Depreciation

Definition:-

Depreciation is non-cash expense (also known as non-cash charge) that provides a source of free cash flow.

Depreciation can’t be count in days it will be count in months. E.g. one month, two months, one year etc.

Depreciation is a non-cash expense that reduces. When it's stated that depreciation is "non-cash," it means that depreciation is taken as an accounting entry, and that the amount of cash held by the business is not affected. Business assets that can be depreciated include equipment, machinery, technology and computers, office furniture, buildings and improvements to buildings, leasehold improvements, and business vehicles. Land cannot be depreciated because it appreciates instead of depreciating.

Depreciation is taken on business assets to recognize the change in value of these assets as they age. Assets depreciate for two reasons:

Wear and tear. For example, an auto will decrease in value because of the mileage, wear on tires, and other factors related to the use of the vehicle.

Obsolescence. Assets also decrease in value as they are replaced by newer models. Last year's car model is less valuable because there is a newer model in the marketplace.

How depreciation is calculated:-

Depreciation is calculated as follows The original cost of the asset, including costs of acquiring

the asset, transporting it, and setting it up

Less the salvage value (the "scrap" value)

Divided over the years of useful life of the asset.  The useful life of an asset is determined by the IRS based on a schedule set up for various types of assets. Check with your tax advisor for more information on "useful life" of different classifications of business assets.

As an example, office furniture is purchased by a business for $20,000. The furniture has a useful life of 10 years and a scrap value of $1000. Using straight-line depreciation (described below), the $19,000 of the cost of the furniture is divided over the 10 years of life, so $1,900 can be deducted on the business's tax return for each of the 10 years.

Methods of depreciation:-Depreciation is determined by one of several methods approved by the IRS.(Internal Revenue Service).The most common method is straight-line depreciation, in which the same amount is expensed each year. Other methods are double-declining balance and sum-of-the years'-digits.

Straight line method: In straight line method:

Span of year calendar Number of hours worked Number of unit produced

In straight line method we use this formula

cost−scrap valueusefull life

Examples of span of year calendar:-

1:-

1-1-2001

Depreciation = 5000

11-1-2001

Depreciation = 5000

21-1-2001

Depreciation = 4576

In above example on 21-1-2001 depreciation is 5000, or on 11-1-2001 depreciation is also 5000, but on 21-1-2001 depreciation is 4576, because we can’t count depreciation less than 15 days, or half month.

2:-

13-05-2001

Depreciation of one year is 3000

What will be depreciation 8 months..?

Depreciation of 8 months is 2000

23-5-2001

Depreciation will be 1750

Note: - Machine account can’t be touched when depreciation is recorded. –Depreciation recorded at the end of the year not recorded during the year.

Examples of remaining two methods of straight line:-

Numbers of hours worked:-

Cost = 50,000, Life = 10,000 hours, Year = 2014 2000 hours, Scrap value = 10,000

50,000−10,00010,000

= PRs 4 per hour

2000×4 = PRs = 8000

Numbers of unit produced:-

Cost = 50,000, Life = 20,000, In 2014 5000 unit produced, Scrap Value = 10,000

50,000−10,00020,000

= 2

5000×2 = 10,000

Declining or Double Declining balance Method:

Meaning of declining is (Reduction in cost). Only method in which scrap value is not deducted initially.

The double-declining-balance method provides for a declining periodic expense over the expected useful life of the asset. This method applies in three steps.

1. Determine the straight-line percentage using the expected useful life

2. Determine the double-declining balance rate by multiplying the straight-line rate from step 1 by two.

3. Compute the depreciation expense by multiplying the double-declining-balance rate from step 2 times the book value of the asset.

To illustrate, the equipment purchased in the preceding example is used to compute double-declining-balance depreciation, for the first year, the depreciation is $9,600, as shown below.

1. Straight-line percentage =20% (100%5

)

2. Double-declining-balance rate = 40% (20% x 2)3. Depreciation expense = $9,600($24,000 x 40%)

Examples:-

Cost = 25000, Life = 5 years, Scrap value = 10,000

Note: Cost – Accumulated depreciation called book value.

Years Book-V cost at beginning

Depreciation rate

Amount of depreciation

Accumulated depreciation

Book-V at the end

1 25000 20% 5000 5000 200002 20000 20% 4000 9000 160003 16000 20% 3200 12200 128004 12800 20% 2560 14760 102405 10240 20% 240 15000 10000

Sum of year digit method:

Explanation

Sum of the years' digits depreciation method, like reducing balance method, is a type of accelerated depreciation technique that allocates higher depreciation expense in the earlier years of an asset's useful life.Calculation of depreciation under this method can be summarized in the following 4 steps:

Step 1: Calculate the sum of the years' digits in an asset's useful life

For an asset having a useful life of 4 years, the sum of the years' digits will be calculated as follows:Sum of years' digits = 4 + 3 + 2 + 1 = 10

Step 2: Calculate the depreciable amount

Depreciable amount, as with all depreciation methods, is equal to: Asset's cost of acquisition or construction including any

subsequent capital expenditure Less: Estimated residual value or scrap value at the end

of the asset's useful life

Step 3: Calculate the un-depreciated useful life

Un-depreciated useful life is equal to the number of years in the asset's useful life that have not yet been subjected to depreciation.Hence, for an asset that has a useful life of 4 years, the un-depreciated useful life to be used in calculating depreciation shall be 4 years in the first year of depreciation, 3 years in the second year and so on.

Step 4: Calculate depreciation using the sum of years' digits & un-depreciated useful life

Depreciation using the sum of the years' digits method can be calculated using the following formula:

Depreciation Expense

=

Un-depreciated useful life (Step 3)

xDepreciable

Amount (Step 2)Sum of the years' digits (Step 1)

Example

Following information relates to a fixed asset:

Cost$100,

000Residual Value

$10,000

Useful Life

3 Years

Calculate depreciation over the useful life of the asset using the sum of the years' digits method.

Step 1: Calculate the sum of the years digitsSum of the years' digits = 3 + 2 + 1 = 6Step 2: Calculate the depreciable amountDepreciable amount = $100,000 - $10,000 = $90,000Step 3: Calculate the un-depreciated useful life

Year 1

Year 2

Year 3

Un- depreciated useful life (years)

3 2 1

Step 4: Calculate depreciation expense

Year 1: Depreciation expense =

3 (Step 3) x $90,000 (Step 2)

= $45,0006 (Step 1)

Year 2: Depreciation expense =

2 (Step 3) x $90,000 (Step 2)

= $30,0006 (Step 1)

Year 3: Depreciation expense =

1 (Step 3) x $90,000 (Step 2)

= $15,0006 (Step 1)

Note: Over the life of the asset, the total depreciation charge equals to the depreciable amount, i.e. $90,000 (Step 2). Also note

that the amount of annual depreciation progressively declines as the asset ages. This method of depreciation is therefore appropriate for assets whose utility and productiveness is greater in the earlier years of their life (e.g. computer equipment).

Sum of year digit method:

Example:-

Year 10,

SYD = N +12×10

10+12

×10

55

Years Amount of depreciation

Depreciation life

1 15000x5/15 50002 15000x04/15 40003 15000x3/15 30004 15000x2/15 20005 15000x1/15 10000

Example:

Cost = 1, 00,000, Life = 6 years, Scrap value = 10,000

In straight line

4-9-2013

100000−1000006

512×15000

5000

In Declining method:-

1, 00,000 x .20% = 20,000 x 4/12 = 6667

Depreciation according to years..

2013 90000×515×412

10000

2014 90000×515×812

=28000

90000×415×412

36000

2015 90000×415×812

=16000

90000×315×412

22000

2016 90000×315×812

=12000

90000×215×412

16000

2017 90000×215×812

=8000

90000×115×412

10000

2018 90000×115×812

4000