DEPRECIATION

CONCEPT
A permanent fall in the value of fixed assets
arising through wear and tear from the use of
those assets in business.
Depreciation in accounting used to denote
decrease in book value of a fixed asset
DEFINITION
Depreciation is a measure of the wearing out,
consumption or other loss of value of
depreciation 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 amortization of assets
whose useful life is predetermined.
DEFINITION
The International Accounting Standards Committee
(IASC) (now international accounting standards
board) defines depreciation as follows: depreciation
is the allocation of the depreciable amount of an
asset over the estimated useful life. The useful life is
in turn defined as the period over which a
depreciable asset is expected to be used by the
enterprise. The depreciable amount of a depreciable
asset is its historical cost in the financial statements,
less the estimated residual value. Residual value or
salvage value is the expected recovery or sales
value of the asset at the end of its useful life.
Depreciation Coverage
Depletion: It refers to the physical deterioration by
the exhaustion of natural resources (oil wells,
mines etc.)
Amortisation: It refers to the economic
deterioration by the expiration of intangible assets
(patents, copyright etc)
Obsolescence: It refers to the economic
deterioration by (a) invention of improved
technique or equipment (b) market decline due o
change in taste and fashion etc (c) inadequacy of
existing plant to meet the increased business.
Causes of Depreciation
1. Deterioration/Wear and Tear: It is the physical process of wearing
out on account of constant use as in case of plant and machinery,
building etc.
2. Obsolescence refers to loss of usefulness due to the development
of improved equipment or processes, changes in style or other
causes not related to the physical conditions of the asset.
3. Exhaustion/Depletion- An asset may got exhausted with usage,
Example mineral mines, oil wells etc.
4. Efflux of time mere passage of time will cause a fall in the value
of an asset even if it is not used.
5. Accidents an asset may reduce in value because of meeting
with an accident.
6. Fall in market price a sudden fall in the market price of the
asset reduces its value even if it remains brand new.
7. Expiration of Legal Rights
Need For Depreciation Accounting

1. To calculate proper profit.

2. To show true financial position.
3. To ascertain the true cost of
production.
4. To accumulate funds for
replacement of assets.
5. To Comply with legal requirements.
Factors Affecting
Depreciation
The amount of depreciation of a fixed asset is
determined taking into account the following
three factors:
1. its original cost,
2. its recoverable cost at the time it is retired from
service and
3. the length of its life.
. The excess of cost over the estimated residual
value is the amount that is to be recorded as
depreciation expense during the assets life-time.
Methods Of Depreciation
1.Straight line method,
2.Diminishing balance method
Straight Line Method Of
Depreciation
This method which is also known as fixed
installment system, provides for equal amount
of depreciation every year. Under this method,
the cost of acquisition plus the installation
charges, minus the scrap value, is spread over
the estimated life of the asset to arrive at the
annual charge. In other words, this method
writes off a fixed percentage, say 20%, of the
original cost of the asset every year in such a
way that the asset is reduced to nil or scrap
value at the end of its life.
Rate of Depreciation under SLM

Amount of Depreciation
=Original Cost- Residual Value/Expected
useful life of asset

Rate of Depreciation
== Amount of Dep/Original cost *100
ILLUSTRATION
A machine had a cost of $24,000, salvage
value of $2,000 and useful life of 5 years
Annual depreciation expense =

Cost Salvage value

Life
= $24,000 - $2,000
5 years

= $4,400 annual depreciation

ILLUSTRATION
A machine had a cost of $30,000,
salvage of $5,000 and useful life of 6
years. Compute depreciation under the
straight line method?
What is depreciation expense in year 3?
Diminishing Balance
Method
This method which is also known as the,
`reducing installment system, or `written down
value method, applies depreciation as a fixed
percentage to the balance of the net cost of the
asset not yet allocated at the end of the
previous accounting period. The rate of
depreciation remains constant year after year
but the amount of depreciation goes on
decreasing.
Rate of Depreciation under DBM
ILLUSTRATION
On 1-1-2003, machinery was purchased
for rs.3,00,000. Depreciation at the rate
of 10% has to be written off. Write up the
machinery account for three years
under:
1. Straight line method (SLM) and
2. Written down value method (WDV)
ILLUSTRATION
On 1-1-2002, machinery was purchased
for rs.30,000. Depreciation at the rate of
10% on original cost was written off
during the first two years. For the next
two years 15% was written off the
diminishing balance of the amount. The
machinery was sold for rs.15,000. Write
up the machinery account for four years
and close the same.
Self Do Questions
Advantages and Disadvantages of
Straight Line Method
Advantages and Disadvantages of
Diminishing Method
Difference Between Straight Line
Method & Diminishing Method