Depreciation

1
 Learning Objectives:
Learning objectives of today’s lecture are to know and understand :
 What is depreciation?
 What are related terms: Depletion, Amortization 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
What is depreciation?
 Depreciation means decrease in
the value of fixed assets due to
their use in business, passage of
time or obsolescence.
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 fair
proportion
a 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?

Amortisation refers to the economic deterioration of

intangible assets like, goodwill, patents, trademark,
copyright etc. It is the practice to write off the intangible
assets over a reasonable period. When a part of an
intangible asset is written off, it is called 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

To ascertain the true and fair profits

To show the asset at its proper value

To make arrangement of funds for replacement

of fixed asset
Ascertaining accurate cost of production

To comply with legal provisions

To avail tax benefits

11
Factors affecting the amount of depreciation
Assessment of depreciation and the amount to be
charged in respect thereof in an accounting period are
usually based on the following three factors:
i. historical cost or other amount substituted for the
historical cost of the depreciable asset when the
asset has been revalued;
ii. expected useful life of the depreciable asset; and
iii. estimated residual value of the depreciable asset.

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:
Straight Line Methods

Written Down Value Method

16
Methods of Providing or Allocating Depreciation

Other Methods:
Sinking Fund Method

Annuity Method

Insurance Policy Method

Revaluation Method – Loose Tools

Depletion Method – Mines, Oil-wells, etc.

Machine Hour Rate 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:
Annual depreciation Cost of Asset  Estimated Scrap Value
 Number of years (Estimated life of
asset)

Rate of depreciation Annual Depreciati on

 Cost of Asset 100

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:
Annual depreciation Cost of Asset  Estimated Scrap
 Number of years (Estimated life of
Value
asset)

Rate of depreciation Annual Depreciati on

 Cost of Asset 100

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.
25000
Depreciation
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

Year Op. WDV Rate of Dep Dep. Clo. WDV

(Rs.) (Rs.)
(Rs.)
1 77,760 11.92% 9,302 68,458
2 68,458 11.92% 9,302 59,156
3 59,156 11.92% 9,302 49,854
4 49,854 11.92% 9,302 40,552
5 40,552 11.92% 9,302 31,250

25
Demerits of Straight Line Method of Depreciation
Unequal charge against income. Total charge on account
of using fixed assets comprises depreciation plus repairing
charges. Under SLM, depreciation charged is fixed but
repairing charges go on increasing year by year. Thus total
charge against income goes on increasing.
 Yea r Depreciation Repairs Total Charge
1 20,000 nil 20,000
2 20,000 1,000 21,000
3 20,000 3,000 23,000
4 20,000 5,000 25,000

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
Unsuitable for long term assets. The assets having long
life, requires several addition and extension from time to
time. This method is not suitable for them. It is also not
suitable for assets having heavy investment.
No provision of funds for replacement. In this method
amount charged as depreciation is not invested outside the
business. It is retained in the business and becomes a part
of working capital. When the asset becomes useless, the
firm has to face the problem of funds for the replacement
of asset as it becomes difficult to withdraw amount from
the working capital.

28
Written Down Value Method of depreciation
Under this method depreciation is charged at a fixed rate
on the opening balance of the asset. This balance is
reduced every year. Thus, the amount of depreciation also
goes on reducing year after year.
Thus, it is clear that under this method value of asset as
well as depreciation charged goes on reducing every year.
Due to this reason this method is also called “Reducing
Instalment Method.” The value of asset left after charging
depreciation is called, written down value. Due to this
reason, this method is called “Written Down Value
Method.”
The rate of depreciation charged under this method is
higher than that charged in straight line method.

29
Calculation of rate of depreciation under WDV method


R= {1 - 𝑛 𝑆
𝐶

}
R = Rate of Depreciation
N*100
= 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 - 𝑛 𝑆
𝐶

}
R = Rate of Depreciation
N*100
= useful life of the asset = 5
years
S = Scrap value of the asset =
31,250
R = {1 - }*100 =
C = Cost 6 of the asset = 77,760
16.67%
5

31
Calculation of Depreciation and WDV

Year Op. WDV Rate of Dep. Clo. WDV

(Rs.) Dep (Rs.) (Rs.)
1 77,760 16.67% 12,960 64,800
2 64,800 16.67% 10,800 54,000
3 54,000 16.67% 9,000 45,000
4 45,000 16.67% 7,500 37,500
5 37,500 16.67% 6,250 31,250

32
Merits of Written Down Value Method of depreciation
Simple. Calculation of depreciation is very simple as the
depreciation is charged every year on the opening balance
of the asset. Depreciation on additional assets purchased
during the year is calculated separately. There is no need to
remember original cost of the assets.
Equal charge against income. Under this method
depreciation charged is reduced every year, while repairing
charges are increased. Thus, the charge
total income remains the same, more or against
less.
No undue pressure in later years.
Approved by taxation authorities.
33
Example: Based on the example with assumed
repairs and maintenance charges
Straight Line Method WDV Method

Year Dep Repairs Tota Dep Repairs Tota

l l
charge charge
1 9,302 0 9,302 12,960 - 12,960

2 9,302 1,100 10,402 10,800 1,100 11,900

3 9,302 2,300 11,602 9,000 2,300 11,300

4 9,302 3,800 13,102 7,500 3,800 11,300

5 9,302 5,500 14,802 6,250 5,500 11,750

34
Demerits of WDV Method of Depreciation
Difficulty in determining the rate of depreciation. It is
very difficult to calculate a rate of depreciation which will
depreciate the asset completely. Even if an asset becomes
obsolete and useless, the books shows some balance.
Interest factor ignored. Like, the fixed instalment
method, interest factor is ignored in diminishing balance
method also.
No provision of funds for replacement. Like the fixed
instalment method, the amount charged as depreciation is
not invested outside the business. It creates problem, while
replacing the asset, when it becomes useless.

35
Demerits of WDV Method of Depreciation
Asset can not be completely written off. Under
diminishing balance the value of asset is not completely
written off. The asset account continues in the books, may
be a very small amount, even after the asset becomes
obsolete and useless.
No information about original cost and accumulated
depreciation. Under this method the asset account shows
the reduced balance after charging depreciation. Assets are
grouped on the basis of rate of depreciation and it becomes
difficult to know the original cost and accumulated
depreciation on any specific fixed asset.

36