Factors affecting depreciation

Cost of asset
Estimated net residual value
Depreciable cost
Estimated useful life

1. Factors Affecting the Amount of Depreciation

2. The calculation of depreciation depends on cost, estimated useful life of asset and probable salvage value or restore value of asset. There are mainly four factors that affecting the amount of depreciation. They are: Cost of asset Estimated net residual value Depreciable cost Estimated useful life

3. Cost of asset The cost of asset also called as historical cost or original cost of asset. The cost of asset includes invoice price and other cost such as freight and transportation cost, transit insurance, installation cost, registration cost, commission paid on purchase of asset add items such as software, etc. which are necessary to put the asset in use . In case of purchase of a second hand asset it includes initial repair cost to put the asset in workable condition.

4. According to Accounting Standand-6 of ICAI, cost of a fixed asset is “the total cost spent in connection with its acquisition, installation and commissioning as well as for addition or improvement of the depreciable asset”. For example, a photocopy machine is purchased for Rs.50,000 and Rs.5,000 is spent on its transportation and installation. In this case the original cost of the machine is Rs.55,000 (i.e. Rs.50,000 + Rs.5,000 ) which will be written- off as depreciation over the useful life of the machine.

5. Estimated Net Residual Value Net Residual value is the estimated net realisable value (or sale value) of the asset at the end of its useful life . The net residual value is calculated after deducting the expenses necessary for the disposal (distribution) of the asset. For example, a machine is purchased for Rs.50,000 and is expected to have a useful life of 10 years. At the end of 10th year it is expected to have a sale value of Rs.6,000 but expenses related to its disposal are estimated at Rs.1,000. Then its net residual value shall be Rs.5,000 (i.e. Rs.6,000 – Rs.1,000).

6. Depreciable Cost Depreciable cost = (original cost of the asset – estimated net residual value of the asset) For ex : A machine purchased for Rs.50,000 transportation and installation +Rs.5,000 -------------------------------- original cost of machine is (50,000+5,000) Rs.55,000 Expected to have useful life of 10 years and At the end of 10th year it is expected to have a sale value of Rs .11,000 but expenses related to its disposal are estimated at -Rs.1,000 --------------------------------- net residual value shall be (11,000-1000) Rs.10,000 --------------------------------- So , Depreciable cost = (Rs.55,000-Rs.10,000) Rs.45,000

7. Rs.45,000 shall be charged as depreciation over a period of 10 years. It is important to mention here that total amount of depreciation charged over the useful life of the asset must be equal to the depreciable cost. Ex :Rs.45,000 = 45,000*10% of 10 times 10 = 45,000 1 = ? 1*45,000/10 = 4,500 . It is the 10% of 45,000. so Charge of depreciation on asset, here is 10% for 1 year. If not then capital expenditure is under recovered. It violates the principle of proper matching of revenue and expense .

8. Estimated Useful Life As per Accounting Standard – 6 useful life of an asset is normally the “period over which it is expected to be used by the enterprise”. In simple useful life of the asset is the period till expiry of the asset on the other hand it is economic or commercial life of the asset. Physical life of an asset is not important because the asset may exist physically but not capable for the use after the expiry date. For ex: a machine is purchased and it is estimated that it can be used in production process for 5 years. After 5 years the machine may still be in good physical condition but can’t be used for production profitably, i.e., if it is still used the cost of production may be very high .

9. Estimation of useful life of an asset is difficult as it depends upon several factors such as usage level of asset, maintenance of the asset, technological changes, market changes, etc. The useful life of an asset is expressed in number of years but it can also be expressed in other units, e.g., number of units of output (as in case of mines) or number of working hours. Useful life depends upon the following factors : Pre-determined by legal or contractual limits, e.g. in case of leasehold asset, the useful life is the period of lease. The number of shifts for which asset is to be used. Repair and maintenance policy of the business organisation. Technological obsolescence. Innovation/improvement in production method. Legal or other restrictions.

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