Accounting for depreciation 1

meaning of depreciation, causes of depreciation, need of depreciation, methods of depreciation

1. Financial Accounting Lecture Series (XVII) Accounting for Depreciation M. C. Sharma Associate Professor Department of Commerce Shaheed Bhagat Singh Evening College (University of Delhi) Delhi 1

2. Learning Objectives: Learning objectives of today’s lecture are to know and understand : What is depreciation? What are related terms: Depletion, A mortisation and Obsolescence? What are the causes of Depreciation? What are the objectives of charging depreciation? What are the factors affecting the amount of depreciation? What are the relevant accounting principles? Methods of providing or allocation depreciation 2

3. What is depreciation? Depreciation means decrease in the value of fixed assets due to their use in business, passage of time or obsolescence. 3

4. Depreciation as per AS 6 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. Depreciation is allocated so as to charge a fair proportion of the depreciable amount in each accounting period during the expected useful life of the asset. Depreciation includes amortisation of assets whose useful life is predetermined. 4

5. Depreciable Asset Depreciable assets are assets which are expected to be used during more than one accounting period ; and have a limited useful life; and are held by an enterprise for use in the production or supply of goods and services, for rental to others, or for administrative purposes and not for the purpose of sale in the ordinary course of business. 5

6. What is depletion? 6 The term ‘Depletion’ refers to the physical deterioration by the exhaustion of natural resources, like, quarries, mines, oil-wells, etc. Due to mining or extraction, the stock of minerals/oil, etc. is depleted/reduced. In case of such assets, usually depreciation is charged on the basis of quantity produced.

7. What is amortisation? 7 Amortisation refers to the economic deterioration of intangible assets like, goodwill, patents, trademark, copyright etc. It is the practice to write off the intangible assets over a reasonable period. When a part of an intangible asset is written off, it is called amortisation.

8. What is obsolescence? The term ‘Obsolescence’ refers to the economic deterioration of assets, due to change in technology, invention of improved equipment, market decline due to change in taste and fashion, etc., or inadequacy of existing plant to meet the increased business. Depreciation is affected by obsolescence as it decreases the value of asset. 8

9. Causes of Depreciation Wear and tear. Fixed assets are purchased for use in business. Due to constant use of fixed assets in business for generating income, the value of such assets is decreased. It is called ‘wear’ and ‘tear’. It is main cause of depreciation. Passage of time. Every asset has a certain economic useful life. With the passage of time effective life of the assets goes on decreasing. Certain assets like a lease, have a certain legal life . With the passage of time, value of such assets goes down, even may not be actually used in the business . 9

10. Causes of Depreciation Depletion . Depletion is reduction of natural resources. In case of wasting assets , depletion is also a cause of fall in the value of assets like, mines, oils wells, quarries, etc. Obsolescence. Due to invention of new technology, the assets based on old technology may become obsolete and out of date. Accidents . Accidents may also cause a permanent fall in the useful life as well as in the value of assets. Permanent fall in price. A permanent fall in the market value of investments is recorded as depreciation. Other assets are depreciated on the basis of its useful life. 10

11. Objectives of Providing Depreciation To ascertain the true and fair profits To show the asset at its proper value To make arrangement of funds for replacement of fixed asset Ascertaining accurate cost of production To comply with legal provisions To avail tax benefits 11

12. Factors affecting the amount of depreciation Assessment of depreciation and the amount to be charged in respect thereof in an accounting period are usually based on the following three factors : historical cost or other amount substituted for the historical cost of the depreciable asset when the asset has been revalued; expected useful life of the depreciable asset; and estimated residual value of the depreciable asset. 12

13. Historical Cost Historical cost of a depreciable asset represents its money outlay or its equivalent in connection with its acquisition, installation and commissioning as well as for additions to or improvement thereof. The historical cost of a depreciable asset may undergo subsequent changes arising as a result of increase or decrease in long term liability on account of exchange fluctuations , price adjustments, changes in duties or similar factors. 13

14. The useful life of a depreciable asset The useful life of a depreciable asset is shorter than its physical life and is : pre-determined by legal or contractual limits directly governed by extraction or consumption; dependent on the extent of use and physical deterioration on account of wear and tear which again depends on operational factors, such as , the number of shifts for which the asset is to be used, repair and maintenance policy of the enterprise etc.; and reduced by obsolescence arising from such factors as : (a) technological changes ; ( b) improvement in production methods ; ( c) change in market demand for the product or service output of the asset; or ( d) legal or other restrictions. 14

15. Relevant Accounting Principles Cost Principle Matching Principle Going Concern Principle Consistency: The depreciation method selected should be applied consistently from period to period . Disclosure 15

16. Methods of Providing or Allocating Depreciation Important Methods: Straight Line Methods Written Down Value Method 16

17. Methods of Providing or Allocating Depreciation Other Methods: Sinking Fund Method Annuity Method Insurance Policy Method Revaluation Method – Loose Tools Depletion Method – Mines, Oil-wells, etc. Machine Hour Rate Method 17

18. Straight Line Method of depreciation Under this method depreciation is charged by a given rate of depreciation on the original cost of the asset every year. Due to this reason depreciation charged annually remains fixed and so the method is called ‘Fixed Instalment Method. This is also called original cost method as the depreciation is charged every year on the original cost of the asset. estimated scrap value of the asset 18

19. Straight Line Method of depreciation If rate of depreciation is not given then annual depreciation and rate of depreciation is calculated by applying the following formulas: Annual depreciation Rate of depreciation 19

20. Straight Line Method of depreciation If rate of depreciation is not given then annual depreciation and rate of depreciation is calculated by applying the following formulas: Annual depreciation Rate of depreciation 20

21. Example: A firm purchased a machine for Rs , 1,75,000 and spent installation charges Rs . 45,000. It’s economic life is 10 years and estimated residual value after 10 years is Rs . 20,000. Charge depreciation by SLM. Annual Depreciation= = 20,000   21

22. Straight Line Method of depreciation When depreciation charged in various years is put on a graph, it gives a straight line parallel to OX axis. Due to this reason this method is called straight line method. 22

23. Merits of Straight Line Method of D epreciation Simple. Every year a fixed amount is charged as depreciation. Calculation of depreciation is also very simple. Asset is completely written off. If an asset continues with a firm for the whole of its useful life and depreciation is provided by SLM, it will be completely written off. Only scrap value of the asset, if any, will be left in the asset account. No window dressing. A fixed amount of depreciation is charged to the profit and loss account every year. The effect of depreciation on profit is equal and chances of manipulating profits are very less. Knowledge of original cost and total depreciation charged. 23

24. Calculation of Depreciation and WDV – SLM Example: Cost of machine – Rs . 77,760, useful life – 5 years, estimated scrap value after 5 years – Rs . 31,250 Charge depreciation by SLM 24 Annual Depreciation= = 9,302 Rate of Depreciation 100 = 11.92%  

25. Straight Line Method Calculation of Depreciation and WDV Year Op. WDV ( Rs .) Rate of Dep Dep. ( Rs .) Clo . WDV ( Rs .) 1 77,760 11.92% 9,302 68,458 2 68,458 11.92% 9,302 59,156 3 59,156 11.92% 9,302 49,854 4 49,854 11.92% 9,302 40,552 5 40,552 11.92% 9,302 31,250 25

26. Demerits of Straight Line Method of D epreciation Unequal charge against income. Total charge on account of using fixed assets comprises depreciation plus repairing charges. Under SLM, depreciation charged is fixed but repairing charges go on increasing year by year. Thus total charge against income goes on increasing. Year Depreciation Repairs Total Charge 1 20,000 nil 20,000 2 20,000 1,000 21,000 3 20,000 3,000 23,000 4 20,000 5,000 25,000 26

27. Demerits of Straight Line Method of D epreciation Interest factor ignored. When a fixed asset is purchased, the amount is invested permanently. If the amount would have been invested outside the firm, the interest would have been received on it. Thus, the loss of interest is ignored, while calculating depreciation. Undue pressure in later years. Under fixed instalment method, the total charge against the income goes on increasing year by year, while efficiency of asset goes on decreasing. Thus, the pressure in later years is unduly high . Difficult to estimate scrap value 27

28. Demerits of Straight Line Method of D epreciation Unsuitable for long term assets. The assets having long life, requires several addition and extension from time to time. This method is not suitable for them. It is also not suitable for assets having heavy investment . No provision of funds for replacement. In this method amount charged as depreciation is not invested outside the business. It is retained in the business and becomes a part of working capital. When the asset becomes useless, the firm has to face the problem of funds for the replacement of asset as it becomes difficult to withdraw amount from the working capital . 28

29. Written Down Value Method of depreciation Under this method depreciation is charged at a fixed rate on the opening balance of the asset. This balance is reduced every year. Thus, the amount of depreciation also goes on reducing year after year. Thus, it is clear that under this method value of asset as well as depreciation charged goes on reducing every year. Due to this reason this method is also called “ Reducing Instalment Method.” The value of asset left after charging depreciation is called, written down value. Due to this reason, this method is called “Written Down Value Method.” The rate of depreciation charged under this method is higher than that charged in straight line method . 29

30. Calculation of rate of depreciation under WDV method R = { 1 - } *100 R = Rate of Depreciation N = useful life of the asset S = Scrap value of the asset C = Cost of the asset   30

31. Calculation of rate of depreciation under WDV method R = { 1 - } *100 R = Rate of Depreciation N = useful life of the asset = 5 years S = Scrap value of the asset = 31,250 C = Cost of the asset = 77,760 R = {1 - }*100 = 16.67%   31

32. Calculation of Depreciation and WDV Year Op. WDV ( Rs .) Rate of Dep Dep. ( Rs .) Clo . WDV ( Rs .) 1 77,760 16.67% 12,960 64,800 2 64,800 16.67% 10,800 54,000 3 54,000 16.67% 9,000 45,000 4 45,000 16.67% 7,500 37,500 5 37,500 16.67% 6,250 31,250 32

33. Merits of Written Down Value Method of depreciation Simple. Calculation of depreciation is very simple as the depreciation is charged every year on the opening balance of the asset. Depreciation on additional assets purchased during the year is calculated separately. There is no need to remember original cost of the assets. Equal charge against income. Under this method depreciation charged is reduced every year, while repairing charges are increased. Thus, the total charge against income remains the same, more or less. No undue pressure in later years. Approved by taxation authorities. 33

34. Example: Based on the example with assumed repairs and maintenance charges Straight Line Method WDV Method Year Dep Repairs Total charge Dep Repairs Total charge 1 9,302 9,302 12,960 - 12,960 2 9,302 1,100 10,402 10,800 1,100 11,900 3 9,302 2,300 11,602 9,000 2,300 11,300 4 9,302 3,800 13,102 7,500 3,800 11,300 5 9,302 5,500 14,802 6,250 5,500 11,750 34

35. Demerits of WDV Method of D epreciation Difficulty in determining the rate of depreciation. It is very difficult to calculate a rate of depreciation which will depreciate the asset completely. Even if an asset becomes obsolete and useless, the books shows some balance. Interest factor ignored. Like, the fixed instalment method, interest factor is ignored in diminishing balance method also. No provision of funds for replacement. Like the fixed instalment method, the amount charged as depreciation is not invested outside the business. It creates problem, while replacing the asset, when it becomes useless . 35

36. Demerits of WDV Method of D epreciation Asset can not be completely written off. Under diminishing balance the value of asset is not completely written off. The asset account continues in the books, may be a very small amount, even after the asset becomes obsolete and useless. No information about original cost and accumulated depreciation. Under this method the asset account shows the reduced balance after charging depreciation. Assets are grouped on the basis of rate of depreciation and it becomes difficult to know the original cost and accumulated depreciation on any specific fixed asset . 36