CHAPTER 27: Depreciation

Introduction  Omission of depreciation may somehow

impair legal capital
 PPE, except for land, usable for a number of
o When dividends are declared out of
years
earnings before provision of
o After such period the6* assets have
depreciation
relatively little value either for service
or for sale Depreciation Period
 The difference between the original cost and
 Depreciation of an asset begins when it is
the remaining value when it is retired or worn
available for use
out
o When the asset is in location and
o Expense that should be distributed to
condition necessary
the periods where the assets were
 Depreciation ceases when the asset is
used
derecognized
 The portion that is allocated to expense in a
o Depreciation doesn’t cease if the
particular period is referred to be three
asset becomes idle temporarily
different terms:
 still depreciates the assets
a. Depreciation
because its future economic
 PPE
benefits are consumed
b. Depletion
through wear and tear and
 Wasting assets
obsolescence
c. Amortization
 An asset held for sale will no longer be subject
 Intangible assets
to depreciation
 All of them have the same meaning, their only
different lies in the type of asset involved Kinds of Depreciation
(Two kinds of Depreciation)
Concept of Depreciation
Physical Depreciation
 Defined as the systematic allocation of the
depreciable amount of an asset over the  Related to the depreciable asset’s wear and
useful life tear and deterioration over a period
 Not so much a matter of valuation  May be caused by:
 A matter of cost allocation in recognition of o Wear and tear due to frequent use
the exhaustion of the useful life of an item of o Passage of time due to nonuse
PPE o Action of the elements
 The objective of depreciation  Wind
o to have each period benefitting from  Sunshine
the use of the asset bear an equitable  Rain
share of the asset cost  Dust
o Casualty or Accident
Depreciation in the Financial Statements
 Fire
 Depreciation is an expense  Flood
o May be part of COGM or an OpEx  Earthquake
 The depreciation charge for each period shall  Other natural disaster
be recognized as an expense unless such o Disease or decay
included in the CA of another asset  Physical cause is applicable to
 Except for non-exhaustible land, all property animals and wooden buildings
shall be depreciated in a systematic basis  Results to the ultimate retirement of the
o Irrespective of the earnings of the property or termination of the service life of
entity an asset
 Financial statements would be misstated if
depreciation is omitted when the entity has a
loss and recognized when the entity has gain
Functional or economic depreciation
 Arises from:
o Inadequacy
 No longer useful to the entity
because of increase in the
volume of operations
o Supersession
 When a new asset is available
that performs the same
function but more efficiently
and effectively
 Or for more substantially less
cost
o Obsolescence
 Is the catchall for economic or
functional depreciation
 Encompasses inadequacy and
supersession
 Arises when there is no future
demand for the product that
the asset produces
 “An asset becomes obsolete when it is
inadequate or superseded”
Factors of Depreciation
(In order to compute properly depreciation, three factors
are necessary)
Depreciable Amount
 also known as depreciable cost
 is the cost of an asset or other amount
substituted for cost less the residual value
 Each part of an item of PPE with a cost
significant in relation to the total cost of the
item shall be depreciated separately
o Just like the engine, tires, and
airframe of an aircraft
 Entity also depreciates separately the
remainder of an item
o The remainder consists of the parts of
an items that are not individually
significant
Residual Value
 The estimated net amount currently
obtainable if the asset is at the end of the
useful life
 Shall be reviewed at least at each financial
year-end
o If expectation differs from previous
estimate, the change will be
accounted for as a change in
accounting estimate
 In practice, the residual value of an asset is
often insignificant
o Making it immaterial in the
calculation of depreciable amount
 May increase greater or equal to the Carrying
Amount
o If it does, the depreciation charge is 0
o Unless the residual value
subsequently decreases to an amount
below the carrying amount
 Depreciation is recognized even if FV is
greater than CA
o As long as the residual value does not
exceed the CA
Useful Life
 Can be the period over which an asset is
expected to be available for use by the entity
 Can be the number of production or similar
units expected to be obtained from the asset
 The useful life of an asset is expressed as:
o Time periods as in years
o Units of output or production
o Service hours or working hours
Factors in Determining Useful Life
 Expected Usage of the Asset
o Usage is assessed by reference to the
asset’s expected capacity or physical
output
 Expected Physical Wear and Tear
o Depends on the operational factors
 Shifts the asset is used
 The repair and maintenance
program
 The care and maintenance of
the asset while idle
 Technical or commercial obsolescence
o Arises from changes and
improvements in production
o Also, by changes in market demand
for the product output
 Legal Limits for the use of the asset
o Expiry date of the related lease
Difference of Service Life and Physical Life
 Service Life
o Period of time that the asset will be
used
o Equivalent of useful life
 Physical Life
 o Refers to how long the asset will last 1
¿
life of asset ∈ years
Depreciation Method
Rationale for Straight line
 Shall reflect the pattern in which the future
economic benefits from the asset are  adopted when the principal of depreciation is
expected to be consumed by the entity passage of time
 Shall be reviewed at least at every year-end  considers depreciation as a function of time
o Such change will be applied if there is rather than as a function of usage
a significant change in the expected  Although use and obsolescence contribute to
pattern of the future economic depreciation, such causes are insignificant
benefits  Straight line method is widely used in practice
o Such change will be accounted for as because of its simplicity
change in accounting estimate  Adjusting entry for depreciation is prepared at
the end of every accounting period
Methods of Depreciation
 Carrying amount is the cost of an asset
1. Equal or Uniform Charge Methods recognized in the balance sheet after
a. Straight line deducting any accumulated depreciation and
b. Composite method accumulated losses
c. Group method
Composite and Group Method
2. Variable charge or use-factor or activity
methods  Large entities own various individual
a. Working hour or service hours depreciable assets
b. Output or production method o Applying unit depreciation would be
3. Decreasing charge or accelerated or time consuming and costly
diminishing balance methods o Unit Depreciation
a. Sum of Years’ digits  Making detailed depreciation
b. Declining Balance method computation for each
c. Double declining balance individual asset
4. Other Methods  That’s why entities find it more practical to
a. Inventory or Appraisal treat these individual assets as if they were a
b. Retirement Method single asset
c. Replacement Method  Two methods that treat individual assets as a
single asset are:
Straight Line Method
o Group Method
 Calculated by allocating the depreciable  All assets are similar in nature
amount equally over the number of years of an in estimated useful life are
estimated useful life grouped and treated as a
 Constant charge over the useful life of the single unit
asset o Composite method
 Formula:  Assets that are:
 dissimilar in nature
Depreciable Amount
Annual Dep.=  assets that have
Useful life ∈ years
different physical
 Depreciable Amount = Cost – Residual Value characteristics
 vary widely in useful
Straight Line Rate
life
 Another Formula in getting annual  “are grouped and treated as a
depreciation: single unit”
 The accounting procedure and the method of
Annual Dep.=Dep. Amount × Straightline rate computation for the composite and group
 Straight line Rate Formula: method are essentially the same
  The average useful life and the composite or
group rate are computed
o Assets are depreciated on this basis
Accounting Procedure for Group and Composite
Method
 Depreciation is reported in a single
accumulated depreciation account
o Thus, it is not related to any specific
asset amount
 Getting Periodic Depreciation
P eriodic Dep .=Comp .∨Grp rate× TC of assets
 When the asset in the group is retired, no
gain or loss is reported
o The asset account is credited for the
cost of the asset retired
o The accumulated depreciation
account is debited for the
cost – salvage proceeds
 When the asset retired is replaced by a similar
asset, the replacement is recorded by
debiting the asset account and crediting cash
or other appropriate account
In solving for Composite Method:
 Composite Life
Total depreciable amount
¿ ¿
total Annual depreciation
 Composite Rate
total annual depreciation
¿ or output
total cost
 Depreciation will be discontinued when
carrying amount of the group becomes lower
than the residual value
o As a result of replacement
Variable charge or Activity Methods
 Assumes that depreciation is more of a
function of use rather than a function of time
 Useful life of the asset is considered in terms
of:
o Output or production method
 the output it produces
o Working hours method
 the number of hours it works
 The depreciation is related to the estimated
production capability of the asset
o Expressed in a rate per unit of output
or per hour of use
Rationale for variable depreciation
 Variable methods are adopted if the principal
cause of depreciation is usage
 The use of these methods is based on the
thoughts that:
o Assets depreciate more rapidly if they
are used full time or overtime
o There is a direct relationship between:
 Utilization of assets
 Realization of revenue
 “If assets are used more
intensively in production
greater revenue is expected”
 Variable methods are found to be appropriate
for assets such as machineries
 The major objection
o Is that the units of output or service
hours may be difficult to estimate
Working Hours method
 Depreciation Rate per hour
depreciable amount
estimated useful life∈terms of working hrs
Output or Production method
 Results in a charge based on the expected use
 Depreciation rate per unit
depreciable amount
¿
estimated useful life∈terms of units ∈output
Decreasing charge or Accelerated Methods
 Provide higher depreciation in the earlier
years and lower depreciation in the later years
of the useful life of an asset
 Resulting in a decreasing depreciation charge
over the useful life
Rationale for accelerated depreciation
 is on the philosophy that new assets are
generally capable of producing more revenue
in the earlier years than in the later years
 the cost of using an asset includes not only
depreciation but also repairs on such asset
 o Such repair costs should be allocated over
the useful life of the asset on a systematic
and uniform basis
 Repairs increases with the age of the asset
 Decreasing charge method would result in a
uniform charge (decreasing charge and
increasing repairs)
Sum of Years’ digits
 Provides for depreciation that is computed by
multiplying the depreciable amount by a
series of fractions
digit ∈theuseful life of the asset
∑ of the digits∈the useful life of the asset
 Easy calculation of the sum of the years’ digit
(SYD)
SYD=Life ( Life+1
2 )
Declining Balance Method
 Under this method, a fixed or uniform rate is
multiplied by the declining carrying amount of
the asset to arrive at the annual dep.
 Also known as:
o Fixed rate on diminishing carrying
amount method
Formula for fixed rate
Rate=1− √residual life ÷ cost
n o No depreciation is recorded until the
 Through the formula it is understandable that
the value of the asset can’t be reduced to a 0
 The formula has also no use if there is no
residual value
 In the absence of a residual value, a nominal
amount of P1 should be assumed
 Not used extensively in practice because the
calculations are complex
Double Declining balance Method
 The common application of the declining
balance method is the double declining
balance
 Same procedure as Declining balance method
 However, the formula of single-line method is
followed then its rate is doubled
 Also known as “200% declining balance
method”
 There is also “150% declining balance”
Other Methods
Inventory Methods
 Consists of merely estimating the value of the
asset at the end of the period
 Depreciation for the year
Balance of theasset account
¿
Valueat the end of the year
 In recording depreciation, no accumulated
depreciation is maintained
o It is credited immediately to the asset
account
 Applied generally to assets that are small and
generally inexpensive like hand tools
o Defended on practical grounds
 Major Objection
o Not systematic
o No set formula
o A great deal of subjectivity is often
encountered in the determination of
the value of the asset at the end of
the year
Retirement and Replacement Method
 Retirement Method
o No depreciation is recorded until the
asset is retired
¿ Original cost of the asset retired −salvage proceeds
 Replacement method
asset is retired and replaced
¿ Replacement cost of the asset retired −salvage proceeds
 May be used in the same situations as the
inventory method
 Such methods are suitable when a large
number of similar items are employed and are
constantly retired and replaced
 Frequently used by public utility entities that
have large number of virtually identical items
o Installed, retired and replaced such as
 Poles
 Lines
 Meters