depreciation 2

Let’s look at… what we did in the last class…

Let’s look at… what we did in the last class…

We started with… ACCOUNTING FOR DEPRECIATION

We started with… ACCOUNTING FOR DEPRECIATION

… with Learning Objectives…Fixed Assets?

Depreciation?

Depreciation, Depletion, Amortization, and Impairment?

Methods of Depreciation?

Accounting for Depreciation

Accounting Standards for Depreciation

Presentation and Disclosures?

We tried to understand Fixed Assets …

Fixed Assets are long-term assets and usually, they have a life more than one year.

Fixed Assets are assets from which benefits are to accrue in future or it provides a stream of future benefits.

Fixed asset is an asset held with the intention of being used for the purpose of producing or providing goods or services and is not held for sale in the normal course of business.

We appreciated difference between Capital Expenditure

vs Revenue Expenses

Cost of a fixed Assets includes…

All those expenses necessary to incur to

bring the asset into operation or to have its

commercial operation.

The CUT-OFF point is the day of operation;

before that all expenses related to an asset

have to be capitalized; and after that all

expenses have to be treated as Revenue

Expenses related to the assets.Day of OperationBefore, Capital Expense After,

Revenue Expense

Accounting for Fixed Assets – Purchase and Other Expenses

We also learnt how to make entries for the purchase of fixed assets and other related expenses.

Where are they shown in the books of accounts?

Depreciation …

Please note that all fixed assetsall fixed assets are

subject to Depreciation except except

freehold landfreehold land.

We tried to understand Depreciation…

Depreciation involves:

…allocating the cost of tangible the cost of tangible

assetsassets to expense in a systematic and

rational manner to periods expected to

benefit from use of its depreciable assets.

We also tried to learn – ‘Why Depreciation’?

Fixed Assets are subject to depreciation and thus, depreciation needs to be provided so as to

–Ensure allocation of original cost of a fixed asset over its useful life;

–Ascertaining the true cost of operations; and

– Providing current valuation of fixed assets in the Balance Sheet.

1. Please disconnect in your mind ‘Physical Depreciation’ and ‘Accounting Depreciation’.

2. Depreciation is not a SOURCE OF FUND.

Two things are to be

remembered about

Depreciation

Now, let’s move with Today’s Agenda…

To begin with, let’s understand completely the nature of Depreciation…

All fixed assets except land lose their

capacity to provide services with passage

of time. This loss of productive capacity is

recognized as Depreciation Expense

which is taken to Profit and Loss Account.

#1

To begin with, let’s understand completely the nature of Depreciation…

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

#2

Asset Depreciation

Depreciation

Economic Depreciationthe gradual decrease inutility in an asset with

use and time

Accounting depreciationThe systematic allocation

of an asset’s value inportions over its

depreciable life—oftenused in engineeringeconomic analysis

PhysicalDepreciation

FunctionalDepreciation

Book depreciation

TaxDepreciation

Our next step is…

How to determine the amount of depreciation each year so that it can be expensed to Profit and Loss Account?

What are the

factors

determining the

depreciation

expenses?

Depreciation Expense Depreciation Expense FactorsFactorsDepreciation Expense Depreciation Expense FactorsFactors

Initial Cost Residual Value- = Depreciable Cost

Useful Life

1

Periodic Depreciation Expense

2 3 4 5

Factor #1

Fac

tor

#2F

ac

to

r #3

Factor#4: Method of determining the

amount of Depreciation

Factor#4: Method of determining the

amount of Depreciation

Factors to Consider in Asset Depreciation

• Depreciable life (How long?)

• Salvage value (Disposal value)

• Cost basis (Depreciation basis)

• Method of depreciation (How?)

Factor #1: Initial Cost

Initial Cost is the cost of acquisition and including costs incurred to make the asset operational.

This cost is also called the HISTORICAL COST.

Factor #2: Residual Value or Salvage Value or Disposable Value

Residual Value is the estimated amount that will be received at the time the asset will be sold or removed from the services.

It is management’s best estimate of what an asset will be worth at the time of its disposable.

It is to be estimated at the time of determining the amount of depreciation.

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 DEPRECIATION BASEBASE.

Factor #3: Estimated Life or Useful Life

The asset’s estimated life is a measure of the service potential that the current user may expect from the asset.

Many times, an asset physical life is taken as estimated life.

Useful life is either (i) the period over which a depreciable asset is expected to be used by the enterprise; or (ii) the number of production or similar units expected to be obtained from the use of the asset by the enterprise.

Useful life of an asset should be determined based on – 1. Expected use of the asset

2. Expected physical wear and tear

3. Expected commercial or technical obsolescence

4. Legal or other limits on the use of the asset.

Factor #4: Methods of Depreciation

The following four depreciation methods are acceptable for Financial Accounting purposes:

1. Straight-Line

2. Units-of-Production

3. Declining-Balance

4. Sum-of-Years-Digits

Straight-lineStraight-line is far more widely used than other methods.

Declining-balance Declining-balance and sum-of-years-digitssum-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.

Straight-Line MethodStraight-Line MethodStraight-Line MethodStraight-Line Method

Cost – estimated residual value

Estimated life

= Annual depreciation

ExampleExampleExampleExample

Original Cost.....………….. Rs.24,000

Estimated Life in years….. 5 years

Estimated Residual Value... Rs.2,000


Estimated Life in years….. 5 years



Rs. 24,000 – Rs. 2,000

5 years

= Rs. 4,400 annual depreciation

Straight-Line RateStraight-Line RateStraight-Line RateStraight-Line Rate

Rs.24,000 – Rs.2,000

5 years = Rs.4,400

Rs.4,400 Rs.24,000

= 18.3%

SLM – Depreciation Amount and Book Value


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.

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.

Units-of-Production MethodUnits-of-Production MethodUnits-of-Production MethodUnits-of-Production Method

Cost – estimated residual valueEstimated life in units, hours, etc.

= Depreciation per unit, hour, etc.

ExampleExampleExampleExample


Estimated Life in hours….. 10,000



Estimated Life in hours….. 10,000


Rs.24,000 – Rs.2,000

10,000 hours

= Depreciation per unit, hour, etc.= Rs.2.20 per hour


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.

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.


Declining-Balance MethodDeclining-Balance MethodDeclining-Balance MethodDeclining-Balance Method

Formula to calculate the Depreciation Rate

Formula to calculate the Depreciation Rate

39.16%=24,000 Rs.2,000 Rs.

- 1 = ONDEPRECIATI OF RATE

ASSETOF COST VALUERESIDUAL ESTIMATED

- 1 = ONDEPRECIATI OF RATE

5

n

DBM – Depreciation Amount and Book Value

Physical Depreciation …

Physical Depreciation occurs

from wear and tear while in use

and from the action of the

weather and 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 lawstaxation laws.

depreciation 2

Economy & Finance