Depreciation

Depreciation
-its causes, methods of

calculation
Meaning of depreciation
• Depreciation is the permanent and continuous decrease in the book
value of depreciable fixed assets due to use, obsolescence, passage
of time, expiration of legal rights.
• Depreciation is concerned with the historical cost: Depreciation is not
the result of fluctuations in value of fixed assets as fluctuations is
related to market price of the fixed asset.
Related terms
• Depletion: physical deterioration by the exhaustion of natural
resources like ore-deposits in mines, oil wells, quarries, etc.
• Amortisation: Economic deterioration due to expiration of intangible
assets like patents, copyrights, goodwill etc.
• Obsolescence: economic deterioration due to invention of improved
technique or equipment, market decline due to change in taste and
fashion, inadequacy of existing plant to meet the requirement of
existing business.
Factors affecting the amount of depreciation
• Historical Cost
• Expected Useful life
• Estimated residual value or salvage value
Causes of Depreciation
• Physical wear and tear
• With the passage of time: Due to interference of forces of nature
• Changes in economic environment: value of an asset decrease due to
decrease in demand of the asset.
• Expiration of legal rights such as patents, lease.
Recording of depreciation in Journal
• Depreciation A/c Dr.
• To fixed asset A/c.
• (being the depreciation provided)
Benefits of Charging Depreciation
• Tax benefit
• Real profit ascertainment
• Compliance to companies act 2013
• Ind AS 16 and Accounting Standard 10 requires charging depreciation.
Methods of Calculating Depreciation
• Straight line Method (SLM): Under straight line method, a fixed and equal amount of
depreciation (calculated at a fixed percentage on the original cost of fixed depreciable
asset) is written off during each accounting period over the expected useful life of the
asset.
• Rate of depreciation under SLM method:
• 1.) Total cost of asset = Purchase price + Expenses to be capitalised (like installation cost)
• 2.) Amount of depreciation= original cost – Residual value
expected useful life of the asset
• Rate of depreciation= Amount of depreciation/original cost X 100
Merits of SLM
• Easy to use and understand.
• Easy to calculate the amount and rate of depreciation.
• Book value of asset becomes zero or equal to its scrap value at the
expiry of its useful life.
Demerits of SLM
• Total charge (dep. + Repairs and renewals) in later years is more as
compared to that in earlier years due to increase in repairs and
renewals. Amount of depreciation remains constant year after year.
• It does not take into consideration the interest on the capital
invested.
• It does not provide for the replacement of the asset on expiry of its
useful life.
Suitability of SLM method
• For assets: ( patents, copyright, trademark, Furniture, Lease etc.)
a) Repair charges are less
b) Lesser possibility of obsolescence.
Written down value method:
• Depreciation is calculated here at a fixed percentage on the original
cost in initial years and on the written down value in subsequent
years.
• The depreciation is written off in each accounting period.
• the book value reduces every year, it is also known as the Reducing
Balance Method .
• Since the book value reduces every year, hence the amount of
depreciation also reduces every year. Under this method, the value of
the asset never reduces to zero.
Formula of depreciation by WDM method
• R = [1-n
Merits
• Uniform total charge: The total charge (Depreciation + Repairs and
Renewals) remains constant every year. As in initial years amount of
depreciation is more and repairs and renewals are less and vice versa
in subsequent years.
• Logical method: as the asset grows older, the depreciation amount
goes on decreasing.
Demerits
• Difficult to calculate the rate of depreciation
• Interest on capital invested is not taken into consideration.
• No replacement of the asset is provided on the expiry of useful life.
• Time consuming to write an asset value down to its break-up value
unless high rate is used.
Suitability of WDV method
• For assets: (Plants and Machineries and Building etc.)
a) the amount of repairs and renewals goes on increasing as the asset
grows older.
b) The possibilities of obsolescence are more.
Units of Production Method
• This method of charging depreciation on the asset is based on the units produced during the year.
The estimated total production of the asset is the criteria for providing depreciation.
• This method is applied where the value of the asset is more closely related to the number of units
it produces. Thus, in the years when the asset is heavily used, the amount of depreciation will be
high.
• Assets on which this method can be applied are Plant and Machinery. As their wear and tear will
depend on how much we use them.
Method of calculation of depreciation
 Annual Depreciation= Depreciable Value × Units produced during the year/Estimated total
production
 Depreciable Value = Original cost – Scrap value

1

Annuity method of Depreciation
• The amount invested in an asset has an opportunity cost i.e., if that amount had been invested in some other form it
would have earned some interest. The fixed instalment and the diminishing balance methods ignore such cost.
• This method of depreciation considers the cost of the asset and also the amount
of interest lost on the capital expenditure. Thus, it is based on
the assumption that if the amount that is spent on the purchase of the asset was
invested elsewhere, it would have earned a certain amount of interest.
• Not only the cost of the asset should be allocated but also the amount of interest
on it should be allocated over the useful life of the asset.
• This method determines the internal rate of return (IRR) on the cash flows of the
asset.
Cont.. Annuity method
• The amount of depreciation is calculated using the Annuity Tables.
• h the amount of interest varies from year to year (it goes on
decreasing) the instalment of depreciation is uniform which is
computed with reference to the annuity table
• The capital expenditure and interest accruing thereof are written off
during the life of the asset.
• The amount of depreciation every year is constant.
• But, the interest charged in the initial years is more and that in later
years is less. Hence, the amount of capital expenditure charged is less
in the initial years and it is more in later years.
By Investopedia
• “The annuity method of depreciation is a process used to calculate
depreciation on an asset by calculating its rate of return—just as if it
were an investment. It is commonly used with assets that have a large
purchase price, long life, and a fixed (or at least constant) rate of
return” (Investopedia).
Suitability of Annuity method
• This method is suitable in case of long-term leases.
• It is not suitable where there are frequent additions or deductions in
the asset because then the calculation of depreciation becomes
difficult.
Merits
• The amount of depreciation to be charged is ascertained from
Annuity Tables. Therefore, this method is scientific.
• This method provides for recovery of invested capital along with
interest.
• This method is most suitable to such assets which require heavy initial
investment
Demerits
• Calculation of depreciation becomes very difficult when additions are
made to assets.
• Calculation of interest is arbitrary.
• This system is not at all suitable for those assets which are of small
value.
Sinking fund method
• Provides for replacement of asset.
• Depreciation fund
• The amount of depreciation is invested in some other securities
carrying particular interest.
• At the end of useful life of asset the securities are sold out and asset
is purchased.

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Depreciation

-its causes, methods of

 Depreciable Value = Original cost – Scrap value

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