Chapter 06

DEPRECIATION
CHAPTER-6
AUTHOR:
DR. KAPIL JAIN
RASHMI SOMANI
1

 Depreciation is an expense that occurs in each accounting
period during which the assets provide the service to the
organization. It is the cost of usefulness lost or the cost of
diminution of service rendered from a fixed asset.
 According to William Pickels, “Depreciation may be defined as
the permanent and continuing diminution in the quality, quantity
or the value of an asset.”
 Some of the factors responsible for causing depreciation are as
follows:
 Usage of fixed assets over a passage of time leads to wear and tear or
physical deterioration of the assets
 Usage of certain fixed assets are prohibited by organizations when their
legal rights are expired
 Usage of fixed assets are restricted due to rapid changes in technology
and demand by organizations
© 2012, Dreamtech Press :: Chapter 6 2
DEFINITION OF DEPRECIATION

 Depreciation is charged to fulfill the following needs:
 Calculating net profit accurately: Implies that deprecation help in
calculating the profit for a year when all cost incurred are properly
charged against the revenue generated by them.
 Showing assets at its reasonable value: Implies that depreciation
charge is carried forward for only that part of the asset, which
represents the expired costs of the expected future service.
 Maintaining the original monetary investment of the asset: Implies
that the owner of a fixed asset is restricted from consuming his/her
capital by charging depreciation on a regular basis.
 Resulting in some incidental advantages: Implies that the provision
of depreciation reduce the profit thereby preventing the distribution
of cash resources of the organization by providing dividends to
stakeholders.
 Providing the replacement on an asset: Helps in the replacement of
an old asset by accumulating fund produced through depreciation.
NEED FOR CHARGING DEPRECIATION

 The measurement of depreciation is based on the following three
factors:
 Total Cost of the Asset: Includes the invoice cost, cash discount, and other costs,
which are required to bring the asset to a usable condition. The other costs
include items, such as freight, shipping charges, installation cost, and repair
costs. The formula for determining total cost of an asset is as follows:
Total Cost of Asset = Invoice cost – Cash discount + Other costs
 Estimated Useful Economic Life: Refers to the useful service life of the asset that
can be calculated in terms of time or output or other operating measurements,
such as kilometers for vehicles. The useful economic life of an asset is the period
during which the organization expects to use the asset to earn revenue. The
useful life of a depreciable asset is shorter than its physical life..
 Estimated Turn-in (residual) Value: Refers to an estimated sales value of the
asset at the end of its economic life. It should be determined after deducting the
disposal and removal cost and cost for getting rid of any unwanted material
during the manufacturing process. The residual value depends on the manner and
the length of time for which the asset is used. Thus, in accounting, depreciation
can be defined as a valuation process if consider the entire life of the asset.
FACTORS AFFECTING THE COMPUTATION
OF DEPRECIATION

METHODS OF CALCULATING
DEPRECIATION
MethodsofCalculating
Depreciation Straight Line Method
Written Down Value Method
Sum of Years' Digit Method
Inventory or Revaluation Method
Annuity Method
Depreciation Fund Method
Insurance Policy Method or Capital Redemption Policy Method
Depletion Method
Machine Hour Rate Method

 In the straight line method, the amount of depreciation is charged
every year throughout the life of the asset.
 This method is based on the assumption that depreciation is a function
of time rather than its usage.
 A fixed proportion of the original cost of the long-term assets is written
off each year. In such a case, the asset account is reduced to zero or a
residual value at the end of its estimated economic useful life.
 When the amount of depreciation and the corresponding time are
plotted on a graph, it gives a straight line. Thus, this method is known
as straight line method.
 It is also known as the fixed installation method, as over the useful life
of the asset, the amount of depreciation remains constant for every
year.
 In straight line method, the formula for calculating depreciation is as
follows:
Depreciation =
Cost of asset−Estimated scrap value
Estimated economic life of asset
STRAIGHT LINE METHOD

 The written down value method is used for the assets, such as
plant and machinery, that show declining efficiency in the
later years of their life.
 This method is also known as reducing balance method as the
book value keeps on reducing by an amount equal to the
annual charge of depreciation.
 In written down value method, the depreciation rate can be
calculated using the following formula:
R = [1- {n (√S/C)}]
Where, R = Depreciation rate
S = Residual value less removal and disposal cost
C = Acquisition costs including costs of installation
n = Estimated economic life in years
WRITTEN DOWN VALUE METHOD

 In this method, the rate of depreciation is determined by a
schedule of fraction, where the denominator (which remains
constant) is the sum of the digits representing the life of the
assets taken in reverse order.
 Thus, if the life of an asset is three years, then the
denominator (which is the same for all the years) is calculated
by adding the digits from one to three (1+2+3).
 This method results in a more accelerated write-off than the
straight line method.
 The formula used for the calculation of depreciation using
sum of years’ digit method is as follows:
Depreciation cost = Original cost –salvage value
Depreciation = depreciation cost * respective fraction
SUM OF YEARS’ DIGITS METHOD

 The inventory method of depreciation is adopted only where
the asset is represented by a large quantity of small and
diverse items having small unit cost.
 The inventory or revaluation system involves the following
steps:
1. Valuing the items, which are in a good condition and would be
useful for future, at their original cost at the end of the financial
year
2. Comparing the calculated cost with the opening balance of the
account and the difference is charged as depreciation
3. Recording the purchase of assets on the debit side of the asset
account in a normal manner
INVENTORY METHOD

 The annuity method of depreciation deals with the effect of cost
of capital (interest on fixed assets) in the calculation of
depreciation.
 It considers that the business, besides losing the original cost of
the asset also loses interest, on the amount used for buying the
asset.
 The lost interest is the amount that an organization would have
earned in case it is invested in some other form of investment.
 Therefore, the asset account is debited with interest, which is
ultimately credited to the profit and loss account, and is credited
with the amount of depreciation, which remains fixed every year.
 The annual amount of depreciation is determined with the help
of the annuity table.
 The amount of total depreciation is determined by adding the
cost of the asset and interest at an expected rate.
ANNUITY METHOD

 In the depreciation fund method, a fund named depreciation
fund or sinking fund is created.
 The amount of depreciation goes on accumulating in the fund
until the asset is completely depleted.
 This method becomes readily available for the replacement of
the asset at the end of its useful life.
 In depreciation fund method, the amount of depreciation of an
asset remains constant throughout its life. It is recorded in the
profit and loss account.
 The amount of annual depreciation is invested in several reliable
securities and bonds, such as government bonds, which provide
interest at a specified rate.
 The process of investing the depreciation amount together with
the interest received goes on until the time of replacement of
the asset.
DEPRECIATION FUND METHOD

 The insurance policy method is also known as the capital
redemption policy method.
 In this method, the organization takes a policy from an insurance
company against the asset.
 The amount of policy is such that it is sufficient to replace the
asset when it is worn out. The fund (equal to the amount of
depreciation) is paid by means of premium every year.
 This fund accumulates at a certain rate of interest with the
insurance company and it is paid back to the insured
organization after the maturation of policy.
 The amount so made available by the insurance company is used
for purchasing a new asset.
 This method is similar to the depreciation fund method with
some differences, which are stated as follows:
 Utilizing cash to pay insurance premiums instead of buying securities
 Getting small rate of interest on compound basis from the insurance
company
INSURANCE POLICY METHOD

 In the depletion method, natural resources include physical
assets, such as mineral deposits, oil and natural gas, and
timber stands.
 These natural resources are exhausted by exploitation. In
some cases, reduction in physical deposits is offset by the
growth or development of additional deposits.
 The cost of natural resources is the price paid for its
acquisition, plus the price paid for the development of such
assets to bring it to a suitable state for production.
 The periodic depletion is not calculated in terms of year.
Depletion for each unit extracted is determined as follows:
Depletion per unit (U) = (Acquisition cost (C) – Residual value
(S))/Estimated life in terms of production units (n)
DEPLETION METHOD OF DEPRECIATION
OF NATURAL RESOURCES

 In the machine hour rate method, the life of the machine is not
estimated in years, but it is determined in hours.
 Proper records are maintained for the running hours of the
machine and depreciation is computed according to them.
 Machine hour rate means the cost of running a machine for an
hour.
 This is an ideal method for calculating depreciation when a
variety of expensive machines is used in production.
 The method can be calculated by using the following formula:
Machine hour rate = Cost of machine/Machine hours
MACHINE HOUR RATE METHOD

 The management of an organization needs to select the most
appropriate method based on various factors. Some of these
factors are discussed as follows:
 Financial Reporting: Measures the expiration of the long-term assets and
establishes their realistic value in the income statement.
 Legal Provision: Plays a significant role in providing the provision for
depreciation. In India, the Companies Act, 1956 provides provisions in
case of organizations to decide which method of depreciation need to be
used.
 Effect on Managerial Decision: Implies that the depreciation method
should be selected by evaluating the effect of the method on managerial
decisions.
 Technology: Helps in selecting the method of depreciation, as the
commercial life of a machine is decided by the technological progress.
The industries that are exposed to rapid technological changes prefer to
have a fixed depreciation rate.
CRITERIA FOR SELECTING THE
DEPRECIATION METHOD

 Depreciation is a systematic and rational method of allocating costs to the
estimated useful life of the fixed assets during which benefits are received.
 Some of the most commonly used methods of depreciation are straight line
method, written down value method, sum of years’ digits method, inventory
method, annuity method, depreciation fund method, and insurance policy
method.
 The service potential of an asset declines with time due to which its useful
life is very limited. Therefore, it is essential for an organization to
determine the actual cost incurred and benefit derived from a fixed asset.
 The straight line method and the written down value methods are the most
commonly used methods of calculating depreciation.
 The management of an organization needs to select the most appropriate
method based on various factors such as financial reporting, legal
provision, effect on managerial decision, and technology.
16
RECAP
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