DEPRECIATION

WHAT IS DEPRECIATION

The Accounting process of gradually converting the unexpired costs of fixed assets into expenses over a series of accounting period is called DEPRECIATION.

Contd.


The acquisition cost of an asset which means the price paid to acquire or buy it is capitalised (means that it is not charged immediately as cost against revenue in the profit and loss account) as per cost convention. Instead it is carried forward as FIXED ASSET in the BALANCE SHEET.

Contd.
Because it is regarded as a pre-payment for the services to be enjoyed by the concern. Therefore it is to be written off as an expense during its useful life. i.e. A portion of the cost should be charged against profit as an expense in each of the accounting periods in which the asset is gainfully used.

Contd
Though depreciation is the measure of reduction in the use value of an asset, it does not refer to the decrease in its market value. Therefore Depreciation is the process of allocating the cost of a fixed asset over its estimated useful life in a rational and systematic manner.

Important Terms
The following are some of the important terms to be known regarding depreciation.
i)

DEPRECIABLE ASSETS :The assets whose lifetime can be estimated and useful during two or more accounting periods in production or service activities of an organisation is called as depreciable assets can also called as FIXED ASSETS.

Important terms contd.

ii) USEFUL LIFE :It is the time during which the asset is helpful in the normal business activities of a firm. It can be less than the total life time of the asset. It can be exactly pre-determined or it should be estimated on reasonable basis.

Important terms contd

iii) REALISABLE VALUE:This is the amount realisable at the end of the assets useful life either as scrap or as second hand asset. iv) EFFLUXION OF TIME:It is the passage of time irrespective of actual use of an asset as in the case of based assets. v) OBSOLESCENCE:It refers to an asset becoming out of date due to improved models or methods.

Objectives
ASCERTAINMENT OF TRUE PROFITS :To find out net profit or net loss , we add the revenues and deduct all the expenses incurred in that period so the portion of cost i.e. depreciation is charged. ii) PRESENTATION OF TRUE FINANCIAL POSITION:Unless depreciation is charged assets may be overstated in the balance sheet.
i)

Objectives contd
iii) REPLACEMENT :A continous decline in the value of asset over several years may lead to a decision to replace the asset. If depreciation is not provided the whole of the profit may be withdrawn during the life of the asset.

Factors affecting the amount of depreciation

i)

Original cost of the asset :Invoice price (-) any trade discounts (+) cost essential to bring the asset to a useable condition such as freight, insurance, installation charges.

Factors contd.
ii) Estimated scrap or Residual value :Residual value is the estimated sale value of the asset at the end of its economic life to the firm. In determining the residual value, the cost to be incurred in the disposal or removing of the asset, should be deducted out of the total realisable value.

Factors contd.
iii) Estimated life :An asset may exist physically but it may not be capable of producing goods at a reasonable cost. Life of the asset can be estimated in terms of year, months, hours, units of output or by other operating measures such as kilometers in case of trucks, taxies e.t.c.

Methods of Depreciation
i) ii) iii) iv) v) vi) vii) viii) ix) x)

Straight line method. Written down value. Annuity method. Depreciation fund method. Insurance policy method. Sum of digits method. Depletion method. Revaluation method. Machine hour rate method. Repairs provision method.

Straight line / Equal installment method

It allocates equal amount to each period. A fixed amount of the original cost is charged as depreciation every year. Formula: Annual depreciation = cost of the asset residual value ----------------------------estimated life

SL- Method contd..

Find depreciation per annum :Cost of machinery 120000 on 1.1.1989. Salvage value 20000. Life of the year 10 years. Dep = 120000 20000 ------------------------- = Rs. 10000. 10

Rate of depreciation
The rate of depreciation is the reciprocal of the estimated useful life. If the useful life of an asset is 10 years, the depreciation rate will be 1/10 or 10%.

WRITTEN DOWN VALUE METHOD

It is also called as diminishing balance method. In this method instead of fixed amount, a fixed rate on the reduced balance of the asset is charged as depreciation every year. Since constant percentage rate is being applied to the written down value, the amount of depreciation charged every year decreases over the life of the asset.

WDV method contd..

The maximum loss of an asset occurs in the early of use. Therefore this method assumes that an asset should be depreciated more in the earlier years of use than later years. Formula : rate of deprn Sum :

ANNUITY METHOD
When an amount is invested in acquiring an asset, the business has to forgo some amount of interest which could have been earned if the money was instead employed in the purchase of an income producing assets like securities, under this method the total amount of depreciation written off during the life of the asset equals the net cost of the assets plus interest calculated on the reducing balance. This method can only be applied to an asset the life of which will extend to a known period. Eg. Lease.

DEPRECIATION FUND METHOD.

 

It is otherwise called as sinking fund method. The amount of annual depreciation is invested outside the business every year in good securities bearing interest at a specified rate. The process of investing the amount of depreciation together with the interest received goes on till the time of replacement of assets. At this time of replacement, all the securities are sold out and with cash received, the new asset is purchased.

INSURANCE POLICY METHOD.



It is otherwise called as Capital Redemption Policy method. Cash which is equal to the amount of depreciation, is paid by way of premium every year. The amount goes on accumulating with the insurance company at a certain rate of interest and is paid back to the insured at the maturity of the policy. The main advantage of this method is that the company need not worry whether the investments as the depreciation fund method, will be sold at best price or not.

SUM OF DIGITS METHOD.

Under this method, the amount of depreciation to be written off each year is calculated by the following formula: =Remaining Life of the Asset(including the current year)/ sum of all digits of the life of the assets in years X cost of the asset.  This method is similar to Written down value method.


SUM OF DIGITS METHOD. (CONTD)

For eg. Suppose the life of an asset costing Rs. 50000 is 10 years. The sum of digits from 1 to 10 comes to 10+9+8+..+1= 55. The depreciation provided for 1st year is 10/55 X 50000 = RS 9091. In the 2nd year it is 9/55 X 50000 = RS 8181

REVALUATION METHOD.


This method is used only in case of small items like cattle(Livestock), or loose tools where it may be too much to maintain an account of each single item. The amount of depreciation to be written off is determined by comparing the value at the end of the year with the beginning of the accounting period.

REVALUATION METHOD.(CONTD)
For eg. Suppose on 1st April 2009, the value of loose tools was Rs 10000 and during the year Rs 30000 worth of tools were purchased. Now if in the end of the year ie 31st March 2010, the loose tools are considered to be worth only RS 20000 then the depreciation amount comes to Rs 10000+ RS 30000 RS 20000 = Rs 20000

DEPLETION METHOD.


This method is used in case of natural resources like mines, quarries etc, where an estimate of total quantity of output likely to be available should be available. Depreciation is caluculated per ton of output.

DEPLETION METHOD.(CONTD)
For eg. Suppose if a mine is purchased for RS 20,00,000 and it is estimated that the total quantity of mineral in the mine is 5,00,000 ton, then the depreciation per ton of output comes to = 20,00,000/ 5,00,000 = RS 4. If the output in the first year is 30,000 then the depreciation will be 30,000 X RS 4 = RS 1,20,000.

MACHINE HOUR RATE METHOD.



This is more or less like the depreciation method. Instead of the usual method of estimating the life of a machine in years, it is estimated in hours. Then, an accurate record is kept recording the number of hours each machine runs and the depreciation is calculated accordingly.

MACHINE HOUR RATE METHOD.(CONTD)

For eg. Suppose the effective life of a machine may be 30,000 hours and the cost of machine is RS 4,50,000 then the hourly depreciation is calculated as follows = 4,50,000/30,000 = RS 15. The depreciation for a particular year during which the machine runs for 2,500 hours will be 2,500 X Rs 15 = RS 37,500

REPAIRS PROVISION METHOD.



Under this method to the cost of the asset(less its estimated scrap value), the amount expected to be spent on its repairs and maintenance throughout its life should be added and the sum is divided by its estimated life.

CHANGES IN METHOD OF DEPRECIATION.



Accounting Standard 6 stated that the method selected should be applied consistently from period to period. A change from one method of providing depreciation to another should be made only if the adoption of the new method is required by statue or if it were considered that the change would result in a more appropriate preparation of the financial statements of the enterprise.

CHANGES IN METHOD OF DEPRECIATION.(CONTD)



When such a change in the method of deprecaiton is made, depreciation should be recalculated in accordance with the new method from the date of the asset coming into use. The deficiency or surplus arising from recomputation should be adjusted in the accounts in the year in which the method of depreciation is changed.

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