Module-4

Depreciation
 Introduction
There is a lot of confusion about
what depreciation actually is. Some people
think it has something to do with an asset
losing its value, while others think that it’s a
mechanism for a business to create a fund
for the replacement of the asset when its no
longer functional.
Cont..

So in this lecture let’s take a look at

• what depreciation really is, how it’s
calculated.
• what are all the different types of
depreciation and its advantages and
disadvantages.
• Based on their nature which type of
depreciation is applicable.etc
Depreciation

• Depreciation is the permanent decrease in the

value of an asset due to use and /or the lapse of
the time.
• Spreading of cost over periods which receive
benefits is known as depreciation.
Salvage Value
• Salvage value is the estimated resale
value of an asset at the end of its useful
life.
• It is subtracted from the cost of a fixed
asset to determine the amount of the
asset cost that will be depreciated. Thus,
salvage value is used as a component of
the depreciation calculation.
Depreciation Terms
Cost :Cost of the asset is the purchase
price of the asset.
Salvage value :Salvage value is the value
of the asset at the end of its useful life.
Useful life: Useful life of asset represents
the number of periods in which the asset is
expected to be used by the company
 Causes of depreciation

• Physical Deterioration
• Obsolescence
• Depletion of an asset
• Passage of time
Physical Deterioration

Caused by Physical wear and tear

Examples: Office furniture,Printing Machine

Obsolescence

Fixed asset become out of date.

Examples: Mobile phones, Computers.

Depletion of an asset

An assets that depletes over time as

resources are extracted from it.

Examples: Gold Mines , Quarries

Passage of time

Some assets confer upon their holders

the exclusive rights to enjoy certain
privileges for a fixed period of time.

Examples: Copyrights, leases on land.

Book Value

The book value of an asset represents the

worth of the asset at a given point in time. It
is equal to the cost basis of the asset less
the total amount of accumulated
depreciation. Accumulated depreciation is
the total amount of depreciation expense
that has been recorded on the books for the
asset.
The formula to calculate the book value of
an asset is as follows:

Book value = Cost basis of the asset –

accumulated depreciation
Depreciation Methods
Straight line method
Units of products
Double declining balance method
Sum of the year’s digits method
Time-based methods

Straight-Line Method.
Sum-of-the-Years’-Digits Method.
Doule Declining-Balance Method
.
Activity-based method

Unit-of-Production Method
Straight line method

With the straight line depreciation method, the

value of an asset is reduced uniformly over each
period until it reaches its salvage value.
Straight line depreciation is the most commonly
used and straightforward depreciation method for
allocating the cost of a capital asset.
Straight-line depreciation, also known as the fixed
or equal-installment depreciation method.
Advantages and disadvantages
• Advantages

• It is suitable for assets that operate uniformly and consistently over

the life of the item.
• Straight-line depreciation is suitable for less expensive items, such as
furniture, that can be written off within the asset's defined legal,
estimated or commercial life.
• Disadvantages
• Most pieces of office equipment, machinery and other items
purchased do not perform exactly the same each year.
• Straight-line depreciation does not account for the loss of efficiency or
the increase in repair expenses over the years and is, therefore, not
as suitable for costly assets such as plant and equipment
Example-1
Example-2

On January 1, 2012 the eginning of the financial year, Mr.John purchased

machinery costing Rupees 5000.Its life was estimated to e 3 years and the
salvage value at the end of this period was expected to e rupees 500. Calculate
the depreciation to e written off y equal annual installments and to show the
machinery and depreciation accounts for 3 years to 31st Decemer 2015, when the
machinery was sold for rupee 400 in cash.
Solution:
Cost of the machine=Rs.5000
Estimated life=3 yrs.
Scrap value=500
Sale amount=Rs.400
Example-3
Example-4

Prepare a depreciation schedule for a piece

of machinery purchased January 2 for 5000,
the estimated useful life is 5 years and the
machine has a salvage value of $500. The
depreciation schedule spans the estimated
life of the machine and includes the
depreciation rate for each year the dollar
amount of that year’s depreciation the book
value and each year’s accumulated
depreciation.
Cost=$5000
depreciation rate/year=100%/Estimated life
=100%/5=20%
Annual depreciation=(cost-salvage
value)Xdepreciation rate/yr
= ($5000-$500)X0.20=$4500X0.2=900
Year Dep.rate(%) Yly dep. Book Accumulated
value Dep.
0 $5000
1 20% 900 $4100 900
2 20% 900 $3200 1800
3 20% 900 $2300 2700
4 20% 900 1400 3600
5 20% 900 500 4500
Sum-of-the-Years’-Digits
Method.
• Sum-of-the-years-digits method is one of
the accelerated depreciation methods. A
higher expense is incurred in the early
years while lower expense is incurred in
the latter years of the asset.
• In sum-of-the-years digits depreciation
method, the remaining life of an asset is
divided by the sum of the years and then
multiplied by the depreciating base to
determine the expense.
Advantages and Disadvantages
• Advantages:

• The sum years’ digits depreciation method as one of accelarated

depreciation methods better matches costs to revenues because
it takes more depreciation in the early years of an assets’ useful
life compare to the straight line depreciation method
• This method reflects more accurately the difference in usage of
different assets from one period to the other compare to the
straight line depreciation method
• Disadvantages:
• SYD depreciation method might be more confusing and harder
to compute compare to the straight line
• It has declining amounts of depreciation expense. Declining
amounts of depreciation expense usually offsets by increasing
the maintenance expense which might smooth the income over
the years
This method the years of the assets lifetime
are labeled 1, 2, 3 and so on and the
depreciation amounts are based on a series
of fractions that have sum of the years digits
as their common denominator.The greatest
digit assigned to a year is used as the
numerator for the first year the next greatest
digit for the second year and so forth.
Formula:
Example-2
Determine the first year’s depreciation
fraction that would be used in the sum of the
years digits method of depreciation for the
following estimated useful lives (a)2 years
(b)5 years.
Example-3
Double-declining-balance
Method

Compared to other depreciation methods, double-declining-balance

depreciation results in larger expense in the earlier years as opposed to
the later years of an asset’s useful life.

The method reflects the fact that assets are more productive in its early
years than in its later years. With the double-declining-balance method,

the depreciation factor is 2x that of a straight line expense method .

 Advantages and disadvantages
Advantages:
The double-declining-balance method is an accelerated, or decreasing-charge,
depreciation method.
Compared to the straight-line depreciation method of allocating an asset's
purchase cost evenly over the life of the asset, the double-declining-balance
method appropriates more depreciation expenses to the early years of an asset's
life and less to later years.
Disadvantages:
A disadvantage of this method is that the calculation is more complex.
Formula
Example
Unit-of-Production Method
Units of Production Method is a method of
charging depreciation on assets.
This method of charging depreciation on
the asset is based on the units produced
during the year.
The estimated total production of the
asset is the criteria for providing
depreciation.
This method is applied where the value of
the asset is more closely related to the
number of units it produces. Thus, in the
years when the asset is heavily used, the
amount of depreciation will be high.
Advantages:

The units of production method involves

determining the cost to depreciate and
dividing that amount by the estimated
production units the company expects to
manufacture over the life of the asset.
The advantages of using the units of
production method include the ease of
calculating the annual depreciation amount
and that the depreciation is matched to the
production quantity.
Disadvantages:

The disadvantage of using the units of

production method is that this method
assumes the asset will depreciate evenly
over its productive life.
Formula
Example
Thank You