Depreciation Methods

ASSINGMENT#2

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 .

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

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

Composite depreciation method 9. Salvage value is also known as scrap value or residual value. 5. In addition. Straight-line depreciation Straight-line depreciation is the simplest and most-often-used technique. this gain above the depreciated value would be recognized as Bahaudin Zakriya Universty Page 6 . 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. Group depreciation method 8. 3. 6. Straight-line method: This table illustrates the straight-line method 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 7. Book value = original cost í accumulated depreciation Book value at the end of year becomes book value at the beginning of next year. 2. 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. 4. At any time book value equals original cost minus accumulated depreciation. Methods of depreciation 1. generally based on either the passage of time or the level of activity (or use) of the asset. The salvage value is an estimate of the value of the asset at the time it will be sold or disposed of. Book value at the beginning of the first year of depreciation is the original cost of the asset. 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. The asset is depreciated until the book value equals scrap value. it may be zero or even negative.

50.250 38.750 betwe en 3.000 5. the resulting capital loss is tax deductible. Company name is SHAMA COOKING OIL. If the sales price is ever less than the book value.626 11.125 the taxati on depar tment s and comp any's view of the profit.625 44.375 in time) 2. then the gain above the original book value is recognized as a capital gain. 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.Depreciation Methods ordinary income by the tax office. 50. The following company is using Straight Line method.875 33. The amount in 00 Bahaudin Zakriya Universty Page 7 .000 5. If the sale price were ever more than the original book value. 50.625 5. of year expense depreciation end of year (at a point 1. of Book value at beginning Depreciation Accumulated Book value at ence years.625 16.000 5.

Depreciation Methods 4. Since double-declining-balance depreciation does not always depreciate an asset fully by its end of life. One popular accelerated method is the declining-balance method. in years). is reached.000 5.500 21. This has the effect of converting from decliningbalance depreciation to straight-line depreciation at a midpoint in the asset's life.000 50. 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.625 5. and apply the greater of the two. Annual depreciation = depreciation rate * book value at beginning of year Double Declining Method When using the double-declining-balance method. 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. Under this method the book value is multiplied by a fixed rate.875 16.000 50. regardless of the method used.625 5.625 5.000 50.000 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.625 5. 5. 7.375 45.000 50. In the last year of depreciation a subtraction might be needed in order to prevent book value from falling below estimated Scrap Value. 6. The process continues until the salvage value or the end of the asset's useful life.750 39.625 5. 50. some methods also compute a straight-line depreciation each year. Bahaudin Zakriya Universty Page 8 . the salvage value is not considered in determining the annual depreciation. but the book value of the asset being depreciated is never brought below its salvage value.250 10.625 22.000 27. 8.500 28.125 33.

Depreciation Methods Method:Double declining .HOOR BANASPATI & COOKING OIL COMPANY is usin this methd for depreciating its assets. 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 .

a useful life of 5 years and a salvage value of 100. compute its depreciation schedule. but less than declining-balance method. and 1/15 for the 5th year. 4.000 miles = $0.000 salvage) / 50. its life is estimated in terms of this level of activity.$2. and 1.000 cost . Next. Assume the vehicle above is estimated to go 50. Since the asset has useful life of 5 years. Under this method annual depreciation is determined by multiplying the Depreciable Cost by a schedule of fractions. Depreciable cost = original cost í salvage value Book value = original cost í accumulated depreciation Example: If an asset has original cost of 1000. 4/15 for the 2nd year. calculate the sum of the digits. First. 3/15 for the 3rd year. Each year.000 miles in its lifetime. 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 . the depreciation expense is then calculated by multiplying the rate by the actual activity level. The per-mile depreciation rate is calculated as: ($17.30 per mile. When the asset is acquired. the years' digits are: 5. 3. 2. but on a level of activity. or a cycle count for a machine. Sum-of-years' digits method Sum-of-years' digits is a depreciation method that results in a more accelerated write-off than straight line. This could be miles driven for a vehicle. 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. 2/15 for the 4th year. The example would be shown as (52+5)/2=15 Depreciation rates are as follows: 5/15 for the 1st year. determine years' digits.Depreciation Methods Activity depreciation Activity depreciation methods are not based on time.

In the end the sum of accumulated depreciation and scrap value equals to the original cost. 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.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. Assets must be similar in nature and have approximately the same useful lives. or a case where the amount the asset is used is not linear year to year. A simple example can be given for construction companies. Group depreciation method Group depreciation method is used for depreciating multiple-asset accounts using straight-line-depreciation method.Depreciation Methods cost 1. Depending on the number of projects. Bahaudin Zakriya Universty Page 11 . where some equipment is used only for some specific purpose. Units of time depreciation Units of time depreciation are similar to units of production. the equipment will be used and depreciation charged accordingly. and are used for depreciation equipment used in mine or natural resource exploration.

The result. without first dividing and then multiplying total depreciation per year by the same number. 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. To calculate depreciation expense. Theoretically. and have different service lives. Common sense requires depreciation expense to be equal to total depreciation per year. Depreciation expense equals the composite depreciation rate times the balance in the asset account (historical cost).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. the cost may be deducted currently as an expense or treated as part of cost of goods sold. For example. multiply the result by the same total historical cost. not surprisingly. To calculate composite depreciation rate. Bahaudin Zakriya Universty Page 12 . Debit the difference between the two to accumulated depreciation. Composite life equals the total depreciable cost divided by the total depreciation per year. Such deductions are allowed for individuals and companies. computers and printers are not similar. The cost of assets not currently consumed generally must be deferred and recovered over time. Where the assets are consumed currently. 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. Composite depreciation rate equals depreciation per year divided by total historical cost. Debit depreciation expense and credit accumulated depreciation. Depreciation on all assets is determined by using the straight-line-depreciation method. Under the composite method no gain or loss is recognized on the sale of an asset. but both are part of the office equipment. debit cash for the amount received and credit the asset account for its original cost. When an asset is sold. will equal to the total depreciation Per Year again.

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

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