Depreciation

▪ 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.

▪ Characteristics
▪ It is the decrease in the value of the asset.
▪ Depreciation word is used for the decrease in the value of
tangible fixed asset.
▪ Value decreases gradually due to charge of depreciation.
 Applicability
• This Statement applies to all depreciable assets, except
:—
• (i) forests, plantations;
• (ii) wasting assets, Minerals and Natural Gas;
• (iii) expenditure on research and development;
• (iv) goodwill;
• (v) live stock – Cattle, Animal Husbandry.

• This statement also does not apply to land unless it has a

limited useful life for the enterprise.
 Causes of Depreciation
 By constant use
 Effect of time
 By expiry of legal rights
 Accident
 Human mistake
 Obsolescence
 Fall in prices
 Depletion
 Depreciation Accounting
➢ To ascertain the true & fair profit or loss of the
organisation

➢ To reveal the true & fair financial position of the

organisation

➢ To provide funds for replacement

➢ To compute the correct tax liability

Contd…
 The term Depreciation is used broadly in the following 2 senses:
1. ECONOMIC DEPRECIATION: It is economic loss due to
both physical deterioration and technological obsolescence. It
may be…
 PHYSICAL DEPRECIATION
 FUNCTIONAL DEPRECIATION
2. ACCOUNTING DEPRECIATION: It is a systematic
allocation of cost basis over a period of time. It may be…
 BOOK DEPRECIATION
 TAX DEPRECIATION
 Depreciation Expense Factors

Factor #2
Initial Cost - Residual Value = Depreciable Cost
Factor #1

Useful Life

Periodic Depreciation Expense

Factor#4: Method of
determining the amount
of Depreciation
 Depreciable Amount or Cost
 Initial cost minus resale value is called the Depreciable amount
and it is this amount that has to be allocated as depreciation
over the estimated life of an asset.

 Depreciable Amount of a depreciable asset is its historical cost,

or other amount substituted for historical cost in the financial
statements, less the estimated residual value.

 This amount is also known as DEPRECIATION BASE.

 Methods of Depreciation
⚫ The following four depreciation methods are acceptable for
Financial Accounting purposes:
1. Straight-Line
2. Declining-Balance
3. Sum-of-Years-Digits
4. Units-of-Production

Declining-balance and sum-of-years-digits are known as

Accelerated Depreciation Methods.
 Straight Line Method (SLM)
 The Straight-Line-Method provides for the same amount of
depreciation expense for each year of useful life.
 It views a fixed asset as providing its services in a level
stream, that is, service provided is equal in each year of the
asset’s life.
 Rate is reciprocal of estimate service life
 It charges an expense, an equal fraction of net cost of assets
each year.
 Straight-Line Method

Cost – estimated residual value

Estimated life
= Annual depreciation
 Example

Original Cost.....………….. Rs.24,000

Estimated Life in years….. 5 years
Estimated Residual Value... Rs.2,000
 Straight-Line Method

Rs. 24,000 – Rs. 2,000

5 years
= Rs. 4,400 annual
depreciation
SLM – Depreciation Amount and Book Value
For example, an equipment worth $1m with an estimated life
of five years and salvage value of $100,000 would have the
following depreciation schedule and asset value after each year
as shown below.
 Straight-Line Method
The straight-line method is widely used
by firms because it is simple and it
provides a reasonable transfer of cost to
periodic expenses if the asset is used
about the same from period to period.
 ACCELERATED METHOD
 This method allows companies to write off more of
their assets in the earlier years and less in the later
years.

 The biggest benefit of this method is the tax benefit.

 By writing off more assets against revenue, companies

report lower income and thus pay less tax.
Contd…
 Stream of benefits provided by a fixed asset may not be
level. Rather the benefits provided maybe great in first
year of assets life and least in last year.
 This is because the assets mechanical efficiency tends
to decline with age, because maintenance cost
increases with age.
 Thus earlier periods would benefit more than later
period and depreciation method will reflect this.
 Two Types
 1. Double declining balance method
 2. Sum-of-the-years digit

In both these methods, we write off approx. 2/3rd of

assets cost in first half of its estimated life.
 Double declining Balance
Method
 This is where the depreciation expense doubles the
straight line depreciation expense of the first year. The
same percentage is then applied to the non
depreciated amount in the subsequent years.

 Here each year depreciation is found by applying rate

to the net book value of the asset as of the beginning
of that year.
Contd…
 This is stated % of straight line rate. Thus for an asset
with a useful life of 10 years, Straight line rate = 10%
 200% declining balance would use a rate of 20%.
Similarly 150 % declining balance would use a rate of
15%.
 The 200% declining balance method is called Double
declining balance method because the deprecation
rate is double the straight line rate.
 DDB in year 1 = 2/n * (Total Acquisition Cost –
Accumulated Depreciation)
where n = number of years

 DDB in year 2 and beyond = 2/n * (Asset Value on

Balance Sheet)
 Sum-of-years-digits
 Here the number 1,2,3,4….n are added where
N= estimated years of useful life

Sum = n(n+1) / 2
For n=10,
SYD = 55
 Depreciation rate each year is fraction where
denominator is the sum of these digits and numerator
for the first year is N, second year is (N-1), then (N-2)
and so on.

 That is, 10/55, 9/55, 8/55 and so on….

 Straight Line v/s Accelerated
Depreciation
 Assume company XYZ is just starting out as a business
and they bought several new computers for their staff.
The purchase value of the computers is $10,000
 Computers do not have a long useful life, but five years
is realistic and adequate. So, n=5
 Computers also deteriorate in value much quicker in
the first year than the later years so an accelerated
depreciation method is more than satisfactory. At then
end of five years, computers are generally worthless so
the salvage value will be $0.
Contd…
 One of the benefits to accelerated depreciation is the
reduction of taxes, but another point of great benefit is
if the equipment requires maintenance.

 Accelerated depreciation will offset the increasing

maintenance cost and essentially equalizes the
combined charges of both maintenance and
depreciation.
The graph below is a simplified view of how the
accelerated depreciation and maintenance cost works
out to give a straight line total expense
If the straight line method was used, the depreciation would be
constant and the maintenance cost would increase which would
increase the total expenses.
To see this side by side, we get the following table using
the same assumptions as before but with the added
maintenance expenses.
 At the beginning of the life, the accelerated method
obviously costs more but towards the later stages of
the useful life, the expenses become much less.

 In the example with maintenance cost included, just

after one year, the depreciation expense is already close
to equal to the straight line method. By year three, the
expense is much less compared to the straight line
method, and so more revenue can be recognized
without any improvements in business.
 The straight line method on the other hand does not
alter the performance of the business. It can be seen as
a revenue smoothing method.
 Depreciation Red Flags
 For the investing part of depreciation, it depends on
the type of company. If you are looking at a rapid tech
company where assets lose most of the value within
the first year, needs to be replaced regularly, and costs
a lot to maintain, the accelerated method is the right
choice.
 This brings us to the big red flag related to
depreciation.
 By depreciating assets too slowly, the company is using
aggressive accounting. Sounds contradictory, but the
result is that earnings are being manipulated by being
artificially inflated.
 This is true for amortization and writing off any other
asset such as impaired assets and/or obsolete
inventory.
 When you go through the financial statements, check
what type of accounting method is used.
 Then compare it to a competitor and see whether it is
inline with industry standards and suitable for the
business model.
 Units of production method
 In this method, depreciation is charged according to
actual usage of the asset i.e. high depreciation is
charged when there is high activity and less
depreciation is charged when there is low activity.
 Zero depreciation is charged if the system is idle for
the whole period
 This method is similar to Straight line method except
that, life of an asset is estimated in terms of no. of
operations or no. of machine hours instead of no. of
years.
 Ex – A truck cost – 60,000$
 And it provides services for 3,00,000 miles.

 So depreciation value would be charged at the rate of

60,000/ 3,00,000 = 20 cents per mile

So depreciation expense in a year in which the truck

travelled 50,000 miles would be, $10,000.
 Units-of-Production
Method
(Cost – estimated residual value) ×No. of Units Produced
Estimated life in units, hours, etc.

= Depreciation per unit, hour,

etc.
 Example

Original Cost.....………….. Rs.24,000

Estimated Life in hours….. 10,000
Estimated Residual Value... Rs.2,000
 Units-of-Production
Method
Rs.24,000 – Rs.2,000
10,000 hours
= Depreciation per
= Rs.2.20 unit,
per hourhour, et
 Units-of-Production
The units-of-production
method is more appropriate
than the straight-line method
when the amount of use of a
fixed asset varies from year to
year.
 Physical Depreciation …
 Physical Depreciation occurs from
wear and tear while in use and from
the action of the weather and
environmental conditions.
 Functional Depreciation
 Functional Depreciation occurs when a fixed
asset is longer able to provide services at the
level for which it was intended, e.g., personal
computer; that is to say, when an asset life is
mentioned in terms of its usage, then we have a
concept of Functional Depreciation.
 Book Depreciation
 Book Depreciation is provided as per the prevailing

accounting standards and the necessary law of land.

 Tax Depreciation
 Tax Depreciation is provided as per the prevailing

taxation laws.
 Minimum Depreciation
 The Department of Company Affairs has clarified that the
rates contained in Schedule XIV to the Company Act, 1956
should be viewed as the minimum rates, and, therefore,
company cannot charge depreciation at rates lower than
specified in the Schedule in relation to the assets. However, if
on technical evaluation, higher rate of depreciation are
justified, the higher rates should be applied.

 Where rates other than Schedule XIV rates are applied,

Appropriate disclosers in the notes to the accounts would be
required
 Depreciation on Items Below Rs.
5000
 As per Schedule XIV of the Companies Act, individual
items of fixed assets below Rs. 5000/- should be
depreciated at 100%. For Exp,
 An item of furniture such as a chair or table is
capable of being used independently, therefore each
chair or table will have to be provided 100%
depreciation if its individual value does not exceed
Rs. 5000. The 100% provision cannot be avoided by
arguing that the furniture can be used only as a set,
i.e. a set of chairs, which in aggregate cost more
than Rs. 5000.
In case of Plant and Machinery:
Where the aggregate actual cost of individual items of
plant and machinery costing Rs. 5000 or less
constitutes more than 10% of total actual cost of plant
and machinery, normal Schedule XIV rates should be
used. (Note number 8 of Schedule XIV of the
Companied Act, 1956)

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 Query
 Info ltd. Has acquired on a 999 year lease a huge
piece of land for Rs. 999 lakhs from the
Government. The land along with any
construction thereon will revert to the
Government after 999 years. Since the said period
is very long and is akin to owning the land, Info
Ltd does not wish to amortize the consideration.
Is that acceptable under Indian GAAP.

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 Response
 AS- 19 “ Leases ” does not apply to lease
agreement to use lands. AS 6 ‘ Depreciation
Accounting”, does not apply to land unless it has
a limited useful life for the enterprise. In other
words, if the life of land is limited than AS 6 would
apply. In the given case, 999 years though very
long is still limited. Therefore, AS 6 would apply.
Therefore each year Info Ltd will have to charge
Rs. 1 lakh to the income statement as
amortization expenses.

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 Part-II
BREAK EVEN ANALYSIS

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Break Even Analysis is the study of cost-volume of
production profit (CVP) relationship.
Profit mainly depends upon three factors-
•Cost of production
•Amount of input
•Sales revenue
Cost of production is sum of two costs: variable cost and fixed
cost.
Fixed cost are assumed to be constant at all levels of output.
e.g. Expenditure on permanent labours and overheads
(Administrative cost).
Variable cost increases with the increase of output of
production i.e. (material cost , inventory cost etc.)

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One of the technique to study the total cost , total revenue
and output relationship is known as Break Even Analysis.
Hence, Break Even Analysis is the study of cost, volume of
production and profit relationship.
It is an analysis to study the point where neither profit nor
loss is occurred. This pint is known as Break Even Point.
This break Even Analysis can be done in two ways:
1.Algebraic method
2.Graphical method
But, usually a Break Even Analysis is done graphically.

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 Importance of Break Even Analysis
It helps in solving the following types of
problems:
• What volume of sales will be necessary to
cover a reasonable return on capital Investment
• Computing costs and revenues for all possible
volumes of output.
• To find the price of an article to give the
desired profit.
• To determine the variable cost per unit.

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 ASSUMPTIONS IN BREAK EVEN ANALYSIS
1. The total cost of production is comprised of fixed cost and
variable cost.
2. Fixed cost remains constant i.e. it is independent of the
quantity produced , it includes salaries , rent of buildings,
depreciation of plants and equipment's etc.
3. Variable cost is directly proportional to the volume of
production.
4. Selling price doesn’t change with the volume of change.
5. Total sales income is PX Q where, P is selling price and Q
is the quantity produced.

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 Break Even Chart
It was invented by Walter Rautenstrauch , an
Industrial Engineer and professor of Columbia
University in 1930.
It is a graphical representation of relationship between
various costs and sales revenue at a given time. It
determines the Break Even Point.

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Functions of Break Even Chart
•It is an aid to management and it depicts a
clearer view of the status of the business.
•It is a graphic representation of the economic
position of the business.
•It shows the profits and losses at various
output level.
•It shows the relationship between Marginal
Cost and fixed Cost.
•It indicates No profit, No loss situation and
margin of safety.
•It can help by making specific plans to effect
profit through the control of expenses.
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• Volume of production , number of units produced is plotted
along the x-axis (Horizontal axis).
• The fixed cost is represented by straight line parallel to the
horizontal axis.
• The cost and sales income (sales revenue) are plotted along
y- axis(vertical axis).
• The sales income line passes through the origin.
• The point of intersection of sales income line and the total
cost line represent the break even point.
• Shaded area between the total cost line and sales income/
revenue line on the left hand side of BEP indicates loss and
the right hand side of the BEP indicates profit.
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Margin of Safety: It is the distance between the BEP and the
output being produced at a particle variable cost line. If
this distance is large,the profit will be large even there is a drop
in production and vice-versa.

Angle of Incidence( θ): This is the angle at which sales

revenue cuts the total cost line. A larger θ indicates more
profit at a higher rate. A larger angle of Incidence at a high
margin of safety marks the extremely favorable business
position.
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Profit Volume Ratio(P/V): It measure the profitability
in relation to sales. It determines the BEP. Can be
increased by increasing the sales price and reducing
the variable cost.

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Effect of an increase in fixed costs
An increase in fixed cost possibly due to the purchase of new
machines increases the total costs and thus shifts BEP towards
Right Hand Side(RHS). This causes the decrease in profit for
the same output and vice-versa.

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Effect of an increase invariable costs
An increase in variable cost and therefore in the total cost
possibly due to increase in labour cost would shift the BEP
towards Right Hand Side(RHS). This causes the decrease in
profit for the same output and vice-versa.

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Effect of an increase in Sales revenue
If the price of an item (goods) increase a new sales revenue will be
drawn with a greater slopes .This will shift the BEP towards Left Hand
Side(LHS). This causes the increase in profit for the same output and
vice-versa.

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Example: The fixed cost for the year 2019 are Rs. 80000.
The estimated sales for the period are valued at Rs.
200000. The variable cost per unit for the single product
made is Rs. 4. if each unit sales at Rs. 20 and the number
of units involved coincides with the expected volume of
output , construct the Break Even Chart.
1.Determine the Break Even Point
2.Above how many units the company should produce in
order to seek profit.
3.Determine the profit earned at a turn of Rs. 160000
4.Find the Margin of Safety.
5.Measure the angle of Incidence.
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• Sales revenue is zero at 0 units and it is 200000 at 10000units.
Therefore draw the sales revenue line OD.

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Thank You

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