Professional Documents
Culture Documents
M. C. Sharma: Department of Commerce Shaheed Bhagat Singh Evening College (University of Delhi) Delhi
M. C. Sharma: Department of Commerce Shaheed Bhagat Singh Evening College (University of Delhi) Delhi
Sharma
Associate Professor
Department of Commerce
Shaheed Bhagat Singh Evening College
(University of Delhi)
Delhi
1
Learning Objectives:
Learning objectives of today’s lecture are to know and
understand :
What is depreciation?
What are related terms: Depletion, Amortisation and
Obsolescence?
What are the causes of Depreciation?
What are the objectives of charging depreciation?
What are the factors affecting the amount of depreciation?
What are the relevant accounting principles?
Methods of providing or allocation depreciation
2
What is depreciation?
Depreciation means decrease in the value of fixed
assets due to their use in business, passage of time or
obsolescence.
3
Depreciation as per AS 6
Depreciation is a measure of the wearing out,
consumption or other loss of value of a depreciable
asset arising from use, effluxion of time or
obsolescence through technology and market changes.
Depreciation is allocated so as to charge a fair
proportion of the depreciable amount in each
accounting period during the expected useful life of
the asset.
Depreciation includes amortisation of assets whose
useful life is predetermined.
4
Depreciable Asset
Depreciable assets are assets which
i. are expected to be used during more than one
accounting period; and
ii. have a limited useful life; and
iii. are held by an enterprise for use in the production or
supply of goods and services, for rental to others, or
for administrative purposes and not for the purpose
of sale in the ordinary course of business.
5
What is depletion?
The term ‘Depletion’ refers to the physical deterioration
by the exhaustion of natural resources, like, quarries,
mines, oil-wells, etc. Due to mining or extraction, the
stock of minerals/oil, etc. is depleted/reduced. In case of
such assets, usually depreciation is charged on the basis
of quantity produced.
6
What is amortisation?
7
What is obsolescence?
The term ‘Obsolescence’ refers to the economic
deterioration of assets, due to change in technology,
invention of improved equipment, market decline due
to change in taste and fashion, etc., or inadequacy of
existing plant to meet the increased business.
Depreciation is affected by obsolescence as it
decreases the value of asset.
8
Causes of Depreciation
Wear and tear. Fixed assets are purchased for use in
business. Due to constant use of fixed assets in
business for generating income, the value of such
assets is decreased. It is called ‘wear’ and ‘tear’. It is
main cause of depreciation.
Passage of time. Every asset has a certain economic
useful life. With the passage of time effective life of the
assets goes on decreasing. Certain assets like a lease,
have a certain legal life. With the passage of time,
value of such assets goes down, even may not be
actually used in the business.
9
Causes of Depreciation
Depletion. Depletion is reduction of natural resources. In
case of wasting assets, depletion is also a cause of fall in the
value of assets like, mines, oils wells, quarries, etc.
Obsolescence. Due to invention of new technology, the
assets based on old technology may become obsolete and
out of date.
Accidents. Accidents may also cause a permanent fall in
the useful life as well as in the value of assets.
Permanent fall in price. A permanent fall in the market
value of investments is recorded as depreciation. Other
assets are depreciated on the basis of its useful life.
10
Objectives of Providing Depreciation
12
Historical Cost
Historical cost of a depreciable asset represents its
money outlay or its equivalent in connection with its
acquisition, installation and commissioning as well as
for additions to or improvement thereof.
The historical cost of a depreciable asset may undergo
subsequent changes arising as a result of increase or
decrease in long term liability on account of exchange
fluctuations, price adjustments, changes in duties or
similar factors.
13
The useful life of a depreciable asset
The useful life of a depreciable asset is shorter than its physical
life and is:
i. pre-determined by legal or contractual limits
ii. directly governed by extraction or consumption;
iii. dependent on the extent of use and physical deterioration
on account of wear and tear which again depends on
operational factors, such as, the number of shifts for which
the asset is to be used, repair and maintenance policy of the
enterprise etc.; and
iv. reduced by obsolescence arising from such factors as: (a)
technological changes; (b) improvement in production
methods; (c) change in market demand for the product or
service output of the asset; or (d) legal or other restrictions.
14
Relevant Accounting Principles
Cost Principle
Matching Principle
Going Concern Principle
Consistency: The depreciation method selected should
be applied consistently from period to period.
Disclosure
15
Methods of Providing or Allocating Depreciation
Important Methods:
16
Methods of Providing or Allocating Depreciation
Other Methods:
Sinking Fund Method
Annuity Method
17
Straight Line Method of depreciation
Under this method depreciation is charged by a given
rate of depreciation on the original cost of the asset
every year.
Due to this reason depreciation charged annually
remains fixed and so the method is called ‘Fixed
Instalment Method.
This is also called original cost method as the
depreciation is charged every year on the original cost
of the asset. estimated scrap value of the asset
18
Straight Line Method of depreciation
If rate of depreciation is not given then annual
depreciation and rate of depreciation is calculated by
applying the following formulas:
Cost of Asset Estimated Scrap Value
Annual depreciation
Number of years (Estimated life of asset)
Annual Depreciati on
Rate of depreciation 100
Cost of Asset
19
Straight Line Method of depreciation
If rate of depreciation is not given then annual
depreciation and rate of depreciation is calculated by
applying the following formulas:
Cost of Asset Estimated Scrap Value
Annual depreciation
Number of years (Estimated life of asset)
Annual Depreciati on
Rate of depreciation 100
Cost of Asset
20
Example: A firm purchased a machine for Rs, 1,75,000
and spent installation charges Rs. 45,000. It’s economic
life is 10 years and estimated residual value after 10
years is Rs. 20,000. Charge depreciation by SLM.
2,20,000 −20,000
Annual Depreciation= = 20,000
10
21
Straight Line Method of depreciation
When depreciation charged in various years is put on a
graph, it gives a straight line parallel to OX axis. Due to
this reason this method is called straight line method.
Depreciation
25000
20000
15000
Depreciation
10000
5000
0
0 1 2 3 4 5 6
22
Merits of Straight Line Method of Depreciation
Simple. Every year a fixed amount is charged as depreciation.
Calculation of depreciation is also very simple.
Asset is completely written off. If an asset continues with a
firm for the whole of its useful life and depreciation is provided
by SLM, it will be completely written off. Only scrap value of the
asset, if any, will be left in the asset account.
No window dressing. A fixed amount of depreciation is charged
to the profit and loss account every year. The effect of
depreciation on profit is equal and chances of manipulating
profits are very less.
Knowledge of original cost and total depreciation charged.
23
Calculation of Depreciation and WDV – SLM
Example: Cost of machine – Rs. 77,760, useful life – 5
years, estimated scrap value after 5 years – Rs. 31,250
Charge depreciation by SLM
77,760 −31,250
Annual Depreciation= = 9,302
5
9,302
Rate of Depreciation = 100 = 11.92%
77,760
24
Straight Line Method
Calculation of Depreciation and WDV
25
Demerits of Straight Line Method of Depreciation
26
Demerits of Straight Line Method of Depreciation
Interest factor ignored. When a fixed asset is purchased,
the amount is invested permanently. If the amount would
have been invested outside the firm, the interest would
have been received on it. Thus, the loss of interest is
ignored, while calculating depreciation.
Undue pressure in later years. Under fixed instalment
method, the total charge against the income goes on
increasing year by year, while efficiency of asset goes on
decreasing. Thus, the pressure in later years is unduly high.
Difficult to estimate scrap value
27
Demerits of Straight Line Method of Depreciation
28
Written Down Value Method of depreciation
29
Calculation of rate of depreciation under WDV method
R= {1 - }*100
𝑛 𝑆
𝐶
R = Rate of Depreciation
N = useful life of the asset
S = Scrap value of the asset
C = Cost of the asset
30
Calculation of rate of depreciation under WDV method
R= {1 - }*100
𝑛 𝑆
𝐶
R = Rate of Depreciation
N = useful life of the asset = 5 years
S = Scrap value of the asset = 31,250
C = Cost of the asset = 77,760
5
R = {1 - }*100 = 16.67%
6
31
Calculation of Depreciation and WDV
32
Merits of Written Down Value Method of depreciation
33
Example: Based on the example with assumed
repairs and maintenance charges
Straight Line Method WDV Method
34
Demerits of WDV Method of Depreciation
35
Demerits of WDV Method of Depreciation
36