ASSIGNMENT-II

By: Rinki Jain

MBA – 1st SEM
02111403909

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, inadequacy, rot,
rust, decay or other such factors.The idea of depreciation is to spread the cost of
that capital asset over the period of its "useful life to the entity" that currently owns
it.

If the full cost of the asset were to be borne in the year that it was purchased, then that
year's expenditure would be unfairly penalised whilst expenditure during the remaining
years, which were still receiving the benefit from the asset, would not be affected.

In order to begin depreciating an asset, three things must first be determined.

• the initial cost of the asset

• the expected useful life of the asset
• the estimated value of the asset at the end of its useful life

The initial cost of the asset is the cost to purchase the asset along with any amounts spent
to get the asset ready to use. Sales taxes, freight, and installation costs are examples of
some of the costs that can be included in the cost of the asset for depreciation purposes.

The expected useful life should be determined at the time the asset is placed in service.
According to the Internal Revenue Service guidelines, most machinery and equipment
have a useful life of seven years, while automobiles and light duty trucks have a useful
life of five years. These guidelines are used for federal income tax purposes; companies
may use different guidelines for financial reporting purposes.

The estimated value at the end of a fixed asset's useful life is typically referred to as the
residual value. In order to properly calculate depreciation, the residual value must be
determined at the time the asset is placed into service.

The total amount to be depreciated over the life of a fixed asset is determined by the
following calculation:

Cost of the fixed asset less residual value

The period over which to depreciate a fixed asset is known as the "useful economic life"
of the asset

Characteristics of Depreciation:
(1) Depreciation is charged in case of fixed assets only, e.g., Building, Plant and
Machinery, Furniture 'etc. There is no question of depreciation in case of current assets-
such as Stock, Debtors, and Bills Receivable etc.

(2) Depreciation causes perpetual, gradual and continuous fall in the value of asset

(3) Depreciation occurs till the last day of the estimated working life of asset

(4) Depreciation occurs on account of use of asset In certain cases, however, depreciation
may occur even if the assets are not used, e.g., Leasehold Property, Patent right,
Copyright etc.

(5) Depreciation is a charge against revenue of an accounting period.

(6) Depreciation does not depend on fluctuations in market value of asset

(7) The amount of depreciation of an accounting year cannot be determined precisely-it

has to be estimated. In certain cases, however, it may be ascertained exactly, e.g.,
Leasehold Property, Patent Right, Copyright etc.

(8) Total depreciation of an asset cannot exceed its depreciable value (cost less scrap
value).

Methods of Depreciation:
A depreciation method is required to allocate, in a systematic way, the total amount to be
depreciated between each accounting period of the asset's useful economic life.

1 Straight Line Method

2 Diminishing Balance Method
3 Sum of Digits Method
4 Depreciation Fund Method/Sinking fund method
5 Annuity Method
6 Machine Hour rate Method
7 Replacement Method
8 Depletion Method
9 Revaluation Method
10 Units of Production method
11 Insurance policy Method
1. Fixed Installment or Original Cost or Straight Line Method

It's the simplest and most popular methods of calculating depreciation. Under this
method the depreciation charge is constant over the life of the asset. Its important
points are :

1. The rate and amount of depreciation remain the same each year.

2. Depreciation rate per cent is calculated on cost of asset each year.

3. At the end of its life the value of asset is reduced to zero or scrap value.

4. The older the asset, the larger the cost of its repairs. But the amount of
depreciation remains the same each year. Hence, the total of depreciation and
repairs increases every year. This reduces annual profit gradually.

5. Computation of depreciation comparatively easy and simple.

Annual depreciation charge = (Original - Residual

value)/Estimated useful value
Example :

Cost of the asset $10,500

Less: Expected salvage value – 500
Depreciable Cost (amount to be
depreciated over the estimated useful
life) $10,000
Years of estimated useful life 5
Depreciation Expense per year $ 2,000

Another example, a company purchased a car on 1 January at a cost of $24,000. The

company estimates that its useful life is four years, after which he will trade it in for
$4,000. The annual depreciation charge is to be calculated using the straight line method.

Depreciation charge = ($24,000 - $4,000)/4= $5,000 p.a.

2 Reducing / Diminishing Balance method

Under this method depreciation is not calculated on cost of asset. It is computed on the
book value. of asset. The book value of the asset is obtained by deducting depreciation
from its cost. The book value of asset gradually reduces on account of depreciation
charge. Since the depreciation percent rate is applied on reducing balance of asset. this
method is called reducing balance or diminishing installment method or written down
value method.

The reducing balance method of depreciation provides a high annual depreciation charge
in the early years of an asset's life but the annual depreciation charge reduces
progressively as the asset ages. In some cases it may be advantageous for a company to
write off its expenses on an asset at a faster rate than allowed by the straight line method.
With a higher fraction of the cost written off during the early years the company will
have more cash, which will lead to greater future wealth because of the time value of
money.

Example :

Book Value - Depreciation Depreciation Accumulated Book Value -

Beginning of Year Rate Expense Depreciation End of Year
$1,000 (Original Cost) 40% $400 $400 $600
$600 40% $240 $640 $360
$360 40% $144 $784 $216
$216 40% $86.40 $870.40 $129.60
$129.60 $129.60 - $100 $29.60 $900 $100 (Scrap Value)

3 Sum of Digits Method

Sum-of-the-years'-digits depreciation is another way to accelerate the depreciation of an
asset. It can result in deductions that are larger than those given by double declining-
balance depreciation in the early years. Although the deductions get smaller each year, all
of the asset's depreciable basis is written off over the property's useful life.

Depreciation expense = (Cost - Salvage value) x Fraction

Fraction for the first year = n / (1+2+3+...+ n)
Fraction for the second year = (n-1) / (1+2+3+...+ n)
Fraction for the third year = (n-2) / (1+2+3+...+ n)
...
Fraction for the last year = 1 / (1+2+3+...+ n)

n represents the number of years for useful life.

This method 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.

Depreciable Cost = Original Cost - Salvage Value

Book Value = Original Cost - Accumulated Depreciation

Example:

If an asset has Original Cost $1000, a useful life of 5 years and a Salvage Value of $100,
compute its depreciation schedule.

First, determine Years' digits. Since the asset has useful life of 5 years, the Years' digits
are: 5, 4, 3, 2, and 1.

Next, calculate the sum of the digits. 5+4+3+2+1=15

Depreciation rates are as follows:

5/15 for the 1st year, 4/15 for the 2nd year, 3/15 for the 3rd year, 2/15 for the 4th year,
and 1/15 for the 5th year.

Book Value - Total Book Value

Depreciation Depreciation Accumulated
Beginning of Depreciable -
Rate Expense Depreciation
Year Cost End of Year
$1,000 $300 ($900 *
$900 5/15 $300 $700
(Original Cost) 5/15)
$240 ($900 *
$700 $900 4/15 $540 $460
4/15)
$180 ($900 *
$460 $900 3/15 $720 $280
3/15)
 $120 ($900 *
$280 $900 2/15 $840 $160
2/15)
$60 ($900 * $100 (Scrap
$160 $900 1/15 $900
1/15) Value)

4 Depreciation Fund Method/Sinking fund method

Under this method, a fixed amount is charged as depreciation every year. It
endeavors to provide the required lump sum cash at the retirement of a long, lived
asset by annually setting aside and investing a fixed sum in readily realizable
securities. These securities earn interest at fixed rate and the same being reinvested
along with successive fixed installments of depreciation, allowed to accumulate at
compound interest. The sinking fund method thus takes into account of this probable
income from interest while fixing the annual depreciation and investing the same
which together with compound interest accumulated to the asset's depreciable cost
by the end of its useful life. Obviously, the fixed installment of annual depreciation is
here smaller as compared to straight line method. Its magnitude, however, rests on
the asset's life span and interest rate. Longer the span and higher the rate, smaller
is the annual depreciation per rupee of depreciable cost.

Shortcomings of Depreciation Fund Method

Depreciation fund method assumes constant rate of return on every periodic

investment in identical securities. This is hardly true in this dynamic world
where rates do vary now and then. Any variation in the rate of return upsets
the earlier periodic allocation for depreciation and entails refection thereof.
Further the amount realized on the sale of security rarely agrees with its
acquisition cost owing to made fluctuations which may be both erratic and
considerable. Those may cause a wide gap between the required and supplied
cash.

5 Annuity Method

The method recognizes the time value (Interest) of money and hence regards the real cost
of using a long-lived asset equivalent to the actual amount invested thereon plus the
interest lost on the acquisition of asset. Under this method, so much depreciation is
written off each year as after debiting the asset account with interest upon the diminishing
value, will reduce the asset to nil at the end of its life. Thus, the amount written off as
depreciation is the same every year, but the interest will diminish each year.

Focusing upon cost recovery and a constant rate of return on the investment in
depreciable assets; also called compound interest method of depreciation. This method
entails first obtaining the Internal Rate of Return (IRR) on the cash inflow and outflow of
the asset. Then the asset's beginning book value is multiplied by the IRR and this amount
is subtracted from the cash flow for the period to determine the periodic depreciation
charge. If cash flow is constant over the determined life of the asset, it is then called the
annuity method. This method is not used in practice and not recommended by Generally
Accepted Accounting Principles (GAAP).

6 Machine Hour Rate Method

This method is applied for depreciating machines. The life of the machines is fixed in
terms of hour. The total cost of the asset less depreciations is divided by the expected life
of the machine in terms of hours. Depreciation to be charged is ascertained by
multiplying the hourly rate of depreciations by the number of hours the machine actually
works during the year.

For example : The life of a machine costing Rs. 10,000 is estimated 10,000 hours. The
hourly rate thus comes to Re 1/- per hour. If the machine is run 1000 hours in a year, the
total depreciation chargeable for the year will be Rs. 1000 @ Re 1/ per hour. This method
is useful for costly machines where a fair estimate of the life of asset can be made n terms
of working hours.

7 Replacement Method of Depreciation

Method in which the current depreciation expense amount, usually determined by the
Straight-Line Depreciation method, is augmented by a percentage derived from a
comparison of the anticipated replacement cost of a depreciable asset with its original
cost. This method requires an estimate to be made of the anticipated replacement cost.

Business valuation method in which its replacement cost (instead of its liquidation value)
is considered which is usually higher than the book value (because depreciation is not
taken into account). Liabilities are deducted from the replacement cost to arrive at the
value of the business. Also called replacement value method.

Under generally accepted accounting principles, the value of a company's assets is based
on its historical costs. The present book value of an asset is determined by its acquisition,
or historical, cost, less any depreciation. A company's financial statements will reflect
this, usually valuing its assets at their present book value.

Replacement costs provide an alternative way of valuing a company's assets. The

replacement, or current, cost of an asset is the amount of money required to replace the
asset by purchasing a similar asset with identical future service capabilities. In
replacement cost accounting, assets and liabilities are valued at their cost to replace.

If replacement costs are used to establish the value of assets, then the replacement
method of depreciation is also used to adjust the value of an asset as it is used over time.
Under the replacement method of depreciation, an anticipated replacement cost for the
asset is estimated. The depreciation expense is then calculated as the sum of the
depreciation based on the historical cost, plus a percentage of the difference between the
historical cost and the replacement cost. Using the replacement method, the depreciation
expense associated with an asset is based on a combination of its historical cost and its
replacement cost.

When an acquiring company seeks to obtain an estimate of a target company's value

before making a purchase offer, the replacement costs of the company's assets often
provide a more accurate value than does the present book value of the assets. The value
of an asset is intended to reflect its earnings potential. Present book value, calculated on
the basis of historical costs and depreciation, does not take into account such factors as
inflation, for example. Replacement costs, on the other hand, are more likely to
accurately reflect economic conditions that can affect the value of a company's assets.

8 Depletion Method

This method is used in case of wasting assets such as mines, oil and gas resources, timber
etc .These assets exhausted by exploitation. In such cases, the price paid for the
acquisition of asset is dividend by the estimated contents of the mines in terms of tons
which will be the price paid for one ton. The amount of total depreciation is calculated
for the year by multiplying the total output in tons with the price paid per ton. Thus the
total price paid is recouped during the life of the asset.

There are two types of depletion methods: cost depletion and percentage depletion. For
some resources, such as timber and most oil and gas wells, only cost depletion is
allowed. For other resources depletion is computed using both the cost depletion and the
percentage depletion methods and the larger of the two values is taken as the depletion
allowance for the period.

Cost Depletion: This method is similar to the units-of-production depreciation method in

which the depreciation is related to the level of the output during each period in
comparison to the total output possible during the depreciable life of the asset. Cost
depletion starts by computing the basis per recoverable unit of the natural resource, and
the depletion allowance for any given period is computed by multiplying the basis per
recoverable unit by the number of units produced in that period.

Percentage Depletion: In percentage depletion the gross possible income from the
property is amortized over the life of the property, in contrast to the amortization of the
cost that is done in depreciation and in cost depletion. The total income from the
property, therefore, needs to be computed before finding the percentage depletion.
Also, since the depletion is on the basis of the income as opposed to the cost, it is
possible that the total depletion can exceed the total cost of the property. To avoid this,
the method requires that the depletion allowance can not exceed 50% of the total taxable
income form the property.

9 Revaluation method
Under this method assets are revalued at the end of each year. The difference of the
revaluation price of the two years is the depreciation be charged to profit and loss account.
However, any appreciation is usually not taken into account.
The method is followed where it is not possible to provide for the depreciation on
mathematical basis or the asset is represented by large number of small and diverse items of
small unit cost such as loose tools or where the life of he asset is uncertain such as animals,
jars, bottles etc.

A method of determining the depreciation charge on a fixed asset against profits for an
accounting period. The asset to be depreciated is revalued each year; the fall in the value
is the amount of depreciation to be written off the asset and charged against the profit and
loss account for the period. It is often used for such depreciating assets as loose tools or a
mine from which materials are extracted.

10 Units-of-output depreciation / Units of Production Method

Method in which depreciation is computed on the basis of an asset's actual use, instead of
the time in service, to match depreciation expense with the revenue generated. It is
suitable where the total number of units of output or usage over the asset's productive or
useful life can be estimated with reasonable accuracy, although their annual total may
vary from year to year. In this method, the number of total units produced or used in an
accounting period is multiplied by a depreciation rate. This rate is computed by dividing
the depreciable cost of the asset by the number of

(1) units estimated to be produced (in case of a manufacturing plant or machine), or

(2) hours or miles estimated to be traveled (in case of a vehicle) over the asset's
estimated useful life.

The units of production method of depreciation is based on an asset’s usage, activity, or

parts produced instead of the passage of time. Under the units of production method,
depreciation during a given year will be very high when many units are produced, and it
will be very low when only a few units are produced.

To illustrate the units of production method, let’s assume that a production machine has a cost of
$500,000 and its useful life is expected to end after producing 240,000 units of a component part.
The salvage value at that point is expected to be $20,000. Under the units of production method,
the machine’s depreciable cost of $480,000 ($500,000 minus $20,000) is divided by 240,000
units, resulting in depreciation of $2 per unit. If the machine produces 10,000 parts in the year
2007, the depreciation for the year will be $20,000 ($2 x 10,000 units). If the machine produces
50,000 parts in the next year, its depreciation for 2008 will be $100,000 ($2 x 50,000 units). The
depreciation will be calculated similarly each year until the asset’s Accumulated Depreciation
reaches $480,000.

The units of production method is also referred to as the units of activity method, since the
method can be used for depreciating airplanes based on air miles, cars on miles driven,
photocopiers on copies made, DVDs on number of times rented, and so on.
Depreciation is an allocation technique and the units of production method might do a better job
of allocating/matching an asset’s cost to the proper period than the straight-line method, which is
based solely on the passage of time.

11 Insurance policy method :

Under this method, an endowment insurance policy is taken on the life of the assert from an
insurance company.The amount of premium is equal to the amount of depreciation and is paid in
cash to the insurance company which goes on accumulating with the insurance company at a
certain rate of in tersest and is paid back at the maturity of the policy. The amount of policy is
such that it is sufficient to replace the asset when it is worn out. The amount so made available by
the insurance company is used for purchasing the new asset. The method to a great extent is
similar in spirit to Sinking Fund Method; of course the procedure is a little different