DEPRECIATION

Depreciation is the diminution in the financial value of an asset owing to wear and tear, efflux of time, obsolescence or similar causes. Depreciation is a permanent continuing and gradual shrinkage in the value of a fixed asset. It is also defined as the permanent and continuous diminution in the quality, quantity or the value of assets. The gradual decrease in the value of an asset because of any cause. The amount of depreciation is charged on the basis of cost of machine, life of the assets and the cost of replacement. TYPES OF DEPRECIATION:(1) STRAIGHT LINE METHOD: Straight-line depreciation is the simplest and mostoften-used technique, 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. The salvage value is an estimate of the value of the asset at the time it will be sold or disposed of; it may be zero or even negative. Salvage value is also known as scrap value or residual value

(2) DOUBLE DECLINING DEPRECIATION 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. 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. One popular accelerated method is the declining-balance method. Under this method the Book Value is multiplied by a fixed rate.

(3) WDV OR DIMINISHING METHOD: Written down value, applicable to

machines that have high rates of depreciation in the initial year or two, and later taper it e.g. a car, is a usable method. Under this method, depreciation is charged at a fixed rate every year, ON THE REDUCING BALANCE A certain percentage is applied to the previous year’s book value, to arrive at the current year’s depreciation/ book value, WHICH SHOWS A DECLINING BALANCE, WEIGHTED FOR EARLIER YEARS, AND LOWER AND LOWER FOR LATER YEARS, as the machine grows older. Accelerates depreciation taken in early years. Reduces the amount taken in later years. Ignores salvage value; starts with depreciable base = asset cost.

(4) SUM OF YEAR DIGIT 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. Under this method annual depreciation is determined by multiplying the Depreciable Cost by a schedule of fractions. (5) Activity depreciation: Activity depreciation methods are not based on time, but on a level of activity. This could be miles driven for a vehicle, or a cycle count for a machine. When the asset is acquired, its life is estimated in terms of this level of activity. Assume the vehicle above is estimated to go 50,000 miles in its lifetime. The per-mile depreciation rate is calculated as: ($17,000 cost - $2,000 salvage) / 50,000 miles = $0.30 per mile. Each year, the depreciation expense is then calculated by multiplying the rate by the actual activity level (6) Units-of-Production Depreciation Method: Under the Units-of-Production method, useful life of the asset is expressed in terms of the total number of units expected to be produced. Annual depreciation is computed in three steps. (7) Units of time depreciation: Units of Time Depreciation is similar to units of production, and is used for depreciation equipment used in mine or natural resource exploration, or cases where the amount the asset is used is not linear year to year.A simple example can be given for construction companies, where some equipment is used only for some specific purpose. Depending on the number of projects, the equipment will be used and depreciation charged accordingly. (8) Group Depreciation Method: Group Depreciation method is used for depreciating multiple-asset accounts using straight-linedepreciation method. Assets must be similar in nature and have approximately the same useful lives. (9) Composite Depreciation Method: The composite method is applied to a collection of assets that are not similar, and have different service lives. For example, computers and printers are not similar, but both are part of the office equipment. Depreciation on all assets is determined by using the straight-line-depreciation method.

METHODS OF DEPRECIATION (how to calculate):-(1) (2) (3) (4) STRAIGHT LINE METHOD WDV OR DIMINISHING METHOD SUM OF YEAR DIGIT METHOD DOUBLE DECLINING DEPRECIATION METHOD

Explanations
(1)

Straight line method WDV or diminishing method :

(a)For Example: Say a machine costs Rs. 10,000 and Rs. 1,000 (as additional setup/installation/maintenance expenses) = Rs 11,000 but we anticipate/guess its Kabari (Scrap Value) at Rs. 3,000 at the end of its useful life, of say, 10 yrs, we get: Cost of Machine + Installation + Directly Associated Costs = Total Cost Total Cost - Salvage Value (At end of 10 yr. Period) = Depreciable base 10,000 + 1,000 =11000 (Total cost) 11000 – 3,000 = 8,000 as the Depreciable Base Depreciable Base = Rs. 8,000, Spread out over 10 yrs = Rs. 8000/10(Yrs) = Rs 800/- depreciation per year.

(b) if an assets has been purchased for Rs. 10000 ans it will have a scrap value of Rs 1000 at the end of its useful llife of 10 year, the amount of depreciation is to be charged every year over the effective life of the assets will be computed as follows: Depreciation= 10000 – 1000/10 years. RS 900 each year or 9%
(2)

Sum of year digit method :

under this method, the numbers 1, 2, 3, …..n (where n is useful economic life) are added and depreciation rate is calculated as follows: Year depreciation rate 1 n/sum of n 2 (n-1)/sum of n 3 (n-2)/sum of n 4 (n-3)/sum of n 5 (n-4)/sum of n 6 * 7 * Where n = 1+2+3+4+5……..+n. These rates are then applied to the net cost. For a machine of 10 years economic life and Rs. 100000, the depreciation for each is computed as follow: Year depreciation Rate. Annual dep. Net book value 1 2 3 4 5 6 7 8 9 10 10/55 9/55 8/55 7/55 6/55 5/55 4/55 3/55 2/55 1/55 18182 16364 14545 12727 10909 9091 7273 5455 3636 1818 81818 65454 50909 38182 27273 18182 10909 5454 1818 1818

(b) if the cost of an asset is RS 10000 and it has an effective life of 5 year. The amount of depreciation to be written off each year will be computed as follows: 1st year 5/1+2+3+4+5 * 10000 = 3333 2nd year 4/15 * 10000 = 2666 rd 3 year 3/15 * 10000 = 2000 th 4 year 2/15 * 10000 = 1333 th 5 year 1/15 * 10000 = 667

(3) Double declining depreciation method:
EXAMPLE OF DOUBLE DECLINING BALANCES METHOD: [The Double Declining Method takes an amount (usually double, i.e. 200% of the amount that we take in the Straight Line Method) and applies it to the book value of an asset each year]: Suppose the asset costing Rs.16,000 has AN ESTIMATED USEFUL LIFE OF 5 YEARS, the depreciation would be calculated as follows:

YEAR 1 2 3 4 5

DEPRECIABLE BASE 16000-0 16000-0-6400 16000-6400-3840=5750 16000-6400-3840-2304
th

PERCENTAGE (FIXED) x 0.40 x 0.40 x 0.40 x 0.40

DEPRECIATION 6,400 3,840 2,304 1,382

Depreciation in the 5 year is only Rs. 74 to finally write off the entire machine depreciable base (Rs. 16000/-) less scrap value (Rs. 2000).

(b) A plant having a scrap value of RS 10000 and life of 5 years was purchased for Rs 10000 in Jan. 1990. You required calculating amount of depreciation for each of the year according to the double declining method. Sol. According to the fixed installment method (without considering salvage value) depreciation would amount to Rs 2000 i.e. 10000/5 years each year. The rate of depreciation therefore comes to 20 %.

In case of double declining method rate of depreciation would be twice of this rate i.e. 40%. Amount of depreciation for each year would therefore be Year book value in the beginning amt. of depreciation. 1 10000 4000 2 6000 2400 3 3600 1440 4 2160 860 5 1300 300
(4)

WDV or diminishing method: Under this method depreciation is calculated by applying depreciation rate to the net book value of the assets at the beginning of that year rather than to the original cost. For a machine whose acquisition cost is Rs. 100000, useful economic life is 10 year and the rate of depreciation is 20 %, the depreciation under WDV method will be as follow:

Year 1 2 3 4 5 6 7 8 9 10 (b)

annual depreciation 100000*.20= 20000 80000*.20= 16000 64000*.20= 12800 51200*.20= 10240 40960*.20= 8192 32768*.20= 6553.6 26214*.20= 5242.88 20971*.20= 4194.3 16777*.20= 3355.44 13421*.20= 2684.35

net book value 80000 64000 51200 40960 32768 26214 20971.52 16777.22 13421.78 10737.43

If the cost of an asset is RS 10000 and residual value RS 1296, economic life 4years and the rate of depreciation would be 40% calculated as follows: Depreciation rate = 1- 4 (1296/10000) ^1/2 = 1 – 6/10 = 40%.

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