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 FINANCIAL ACCOUNTING 2

METHODS OF
DEPRECIATION
METHODS OF DEPRECIATION

LEARNING OBJECTIVES:
1. Understand the concept of
depreciation.
2. Identify the specific causes of
depreciation.
3. Identify the factors involved in
determining depreciation.
4. Know the different methods of
depreciation.
METHODS OF DEPRECIATION

LEARNING OBJECTIVES:
5. Compute depreciation under
the different methods.
6. Compute for the book value
of the depreciable asset under
each method.
 What is depreciation?

• The systematic allocation of

the depreciable amount of an
asset over its useful life.
• A process of cost allocation
• The objective is to have each
period benefiting from the use
of the asset bear an equitable
share of the asset cost.
 Depreciation Period

• Depreciation begins when an

asset is available for use
• Meaning, in the condition and
location intended by
management
• Depreciation ceases when the
asset is derecognized
• Depreciation does not cease
when the asset becomes
temporarily idle.
 APPLICATION OF MATCHING PRINCIPLE

• Systematic & Rational

Allocation
– Expenses are recognized on
the basis of systematic and
rational procedures when
costs are expected to benefit
of several accounting periods.
 Kinds of Depreciation

• Physical Depreciation
– Related to the depreciable
asset’s wear and tear
• Functional Depreciation
– Arises from inadequacy,
supersession, and
obsolescence
 Kinds of Depreciation

• Physical Depreciation
– Wear & tear due to frequent
use
– Passage of time due to nonuse
– Action of the elements
– Casualty or accident
– Disease or decay (animal and
wooden buildings)
 Kinds of Depreciation

• Functional Depreciation
– Inadequacy
– Obsolescence
– Supersession
 FACTORS OF DEPRECIATION

1. the cost of the asset;

2. The life of the asset;
3. the expected residual value of
the asset;
4. and, by the method of
depreciation selected for
amortisation of the asset which
must be systematic and
rational.
 COST OF THE ASSET

• Cost of asset means the basic

acquisition cost of the asset
plus all incidental expenses
which are required to the asset
into use.
• The incidental expenses like
freight, import duty, Brokerage,
legal expenses and installation
charges are also form a part of
cost of asset.
 USEFUL LIFE

• The useful life of an asset is the period

of time during which the firm expects to
use the asset for earning revenue, or
• The number of production or similar
units expected to be obtained from the
asset by the entity.
• It is not an easy task to estimate an
accurate life of the asset.
• The useful service life of an asset may
come to an end whether as a result of
physical causes or as a result of
changing economic significance or both
 USEFUL LIFE IS EXPRESSED AS:

• Time periods as in years

• Units or output or
production
• Service hours or working
hours
 FACTORS IN DETERMINING USEFUL LIFE

• Expected usage of the asset

• Expected physical wear and
tear
• Technical or commercial
obsolescence
• Legal limits
 Service life vs. Physical life

• Service life
– The period of time an asset
shall be used by an entity in
generating revenue
– Equivalent to useful or
economic life
• Physical life
– Refers to how long the asset
shall last
 SALVAGE or RESIDUAL VALUE

• Salvage value of an asset

refers to the amount that can
be expected to realise from
disposal of the asset at the
ends of its useful life
 When to start depreciating?

• Depreciation starts when the

asset is available for use in
the manner intended by
management
• Each significant part of the
asset is depreciated
separately
– Example: the engines and
airframe of an aircraft are
depreciated separately.
 When to stop depreciating?

• Depreciation stops when the

asset is:
– Derecognized (sold or dispose of)
– Classified as held for sale
– Fully depreciated (carrying
amount is equal to zero or equal
to its salvage value)
**Depreciation does NOT CEASE
when the asset becomes idle or
is retired from active use.
 RECORDING DEPRECIATION

At the end of the period:

Depreciation xxxx
Accu. Depreciation xxxx
 STATEMENT PRESENTATION

Income Statement:
Depreciation xxxx

Balance Sheet:
Cost xxxx
Less: Accu.Depreciation xxxx
Book value xxxx
 DEPRECIATION METHODS

• PAS 16 does not prescribe any

specific method.
• The choice of depreciation
method depends on
management's judgment.
• PAS 16 requires to choose the
depreciation method that best
reflects the pattern in which the
future economic benefits from
the asset are expected to be
consumed by the entity.
 DEPRECIATION METHODS

• PAS 16, prohibits the use of depreciation

method that is based on revenue
because revenue generally reflects
factors other than the consumption of
the economic benefits of the asset.
• The depreciation method shall be
reviewed at least every year-end.
• The method shall be changed if there is a
significant change in the expected
pattern of future economic benefits.
• Any change is accounted for as a change
in estimate (prospectively).
 Uniform or Constant Charge Method

• This method is based on the

assumption that depreciation
is a function of time and the
service potential is assumed
to decline by an equal
amount in each period.
 Uniform or Constant Charge Method

• Straight line method

• Composite method
• Group method
 Variable Charge Method

• It is based on the assumption that

depreciation is a variable charge
rather than a fixed cost.
• Under this method, it is assumed that
the value of an asset declines as a
function of use rather than through
the passage of time.
• Assets depreciate more rapidly if they
are used full time or overtime.
• There is a direct relationship between
utilization of assets and realization of
revenue.
 Variable Charge Method

• Service hours method

• Production output method
 STRAIGHT LINE METHOD

• Under this method, an equal amount

is provided each year for depreciation
of each asset until the asset has been
written down to nil or its scrap value at
the end of the estimated life of the
asset'’.
• The name of this method is derived
from the fact that if the successive
annual depreciation over the life of the
asset are plotted on a graph, the result
will be a straight line with a slope
equal to the annual depreciation.
 STRAIGHT LINE METHOD

C-S
D= n
Where:
D = Annual depreciation.
C = Cost of the asset
S = Salvage or scrap value
n = Estimated life of years.
 STRAIGHT LINE METHOD CONCEPTS

a) The asset is expected to render a

uniform service through out its
estimated useful life
b) Annual repairs and maintenance
costs are assumed to remain
constant over its life.
c) The asset is expected to earn an
equal amount of revenue each
year throughout its life.
d) The amount of depreciation is a
function of time only.
 ILLUSTRATIVE PROBLEM

Assume that a machinery

was acquired on January 1,
2020 at a cost of P900,000,
residual value of zero, and
an estimated useful life of 5
years.
 ILLUSTRATIVE PROBLEM

900,000 – 0
D = 5 years
= 180,000

Entry on Dec. 31, 2020:

Depreciation 180,000
Accu. Depreciation180,000
 DEPRECIATION TABLE

End of year Depreciation Accumulated Carrying

Expense Depreciation Amount
900,000
2020 180,000 180,000 720,000
2021 180,000360,000 540,000
2022 180,000540,000 360,000
2023 180,000 720,000 180,000
2024 180,000900,000 -0-
 DEPRECIATION TABLE

**Assume the machinery was acquired on August

1, 2020.
900,000
2020 75,000 75,000 825,000
2021 180,000255,000 645,000
2022 180,000435,000 465,000
2023 180,000 615,000 285,000
2024 180,000795,000 105,000
2025 105,000900,000 -0-
 PLEASE ANSWER FOR 15 MINS.!!!

Bitter Company acquired a

machinery on April 1, 2019:

Cost 1,200,000
Residual value 120,000
Estimated useful life 8 yrs.
Required:
Prepare the depreciation table.
 ANNUAL DEPRECIATION

1,200,000 – 120,000
Depreciation = 8 yrs.
= 135,000

2019:
P135,000 x 9/12 = P101,250
 DEPRECIATION TABLE

1,200,000
2019 101,250101,250 1,098,750
2020 135,000 236,250 963,750
2021 135,000371,250 828,750
2022 135,000506,250 693,750
2023 135,000 641,250 558,750
 GROUP & COMPOSITE METHOD

• Treats a collection of assets as a single

account
• Group – similar assets
– All assets that are similar in nature
and in estimated useful life are
grouped and treated as a single unit
• Composite – dissimilar assets
– 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.
 GROUP & COMPOSITE METHOD

• Depreciation is accumulated
in a single account
• Depreciation rate is based on
the average life of the asset
• Annual Depreciation is DR x
cost of all assets in the group
Depreciation = DR x Cost
*DR = depreciation rate
 GROUP METHOD

Given:
Total cost P540,000
60 machines
Useful life – 4 years

Cost per machine = P540,000 /60

= P9,000/machine
DR = 100%/4 yrs.
=25 %
 GROUP METHOD

Depreciation = DR x Cost
= 25% x P540,000
= P135,000
 DEPRECIATION RATE

GROUP METHOD:
GR = 100%/AUL
*GR = group rate
*AUL = average estimated useful life

COMPOSITE METHOD:
CR = TAD/TC
*CR= composite rate
*TAD = total annual depreciation
*TC = total cost

Depreciation = Cost x GR (group method)

Depreciation = Cost x CR (composite method)
 GROUP & COMPOSITE METHOD

• To get the depreciation for

the year, the depreciation
rate is multiplied by the cost
of all assets in the group
regardless of age.

Depreciation = Cost x GR or
CR
 GROUP & COMPOSITE METHOD

• When an item in the group is

retired, no gain or loss is
recognized.
• To record the retirement, the
accumulated depreciation
account is debited for the cost
minus the salvage proceeds
and the asset account is
credited equal to its cost
 GROUP & COMPOSITE METHOD

• Entry for the retirement:

NO PROCEEDS
Accu. Depreciation xxx
Asset (cost) xxx
WITH PROCEEDS
Cash xxx
Accu. Depreciation xxx
Asset (cost) xxx
 GROUP & COMPOSITE METHOD

• Entry for the retirement:

NO PROCEEDS (2014)
Accu. Depreciation 360,000
Machinery (9,000 x 40) 360,000
 GROUP & COMPOSITE METHOD

2015:
• Depreciation
= 25% x P180,000 (540,000 – 360,000)
= 45,000
• Entry for the retirement:
WITH PROCEEDS (2015)
Cash 30,000
Accu. Depreciation 150,000
Machinery (9,000 x 20) 180,000
 GROUP & COMPOSITE METHOD
Accumulated Depreciation
2012 135,000
2013 135,000
12/31/14 360,000 2014 135,000
360,000 405,000
1/1/15 45,000
2015 105,000
12/31/15 150,000 Total 150,000
 GROUP & COMPOSITE METHOD

• When an asset is replaced by

a similar asset, the
replacement is recorded by
debiting the asset account
and crediting cash or other
appropriate account.
Entry:
Asset xxx
Cash/Accounts Payable xxx
 Variable Charge Method

• Service hours method

Depreciation = DR x actual
hours worked
• Production output method
Depreciation = DR x actual units
produced
 DEPRECIATION RATE

• Service hours
Cost – Salvage value
DRH = Total service hours

• Production output
Cost – Salvage value
DRU = Total production output
 Variable Charge Method

• Service hours
Depreciation = DRH x Actual
hours used during the year

• Production output
Depreciation = DRU x Actual
units produced during the
year
 ILLUSTRATIVE PROBLEM:

Austere Company purchased machinery for

P570,000 on July 1, 2019. Useful life
10 years, residual value of P20,000, production
of 200,000 units, and working hours of 50,000.
The entity used the machinery for 3,000 hours
in 2019 and 5,000 hours in 2020.
The machinery produced 18,000 units in 2019
and 22,000 units in 2020.

Required: Compute for the depreciation expense

and book value for 2019 & 2020 under straight
line, service hours, and production output
method.
 STRAIGHT LINE

570,000
2019 27,500 27,500 542,500
2020 55,000 82,500 487,500
 SERVICE HOURS METHOD

570,000
2019 33,000 33,000 537,000
2020 55,000 88,000 482,000

DRH = 570,000 – 20,000 = P11

50,000 HRS.
 PRODUCTION OUTPUT METHOD

570,000
2019 49,500 49,500 520,500
2020 60,500 110,000 460,000
18,000 x P2.75 = 49,500
22,000 x P2.75 = 60,500

DRU = 570,000 – 20,000 = P2.75

200,000 UNITS
 OPEN FORUM
QUESTIONS????
REACTIONS!!!!!

Conceptual Framework & Acctg. Standards (by: Zeus Vernon B. Millan) 59