DEPRECIATIO

N
Introduction
Property,plant and equipment, except land, nor
mally are usable for a number of years after whi
ch the assets have relatively little value either fo
r service or for sale.
The difference between the original cost of a pro
perty and any remaining value when it is retired
or worn out is an expense that should be distrib
uted to the periods during which the asset is us
ed.
The portion that is allocated to expense in a part
icular period is referred to by three different ter
The three terms are similar in meaning. The only difference lies in th
e type of asset involved.

Technically, depreciation refers to property,plant and equipment, dep

letion to wasting assets and amortization to intangible assets.

Concept of Depreciation
Depreciation is defined as the systematic allocation of the deprecia
ble amount of an asset over useful life.

Depreciation is not so much a matter of valuation.

Depreciation is a matter of cost allocation in recognition of the exha

ustion 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. It may be a part of the cost of goods man
ufactured or an operating expense.

The depreciation charge for each period shall be recognized as expe

nse 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 ea
rnings 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 depr
eciation.
Depreciation period
Depreciation of an asset begins when it is available for use, meani
ng, 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 idl
e temporarily.

Temporarily 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, provide 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 a
nd functional or economic depreciation.

Physical depreciation is related to the depreciable asset's wear and

tear and deterioration over a period.

Physical deterioration 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 nat

ural disaster.

e. Disease or decay - This physical cause is applicable to animals a

nd 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, supers

ession and obsolescence.

Inadequacy arises when the asset is no longer useful to the entity b

ecause of an increase in the volume of operations.

For example, adequate buildings acquired at the inception of busine

ss may become inadequate or limited in their future service potential
when unexpected business growth or expansion requires larger facil
ities for efficient operation.

Supersession arises when a new asset becomes available and the

new asset can perform the same function more efficiently and econo
mically or for substantially less cost.

Obsolescence is the catchall for economic or functional depreciatio

n.
For example, obsolescence arises when there is no future demand for t
he product which the asset produces.

Obsolescence encompasses inadequacy and suppersession.

In other words, an asset becomes obsolete if it is inadequate or superse

ded.

Factors of Depreciation
In order to properly compute the amount of depreciation, three factors a
re 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 se
parately.
For example, it may be appropriate to depreciate separately the airframe, engin
es, fittings (seats and floor coverings) and tires of an aircraft.

To the extent that an entity depreciates separately some significant parts of an i

tem of property, plant and equipment, it also depreciates separately the remain
der of the item.

The remainder consists of the parts of the item that are individually not significa
nt.

Residual Value

Residual value of an asset is the estimated amount that an entity would currentl
y obtain from disposal of the asset, after deducting the estimated cost of dispos
al, if the asset were already at the age and condition expected at the end of its
useful life.

Simply stated, residual value is the estimated net amount currently obtainable if
the asset is at the end of its useful life.

The residual value of an asset shall be reviewed at least at each financial year-
end if expectation differs from previous estimate, the change shall be accounte
d for as a change in accounting estimate.
In practice, the residual value of an asset is often insignificant and therefo
re immaterial in the calculation of the depreciable amount.

The residual value of an asset may increase to an amount equal to or gre

ater than the carrying amount of the asset.

If it does, the depreciation charge is zero unless and until the residual val
ue subsequently decreases to an amount below the carrying amount of th
e asset.

Useful Life

Useful life or service life is either the period of time over which an asset is
expected to be used by the entity or the number of production or similar u
nits expected to be obtained from the asset by the entity.

As distinguished from useful life, physical life refers to how long the asset
would last.

The useful life of an asset may be expressed in years, units of output and
service hours.
Factors in determining useful life
a. Expected usage of the asset- is assessed by reference to the expected
capacity or physical output.

b. Expected physical wear and tear- depends on the operational factors su

ch as the number of shifts the asset is used, the repair and maintenance pr
ogram, and the care and maintenance of the asset while idle.

c. Technical obsolescence- arises from changes or improvements in produ

ction 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 or the relate
d lease.

Methods of Depreciation

1. Equal or uniform charge methods- straight line, composite method and g

roup method
2. Variable charge or use-factor methods - service hours and output or pro
duction method

3. Decreasing charge or accelerated or diminishing balance methods- sum

of the years' digits, declining balance and double declining balance.

4. Other methods- inventory, retirement, and replacement method.

Straight Line Method

Under the straight line method, the annual depreciation charge is calculate
d by allocating the depreciable amount equally over the number of years of
estimated useful life.

In other words, straight line depreciation is a constant charge over the usef
ul life of the asset.

The formula for the computation is as follows:

Annual Depreciation= Cost minus residual value

Life in years
Cost minus residual value equals depreciable amount.

Depreciable amount multiplied by the annual straight line rate of depreciation al

so gives the amount of annual depreciation.

The straight line rate is determined by dividing 100% by the life of the asset in y
ears.

For example, if the life of an asset is 5 years, the annual straight line rate is 20
%, compute by dividing 100% by 5 years

The straight line method is widely used in practice because of simplicity .

This 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 th

an as a function of usage.

Examples of assets which depreciate principally because of passage of time ar

e buildings, other structures such as radio and TV powers, dams, bridges and o
ffice equipment such as typewriters, adding machine computers.
Composite method or Group method

The composite method or group method are a variation of the straight line method o
f depreciation.

Under the composite method, assets that are dissimilar in nature or assets that hav
e different physical characteristics and vary widely in useful life, are grouped and tre
ated as single unit.

Under the group method, all assets that are similar in nature and in estimated usefu
l life are grouped and trted as a single unit.

The acounting procedure and the method of computation for the composite and gro
up method are essentially the same.

In other words, the average lfe and the composite or group rate are computed, and
the assets in the group are depreciated on that basis

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 gro
up to get the periodic depreciation.

c. When the asset in the group is retired, no gain or loss is recognized.

The asset is credited for the cost of the asset retired and the accumulate
d depreciation 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 and crediting cash or other appropriate
account.

Subsequently, the composite or group arte is multiplied by the balance of

the asset account to get the periodic depreciation.

Variable Charge Methods of Depreciation

The variable methods assume that depreciation is more a function of use
rather than passage of time.

The life of the asset is considered in terms of the output it produces or th

e number of hours it works.

Thus, depreciation is related to estiamted production capability of the ass

et and is expressed in a rate per unit of output or per hour of use.
The variable methods are working hours method and output or production
method.

Such 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 realizatio

n of revenue.

If assets are used more intensively in production, greater revenue is expec

ted.

The variable methods are found to be appropriate for assets such as mac
hineries.

Working Hours Method

Under working hours method, a depreciation rate per hour is computed by

dividing the depreciable amount by the estimated life in terms of service h
ours
The depreciation rate per hour is then multiplied by the actual hours work
ed in one period to get the depreciation for that period.

Output or Production Method of Depreciation

The output or production method results in a charge based on the expect

ed use or output.

Under this method, a depreciation rate per unit is computed by dividing th

e depreciable amount by the estimated life in terms of unit of output.

The depreciation rate per unit is then multiplied by the yearly output to ge
t the annual depreciation.

Decreasing Charge or Accelerated Methods