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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

Initial Cost
Factor #1

Factor #2

Residual Value

Depreciable Cost
Useful Life

Factor#4: Method of determining the amount of Depreciation

Periodic Depreciation Expense

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 assets 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 unit, hour, et = Rs.2.20 per hour

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 of the

occurs weather

from and

wear and tear while in use and from

the

action

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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T H A N K Y O U !!!
- Kanika Monga (140) - Nishant Sharma (189) - Karan Batheja (190)

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