Allocation of the cost of tangible assets to periods in which the assets are used. Several standard methods of computing depreciation expense may be used. including fixed percentage. One such cost is the cost of assets used but not currently consumed in the activity. the capital stock at the end of the period. Such expense is recognized by businesses for financial reporting and tax purposes. C1. and declining balance methods. Depreciation is any method of allocating such net cost to those periods expected to benefit from use of the Bahaudin Zakriya Universty Page 4 . The cost of an asset so allocated is the difference between the amount paid for the asset and the amount expected to be received upon its disposition.NN C0 at the beginning of a period. investment is I and depreciation D. the receipts from the activity must be reduced by appropriate costs. Methods of computing depreciation may vary by asset for the same business. decline in value of assets. Such costs must be allocated to the period of use. Accounting concept In determining the profits (net income) from an activity. Depreciation expense generally begins when the asset is placed in service.

not valuation. beginning when the asset is placed in service. The costs are allocated in a rational and systematic manner as depreciation expense to each period in which the asset is used. Thus. 3. the costs must be deferred rather than treated as a current expense. the business recognizes gain or loss based on net basis of the asset. When a depreciable asset is sold. cost of the asset. However. using tangible assets may incur costs related to those assets. The business then records depreciation expense as an allocation of such costs for financial reporting. Depletion and amortization are similar concepts for mineral assets (including oil) and intangible assets. Accounting rules also require that an impairment charge or expense be recognized if the value of assets declines unexpectedly. 4. The rules of some countries specify lives and methods to be used for particular types of assets. Depreciation is a method of allocation. However. Depreciation expense is recorded in the income statement of a business. and a method of apportioning the cost over such life. Where the assets produce benefit in future periods. depreciation does not affect a statement of cash flows. including all costs related to acquisition. respectively. Depreciation is generally recognized under historical cost systems of accounting. Generally this involves four criteria: 1. The impact of accumulated depreciation expense is generally recorded in a separate account and disclosed in financial statements under most accounting principles. In some countries or for some purposes. 2. salvage value may be ignored. expected salvage value of the asset. but cost of acquiring assets does. in most countries the life is based on business experience. Cost generally is the amount paid for the asset. Depreciation expense does not require current outlay of cash. the net Bahaudin Zakriya Universty Page 5 . Such charges are usually nonrecurring. Some proposals for fair value accounting have no provision for systematic depreciation expense. Generally.Depreciation Methods asset. Any business or income producing activity. and may relate to any type of asset. estimated useful life of the asset. and the method may be chosen from one of several acceptable methods. This net basis is cost less depreciation. The asset is referred to as a depreciable asset. the cost of acquiring depreciable assets may require such outlay.

Methods of depreciation 1. 4. In addition. Composite depreciation method 9. Book value at the beginning of the first year of depreciation is the original cost of the asset. Group depreciation method 8. it may be zero or even negative. Book value = original cost í accumulated depreciation Book value at the end of year becomes book value at the beginning of next year. 3. 5. If the vehicle was to be sold and the sales price exceeded the depreciated value (net book value) then the excess would be considered a gain and subject to depreciation recapture. Salvage value is also known as scrap value or residual value. Straight-line method: Declining-balance method (or Reducing balance method) Double Declining Method Activity depreciation Sum-of-years' digits method Units-of-production depreciation method 7. generally based on either the passage of time or the level of activity (or use) of the asset. this gain above the depreciated value would be recognized as Bahaudin Zakriya Universty Page 6 . At any time book value equals original cost minus accumulated depreciation. in which the company estimates the salvage value of the asset at the end of the period during which it will be used to generate revenues (useful life) and will expense a portion of original cost in equal increments over that period. 2. The salvage value is an estimate of the value of the asset at the time it will be sold or disposed of. The asset is depreciated until the book value equals scrap value. Tax depreciation There are several methods for calculating depreciation.Depreciation Methods cost in excess of accumulated depreciation is disclosed in the presentation of assets and liabilities (balance sheet) of a business. Straight-line method: This table illustrates the straight-line method of depreciation. 6. Straight-line depreciation Straight-line depreciation is the simplest and most-often-used technique.

626 11. then the gain above the original book value is recognized as a capital gain.750 betwe en 3.125 the taxati on depar tment s and comp any's view of the profit. Company name is SHAMA COOKING OIL. The following company is using Straight Line method.250 38. 50.Depreciation Methods ordinary income by the tax office. If a company chooses to depreciate an asset at a different rate from that used by the tax office then this generates a timing difference in the income statement due to the differ No. If the sale price were ever more than the original book value.625 16. 50.875 33. of year expense depreciation end of year (at a point 1. The amount in 00 Bahaudin Zakriya Universty Page 7 .000 5.625 5.000 5.000 5. If the sales price is ever less than the book value. 50. the resulting capital loss is tax deductible.625 44.375 in time) 2. of Book value at beginning Depreciation Accumulated Book value at ence years.

regardless of the method used. This may be a more realistic reflection of an asset's actual expected benefit from the use of the asset: many assets are most useful when they are new. Annual depreciation = depreciation rate * book value at beginning of year Double Declining Method When using the double-declining-balance method. 6.500 28. The process continues until the salvage value or the end of the asset's useful life. in years). 5.625 5. and apply the greater of the two.625 5.000 Declining-balance method (or Reducing balance method) Depreciation methods that provide for a higher depreciation charge in the first year of an asset's life and gradually decreasing charges in subsequent years are called accelerated depreciation methods. but the book value of the asset being depreciated is never brought below its salvage value. 7. some methods also compute a straight-line depreciation each year.000 50.625 5.000 50.500 21.875 16.375 45.Depreciation Methods 4. Under this method the book value is multiplied by a fixed rate.000 5.000 50. 8.625 5. In the last year of depreciation a subtraction might be needed in order to prevent book value from falling below estimated Scrap Value.125 33.750 39. Bahaudin Zakriya Universty Page 8 . It is possible to find a rate that would allow for full depreciation by its end of life with the formula: where N is the estimated life of the asset (for example. One popular accelerated method is the declining-balance method.000 27. This has the effect of converting from decliningbalance depreciation to straight-line depreciation at a midpoint in the asset's life.625 22. is reached. the salvage value is not considered in determining the annual depreciation. 50. Since double-declining-balance depreciation does not always depreciate an asset fully by its end of life.625 5.250 10.000 50.

Depreciation Methods Method:Double declining . Asset 1 Book value at Depreciation beginning of year rate Rs17000000 (original cost) 10200000 6120000 3672000 2203200 40% 40% 40% 40% (22032002000000) Depreciation Accumulated expense depreciation 6800000 4080000 2448000 1468800 203200 6800000 10880000 13328000 14796800 15000000 Book value at end of year 10200000 6120000 3672000 2203200 2000000 (scrap value) An other asset furniture &fixture´ depreciation schedule is Book value at Depreciation Depreciation beginning rate expense Accumulated Book value depreciation at the end 15000000 9000000 5400000 3240000 1944000 40% 40% 40% 40% 19440001000000 6000000 3600000 2160000 1296000 944000 6000000 9600000 11760000 13056000 14000000 9000000 5400000 3240000 1944000 1000000 Bahaudin Zakriya Universty Page 9 .HOOR BANASPATI & COOKING OIL COMPANY is usin this methd for depreciating its assets.

compute its depreciation schedule. Depreciable cost = original cost í salvage value Book value = original cost í accumulated depreciation Example: If an asset has original cost of 1000. The per-mile depreciation rate is calculated as: ($17. but on a level of activity.30 per mile. Sum-of-years' digits method Sum-of-years' digits is a depreciation method that results in a more accelerated write-off than straight line. but less than declining-balance method. and 1. 5+4+3+2+1=15 The sum of the digits can also be determined by using the formula (n2+n)/2 where n is equal to the useful life of the asset.000 salvage) / 50. calculate the sum of the digits. Next. When the asset is acquired.000 miles in its lifetime. 2/15 for the 4th year.000 miles = $0. a useful life of 5 years and a salvage value of 100. 3. or a cycle count for a machine. and 1/15 for the 5th year. This could be miles driven for a vehicle. First.000 cost . 3/15 for the 3rd year. 4/15 for the 2nd year. Since the asset has useful life of 5 years. Assume the vehicle above is estimated to go 50. 2. Under this method annual depreciation is determined by multiplying the Depreciable Cost by a schedule of fractions. 4. its life is estimated in terms of this level of activity. Book value beginning of year at Total Depreciation Depreciation depreciable rate expense Accumulated Book value depreciation end of year at Bahaudin Zakriya Universty Page 10 . Each year. determine years' digits. the years' digits are: 5. The example would be shown as (52+5)/2=15 Depreciation rates are as follows: 5/15 for the 1st year.$2.Depreciation Methods Activity depreciation Activity depreciation methods are not based on time. the depreciation expense is then calculated by multiplying the rate by the actual activity level.

or a case where the amount the asset is used is not linear year to year.Depreciation Methods cost 1. Units of time depreciation Units of time depreciation are similar to units of production. A simple example can be given for construction companies.000 cost) 700 460 280 160 (original 900 900 900 900 $900 5/15 4/15 3/15 2/15 1/15 300 5/15) 240 4/15) 180 3/15) 120 2/15) (900 (900 (900 (900 * * * * 300 540 720 840 700 460 280 160 100 value) (scrap 60 (900 * 1/15) 900 Units-of-production depreciation method Under the units-of-production method. Bahaudin Zakriya Universty Page 11 . Assets must be similar in nature and have approximately the same useful lives. where some equipment is used only for some specific purpose. Group depreciation method Group depreciation method is used for depreciating multiple-asset accounts using straight-line-depreciation method. Depending on the number of projects. In the end the sum of accumulated depreciation and scrap value equals to the original cost. the equipment will be used and depreciation charged accordingly. useful life of the asset is expressed in terms of the total number of units expected to be produced: Depreciation stops when book value is equal to the Scrap Value of the asset. and are used for depreciation equipment used in mine or natural resource exploration.

but both are part of the office equipment. Composite depreciation rate equals depreciation per year divided by total historical cost. multiply the result by the same total historical cost. Debit the difference between the two to accumulated depreciation. Tax depreciation Most income tax systems allow a tax deduction for recovery of the cost of assets used in a business or for the production of income. To calculate depreciation expense. without first dividing and then multiplying total depreciation per year by the same number. Such deductions are allowed for individuals and companies. Depreciation expense equals the composite depreciation rate times the balance in the asset account (historical cost). and have different service lives. Depreciation on all assets is determined by using the straight-line-depreciation method. Common sense requires depreciation expense to be equal to total depreciation per year. the cost may be deducted currently as an expense or treated as part of cost of goods sold. For example. Composite life equals the total depreciable cost divided by the total depreciation per year. Debit depreciation expense and credit accumulated depreciation. Theoretically. this makes sense because the gains and losses from assets sold before and after the composite life will average themselves out. divide depreciation per year by total historical cost. The cost of assets not currently consumed generally must be deferred and recovered over time. not surprisingly.Depreciation Methods Histori Salvage Asset cal value cost Depreciabl Depreciatio e Life n cost per year Composite depreciation method The composite method is applied to a collection of assets that are not similar. Under the composite method no gain or loss is recognized on the sale of an asset. To calculate composite depreciation rate. The result. Bahaudin Zakriya Universty Page 12 . When an asset is sold. debit cash for the amount received and credit the asset account for its original cost. will equal to the total depreciation Per Year again. computers and printers are not similar. Where the assets are consumed currently.

Bahaudin Zakriya Universty Page 13 . and may vary within a country based on type of asset or type of taxpayer.Depreciation Methods such as through depreciation.) and personal property (equipment. Rules vary highly by country. all property of a particular type is considered acquired at the midpoint of the acquisition period. The United States system allows a taxpayer to use a half year convention for personal property or mid-month convention for real property. etc. etc. Under such a convention. Many systems that specify depreciation lives and methods for financial reporting require the same lives and methods be used for tax purposes. United States rules require a mid-quarter convention for personal property if more than 40% of the acquisitions for the year are in the final quarter.). Averaging conventions Depreciation calculations can become complex if done for each asset a business owns. Many systems therefore permit combining assets of a similar type acquired in the same year into a ³pool. Other systems allow depreciation expense over some life using some depreciation method or percentage. One half of a full period depreciation is allowed in the acquisition period and in the final depreciation period. at least in part.´ Depreciation is then computed for all assets in the pool as a single calculation. in the year the assets are acquired. Most tax systems provide different rules for real property (buildings. Calculations for such pool must make assumptions regarding the date of acquisition. Some systems permit full deduction of the cost.