DepreciationDepreciation is defined as “Allocating the cost of plant and equipment over the years of use.

Diagrammatic description of depreciation

Cost of a plant asset Balance SheetAssets:

Plant and equipment

As services are received

Income StatementRevenue:Expenses:

Depreciation

Depreciation

– The allowance for wear and tear on equipment and machinery

– Amount of decreasing value in a capital asset allowed to be deducted from a business tax return

– Cost Recovery– Depreciation is a non-cash expense on your schedule F

(farm profit or loss statement)

• Depreciable property can be either tangible or intangible

Depreciation

– The allowance for wear and tear on equipment and machinery

– Amount of decreasing value in a capital asset allowed to be deducted from a business tax return

– Cost Recovery– Depreciation is a non-cash expense on your schedule F

(farm profit or loss statement)

• Depreciable property can be either tangible or intangible

Intangible Depreciable Property

• Purchased property that has value that you cannot readily see or touch– Computer Software– Copyrights, patents, etc

What cannot be depreciated?

• Property placed into service and disposed of in the same year.

• Land (land can never be depreciated)• Inventory– You cannot depreciate property held for resale in the

normal course of business• Leased property– The value of the lease is already showing up as a rental

expense

When depreciation begins & ends?

• Begins– When you “place the property in service”.– When it is ready and available for a specific use in the business

• Example– When it was bought for the business

• Ends– When the cost of the item has been recovered or when it is retired

from service, whichever happens first

• Example– When it is sold or is not longer useable

Causes Of Depreciation

There are three major causes of depreciation;Physical deterioration:It results from the use of asset-wear and tear and the action of elements.Inadequacy of a plant asset:It is the inability of an asset to meet future needs because it doesn’t provide sufficient product or services.

Obsolescence:It is the decline in usefulness of an asset due to

inventions and technological advancements.

Methods Of Depreciation

1 straight-Line MethodIn this method an equal amount of the cost of plant asset is charged to each accounting period.it can be determined asDepreciation Per period = Asset cost – Estimated salvage valueNumber of accounting periods in estimated useful life

Contd……Example:Let us consider the asset of cost = 54,000Estimated salvage value = 4,000Number of accounting periods = 10 yearsPutting the values in the formula54,000-4,000/10 year = 5,000 per year

End Of Year Depreciation Expense Dr ; Accumulated Depreciation Cr

Total Accumulated Depreciation

Book Value

Rs.54,000

1 5,000 5,000 49,000

2 5,000 10,000 44,000

3 5,000 15,000 39,0004 5,000 20,000 34,000

5 5,000 25,000 29,000

6 5,000 30,000 24,000

7 5,000 35,000 19,000

8 5,000 40,000 14,000

9 5,000 45,000 9,000

10 5,000 50,000 4,000

Rs.50,000

2.Units-of-Production(Output) Method• It assigns equal amount of depreciation to

each unit of product manufactured or service rendered by an asset.

• This method is based on physical output.

• It is applied in situation where usage rather than obsolescence leads to the demise of asset.

Contd…The formula to calculate depreciation under this method is given as under;Depreciation per unit = Asset cost- Estimated salvage value ÷ Estimated total units of productionDepreciation per period = 〔 Depreciation per unit× Number of units of goods or services provided〕Example :54,000-4,000÷50,000 = 1 per unit

3.Accelerated Depreciation Methods:In this method higher amounts of depreciation are recorded during the early year of an asset's life while lower amounts are recorded in later years of an asset.Reasons for the use of this method:1. The value of the benefits received from the

asset decline with age.2. The asset is a high technology asset subject

to rapid obsolescence.3. Repairs increase substantially in the asset's

later year.

Types of accelerated depreciation method

It has of two types; 1. Sum-of-the-years-digits method(SOYD)It adds the consecutive digits for each year of an asset's estimated life together and uses that as the denominator of a friction.

Contd…..The formula is

Example

Let us consider the useful life of an asset is 10 years SOYD will be calculated as SOYD = n (n+1) = 10(10+1)/2 = 55 2

Illustration sum of the year-digit Depreciation Schedule

End Of Year Depreciation Expense Dr; Accumulated Depreciation Cr

Total Accumulated Depreciation

Book Value

54,000

1 50,000 × 10/55 = 9,091 9,091 44,909

2 50,000 × 9/55 = 8,182 17,273 36,727

3 50,000 × 8/55 =7,273 24,546 29,454

4 50,000 × 7/55 = 6,634 30,910 23,090

5 50,000 × 6/55 = 5,455 36,365 17,635

6 50,000 × 5/55 = 4,545 40,910 13,090

7 50,000 × 4/55 = 3,636 44,546 9,454

8 50,000 × 3/55 = 2,727 47,273 6,727

9 50,000 × 2/55 = 1,818 49,091 4,909

10 50,000 × 1/55 = 909 50,000 4,000

Rs.50,000

Double declining balance method

• To apply the double-declining-balance (DDB) method, calculate the straight-line depreciation rate.

• ie divide 100% by the number of useful life,• Eg 100%/5 20%, • Then multiply that rate by 2• 20% × 2 = 40%• Next, apply, the DDB rate to the assets book value.• Ignore salvage value.• The formula is = [2× straight line rate × asset cost –

accumulated depreciation]

Illustration Of Double-Declining-Balance (DDB) Depreciation Schedule

Depreciation expense Dr ; Accumulated Depreciation Cr

Total Accumulated depreciation

Book Value

1 20 % of 54,000 = Rs 10,800 10,800 43,200

2 20 % of 43,200 = Rs 8,640 19,440 34,560

3 20 % of 34,560 = Rs 6,912 26,352 27,648

4 20 % of 27,648= Rs 5,530 31,882 22,648

5 20 % of 22,118 = Rs 4,424 36,306 17,694

6 20 % of 17,694 = Rs 3,359 39,845 14,155

7 20 % of 14,155= Rs 2,831 42,676 11,324

8 20 % of 11324= Rs 2,265 44,941 9,059

9 20 % of 9,059= Rs 1,812 46,753 7,247

10 20 % of 7,247 = Rs 1,449 48,202 5,798

Modified accelerated cost recovery system (MACRS)

• Companies used some time a particular type of depreciation for tax purposes known as Modified accelerated cost recovery system.

• Under this method, a company uses one of the eight classes for recovery purposes.

• For example, next slide

Modified Accelerated Cost Recovery System (MACRS)

Recovery Year

3-year 5-year 7-year 10-year

1 33.33% 20.00% 14.29% 10.00%

2 44.45 32.00 24.49 18.00

3 14.81 19.20 17.49 14.40

4 7.41 11.52 12.49 11.52

5 11.52 8.93 9.22

6 5.76 8.92 7.37

7 8.93 6.55

8 4.46 6.55

9 6.56

10 6.55

11 3.28

Totals 100.00% 100.00% 100.00% 100.00%

Year Depreciation Calculation Using Formula Calculation Using Table

2009 $20 million $100 × 1/5 × 200% × 0.5 $100 million × 20%

2010 $32 million ($100 − $20) × 1/5 × 200% $100 million × 32%

2011 $19.2 million ($100 − $20 − $32 million) × 1/5 × 200% $100 million × 19.2%

2012 $11.52 million ($100 − $20 − $32 − $19.2) × 1/5 × 200% $100 million × 11.52%

2013 $11.52 million (Note A) $100 million × 11.52%

2014 $5.76 million $11.52 million × 0.5 (Note B) $100 million × 5.76%

Partial depreciation

• So far we have discussed depreciation by putting the asset into service at the beginning of the accounting period.

• what if, we put the asset into service during the accounting period.

• when assets are acquired during an accounting period, the first depreciation is for a partial year.

• Round off to the nearest full month, eg;• If the asset is purchased on or before the 15th day of the month,

treat it as it were purchased on the first day of the month.• Or treat the asset in the following month 1st date if it was

purchased on 15th or after date.

Example

• To calculate partial year depreciation for each of the four methods, consider a machine which

• Cost = Rs 7,600 on sep 1, 1997• Salvage value = Rs 400• Useful life = 5 years • Total unit of production = 25000

Straight line Method

• Partial year depreciation calculation is very easy for straight line method

• For example • The annual depreciation is = (7600-400)/5years =

Rs 1440• The machine would operate for four months

prior to the end of accounting period, hence covering one third of the year,

• The 1997, depreciation is Rs 1440× 1/3 = Rs 480

Units of production method

• No unusual computation is required to record depreciation for the partial year

• Just multiply the depreciation charge per unit by the unit produced.

• The charge for partial year will be less because few unit of goods produced.

Units of production method

• No unusual computation is required to record depreciation for the partial year

• Just multiply the depreciation charge per unit by the unit produced.

• The charge for partial year will be less because few unit of goods produced.

Sum of the years digits method• Under this method, the computation is complex a little bit.• Problems occur because the 12 months of the depreciation does

not correspond with the 12 month of financial statements.• For example • Depreciation for the four months of 1997 is• (7600-400)× 5/15 × 1/3 = Rs 800.• In 1998, the depreciation is recorded as follows;• For the first two third of the year. (Rs 7,200 × 5/15 × 2/3) = Rs

1,600• For the last one third of the year. (Rs 7,200 × 4/15 × 1/3) = Rs 640• Total depreciation for the year 1998 = Rs 2240

Double declining balance method

• Under this method, it is relatively easy to determine depreciation for a partial year and then for subsequent full years.

• For example• Partial year depreciation for 1997 is (Rs 7600 × 0.4 ×

1/3) = Rs 1,013.• For subsequent years, use the regular procedure for

computation.• eg 1998, depreciation would be = [(Rs 7600- Rs

1,013) × 0.4] = Rs 2,635.

Sum-Of-The-Years’-Digits Methods

1.Rs 7,200×5/15=Rs.2,400

Year Depreciation for each year of life of asset (September 1-August 31)

Depreciation for each calendar year (Jan 1-December 31)