CONCEPT OF DEPRECIATION

Depreciation is defined as the systematic allocation of the depreciable amount of an asset over the
useful life.
Depreciation is not so much a matter of valuation.
Depreciation is a matter of cost allocation in recognition of the exhaustion of the useful life of an item
of property, plant, and equipment.
The objective of depreciation is to have each period benefiting from the use of the asset bear an
equitable share of the asset cost.

Depreciation in the financial statements

Depreciation is an expense. Depreciation may be a part of the cost of goods manufactured or an
operating expense.
The depreciation charge for each period shall be recognized as expense unless it is included in the
carrying amount of another asset.
Except for nonexhaustible land, all property shall be depreciated on a systematic basis over the useful
life of the asset irrespective of the earnings of the entity.
The financial statements would be misstated if depreciation is omitted when the entity has a loss and
recognized when the entity has a gain.
The omission of depreciation may somehow impair legal capital if and when dividends are declared
out of earnings before provision for depreciation.
Depreciation period
Depreciation of an asset begins when it is available for use or when the asset is in the location and
condition necessary for it to be capable of operating in the manner intended by management.
Depreciation ceases when the asset is derecognized.
Therefore, depreciation does not cease when the asset becomes idle temporarily.
Temporary idle activity does not preclude depreciating the asset as future economic benefits are
consumed not only through usage but also through wear and tear and obsolescence.
PFRS 5, paragraph 25, provides that if the asset is classified as held for sale depreciation shall be
discontinued.
Kinds of depreciation
There are two kinds of depreciation, namely physical depreciation and functional or economic
depreciation.
Physical depreciation is related to the depreciable asset's wear and tear and deterioration over a
period.
Physical depreciation may be caused by:
a. Wear and tear due to frequent use
b. Passage of time due to nonuse
c. Action of the elements such as wind, sunshine, rain or dust
d. Casualty or accident such as fire, flood, earthquake and other natural disaster
e. Disease or decay is a physical cause applicable to animals and wooden buildings.
Accordingly, physical depreciation results to the ultimate retirement of the property or termination of
the service life of the asset.
Functional or economic depreciation arises from inadequacy, supersession and obsolescence.
Inadequacy arises when the asset is no longer useful because of an increase in the volume of
operations.
For example, adequate buildings acquired at the inception of business may become inadequate or
limited in their future service potential when unexpected business growth or expansion requires larger
facilities for efficient operation.
Supersession arises when a new asset becomes available, and the new asset can perform the same
function more efficiently and economically or for substantially less cost.
Obsolescence is the catchall for economic or functional depreciation.
For example, obsolescence arises when there is no future demand for the product which the asset
produces.
Obsolescence encompasses inadequacy and supersession.
An asset becomes obsolete if it is inadequate or superseded.

Factors of depreciation
In order to properly compute the amount of depreciation, three factors are necessary, namely
depreciable amount, residual value and useful life.
Depreciable amount
Depreciable amount or depreciable cost is the cost of an asset or other amount substituted for cost,
less the residual value.
Each part of an item of property, plant and equipment with a cost that is significant in relation to the
total cost of the item shall be depreciated separately.
For example, it may be appropriate to depreciate separately the airframe, engines, fittings, such as
seats and floor coverings and tires of an aircraft.
The entity also depreciates separately the remainder of the item and the remainder consists of the parts
of the item that are individually not significant.
Residual value
Residual value is the estimated net amount currently obtainable if the asset is at the end of the useful
life.
The residual value of an asset shall be reviewed at least at each financial year-end and if expectation
differs from previous estimate, the change shall be accounted for as a change in an accounting
estimate.
 In practice, the residual value of an asset is often insignificant and therefore immaterial in the
calculation of the depreciable amount.
The residual value of an asset may increase to an amount equal to or greater than the carrying amount.
If it does, the depreciation charge is zero unless and until the residual value subsequently decreases to
an amount below the carrying amount.
Depreciation is recognized even if the fair value of the asset exceeds the carrying amount as long as
the residual value does not exceed the carrying amount.
Useful life
Useful life is either the period over which an asset is expected to be available for use or the number of
production units expected to be obtained from the asset.
Accordingly, the useful life of an asset is expressed as:
a. Time periods as in years
b. Units of output or production
C. Service hours or working hours
Factors in determining useful life
a. Expected usage of the asset - Usage is assessed by reference to the asset's expected capacity or
physical output.
b. Expected physical wear and tear depends on the operational factors such as the number of shifts the
asset is used, the repair and maintenance program, and the care and maintenance of the asset while
idle.
c. Technical or commercial obsolescence arises from changes or improvements in production or
change in the market demand for the product output of the asset.
d. Legal limits for the use of the asset, such as the expiry date of the related lease.
Incidentally, the service life of an asset should be distinguished from physical life.
Service life is the period of time an asset shall be used by an entity. The service life is the equivalent
of useful life.
Physical life refers to how long the asset shall last.
Depreciation method
The depreciation method shall reflect the pattern in which the future economic benefits from the asset
are expected to be consumed by the entity.
The depreciation method shall be reviewed at least at every year-end.
The depreciation method shall be changed if there is a significant change in the expected pattern of
future economic benefits.
Such change in depreciation method shall be accounted for as change in accounting estimate.
Methods of depreciation
1. Equal or uniform charge methods
a. Straight line
b. Composite method
c. Group method
2. Variable charge or use-factor or activity methods
a. Working hours or service hours
b. Output or production method
3. Decreasing charge or accelerated or diminishing balance methods
a. Sum of years' digits
b. Declining balance method
c. Double declining balance
4. Other methods
a. Inventory method
b. Retirement method
c. Replacement method
Straight line method
Under the straight line method, the annual depreciation charge is calculated by allocating the
depreciable amount equally over the number of years of estimated useful life.
Otherwise stated, straight line depreciation is a constant charge over the useful life of the asset.
The formula for the computation of the annual depreciation following the straight line method is as
follows:
Annual depreciation = Useful life in years
Cost minus residual value equals depreciable amount
Straight line rate
Depreciable amount multiplied by the straight line rate of depreciation also gives the amount of
annual depreciation.
The straight line rate is determined by dividing 100% by the life of the asset in years.
For example, if the useful life of the asset is 5 years, the annual straight line rate is 20%, computed by
dividing 100% by 5 years.
Rationale for straight line
The straight line method is adopted when the principal cause of depreciation is passage of time.
The straight line approach considers depreciation as a function of time rather than as a function of
usage.
 Examples of assets which depreciate principally because of passage of time are buildings, other
structures such as radio and TV towers, dams, bridges, and office equipment such as typewriters,
adding machines, computers.
Although use and obsolescence contribute to the depreciation of such assets, such causes are
insignificant compared to the effects of time.
The straight line method is widely used in practice because of simplicity.
Composite and group method
Large entities own various individual depreciable assets. For these entities, making detailed
depreciation computation for each individual asset referred to as unit depreciation consuming and
costly. is time
Large entities find it more practical to compute depreciation by treating many individual assets as a
single asset.
The two methods of depreciating various individual assets as a single asset are composite method and
group method.
Under the composite method, assets that are dissimilar in nature or assets that have different physical
characteristics and vary widely in useful life, are grouped and treated as a single unit.
Under the group method all assets that are similar in nature and in estimated useful life are grouped
and treated as a single unit.
The accounting procedure and the method of computation for the composite and group method are
essentially the same.
Accounting procedures
a. Depreciation is reported in a single accumulated depreciation account. Thus, the accumulated
depreciation account is not related to any specific asset account.
b. The composite or group rate is multiplied by the total cost of the assets in the group to get the
periodic depreciation.
c. When an asset in the group is retired, no gain or loss is reported. The asset account is credited for
the cost of the asset retired and the accumulated depreciation account is debited for the cost minus
salvage proceeds.
d. 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.
Subsequently, the composite or group rate is multiplied by th balance of the asset account to get the
periodic depreciation
Variable charge or activity methods
The variable or activity methods assume that depreciation is more a function of use rather than
passage of time.
The useful life of the asset is considered in terms of the output it produces or the number of hours it
works.
Thus, depreciation is related to the estimated production capability of the asset and is expressed in a
rate per unit of output or per hour of use.
There are two variable methods, namely:
a. Working hours, method
b. Output or production method
Rationale for variable depreciation
The variable methods are adopted if the principal cause of depreciation is usage.
The use of these methods is based on the following:
a. Assets depreciate more rapidly if they are used full time or overtime.
b. There is a direct relationship between utilization of assets and realization of revenue.
If assets are used more intensively in production, greater revenue is expected.
The variable methods are found to be appropriate for assets such as machineries,
The major objection to these methods is that the units of output or service hours which serve as the
basis of depreciation may be difficult to estimate.
Output or production method
The output or production method results in a charge based on the expected use or output.
Under this method, a depreciation rate per unit is computed by dividing the depreciable amount by the
estimated useful life in terms of units of output.
Thus, the rate per unit is P4, computed by dividing P600,000 by 150,000 units.
The depreciation rate per unit is then multiplied by the yearly output to get the annual depreciation.

1. Depreciation: Depreciation refers to the decrease in the value of an asset over time due to
wear and tear, obsolescence, or other factors. It's a way of allocating the cost of an asset over
its useful life.
2. Physical and Functional Depreciation:
 Physical Depreciation: This type of depreciation occurs due to wear and tear or
deterioration of the physical components of an asset over time. For example, a
machine might experience physical depreciation through rust, corrosion, or
mechanical breakdowns.
 Functional Depreciation: Functional depreciation happens when an asset becomes
less efficient or effective in performing its intended function over time. This can
occur due to technological advancements, changes in market demand, or the
development of superior alternatives. For instance, a computer may suffer functional
depreciation as newer, faster models are introduced to the market.
3. Straight Line Depreciation: Straight-line depreciation is one of the simplest methods used to
allocate the cost of an asset evenly over its useful life. Under this method, the depreciation
expense is the same for each period, calculated by dividing the cost of the asset by its useful
life. This method assumes that the asset depreciates at a constant rate over time.
4. Composite and Group Method:
  Composite Method: This method is used when a group of similar assets is depreciated
together as a single unit. Instead of depreciating each asset individually, the total cost
of the group is depreciated over their combined useful life. It simplifies the
depreciation process for assets with similar characteristics.
 Group Method: Similar to the composite method, the group method involves
depreciating a group of assets together. However, unlike the composite method where
assets are similar, in the group method, assets may have different useful lives or
depreciation rates. The group method allows for more flexibility in grouping assets
based on factors like usage patterns or maintenance schedules.
5. Working Hours Method: This depreciation method considers the usage of an asset in
determining its depreciation expense. Instead of basing depreciation solely on time, the
working hours method calculates depreciation based on the number of hours the asset is used.
This is particularly useful for assets whose wear and tear are directly related to the hours of
operation, such as machinery or vehicles.
6. Output or Production Method: In this method, depreciation is calculated based on the
output or production of the asset. The depreciation expense is tied to the level of production
achieved by the asset rather than its time in service. Assets that use this method are typically
those whose value diminishes as they produce output, such as manufacturing equipment or
mining machinery.
The effects of depreciation can be seen across various aspects of business operations and financial
transactions:
1. Constructions:
 Financial Reporting: Depreciation impacts financial reporting by reducing the value
of assets on the balance sheet. For constructions, such as buildings or infrastructure,
depreciation accounts for the wear and tear over time, reflecting the decrease in their
value due to factors like aging, usage, and obsolescence.
 Tax Implications: Depreciation is often tax-deductible, allowing businesses to reduce
their taxable income and, consequently, their tax liability. This can be particularly
relevant for construction companies that own or operate buildings, machinery, or
equipment, as depreciation expenses can offset taxable income derived from
construction activities.
2. Exchange:
 Asset Valuation: Depreciation affects the valuation of assets in exchange
transactions. When businesses buy or sell assets, the price negotiated may be
influenced by factors such as the remaining useful life and depreciation of the asset.
Sellers may adjust prices to reflect the depreciation already incurred, while buyers
may consider future depreciation when assessing the asset's value.
 Currency Exchange: In international transactions, currency depreciation can affect
exchange rates and the value of assets held in foreign currencies. Depreciation of
assets denominated in a foreign currency may lead to losses or gains depending on
exchange rate fluctuations, impacting the overall financial position of businesses
engaged in cross-border trade or investments.
3. Government Grant:
 Financial Reporting: Government grants received for assets may have specific
requirements regarding depreciation. Depreciation methods and schedules may need
to comply with grant agreements or regulations set by government authorities.
Businesses must accurately account for government grants and their related
depreciation effects to ensure compliance with reporting standards and regulatory
requirements.
 Impact on Cash Flows: Government grants may affect the timing and amount of
depreciation expenses. Some grants may provide upfront funding for asset acquisition
or development, reducing the initial investment and potentially affecting the
depreciation schedule. Businesses need to consider the impact of government grants
on their cash flows, profitability, and financial performance over time, including any
conditions or restrictions associated with the grants.