ACCOUNTING FOR DEPRECIATION

Depreciation
• Depreciation is the systematic allocation of
the depreciable amount of an asset over its
useful life.

• Depreciable amount is the cost of an asset, or

other amount substituted for cost, less its
residual value.
 Why Charge Depreciation?
It is essential to calculate depreciation on assets in
order to
• Accurately determine the profit or loss made by a
business
• Accurately ascertain the financial position of a
business
• Depreciation also draws attention to the fact that a
certain amount should be retained by a business out
of gross revenue, for replacement of assets used up
in the course of business.
 Determining the Depreciation Amount
The factors that are generally taken into account for
estimating the exact amount of depreciation are:

• Cost of asset including expenses for installation

and commissioning.

• Estimated useful life of the asset.

• Estimated scrap or salvage value of the asset at

the end of its useful life.
 Methods of Charging Depreciation
• The method of depreciation needs to be adopted keeping in mind
the nature of the asset and the conditions under which it is to be
used.

• The most commonly used methods are the straight-line method

and the reducing balance method. In some cases depreciation may
be based on production hours or production units

• In most cases the straight-line method is suitable.

• However the income tax law prescribes the reducing balance

method except in the case of ships.
 
 Straight Line Method (SLM)
Under this method, an equal amount is provided every year
during the useful life of the asset so as to reduce the cost of the
asset to nil or to its scrap value at the end of its useful life.

Cost of Asset – Scrap Value

Straight Line Depreciation = -----------------------------------
Useful life of asset

Suppose an asset costs Rs. 1,05,000, has a useful life of 10 years

and a scrap value of Rs. 5,000 at the end of 5years. The
depreciation to be charged every year under the straight line
method will be Rs. 20,000.
 Example- Straight Line Method
The corresponding depreciation schedule is given in the following Table
Depreciation schedule–Straight Line method
Year Cost Annual Year-end Accumulated Year-end
Depreciation Depreciation Book Value
(Rs.) (Rs.) (Rs.) (Rs.)
1 105,000 20,000 20,000 85,000
2 105,000 20,000 40,000 65,000
3 105,000 20,000 60,000 45,000
4 105,000 20,000 80,000 25,000
5 105,000 20,000 100,000 5,000
 Straight Line Method (SLM)
• This method is simple to apply and gives accurate results for
assets such as plant and machinery, leases, patents and
copyrights.

• It is based on the assumption that the asset provides equal

utility every year over its lifetime and entails equal amount of
expense every year.

• This may however not hold in all cases. The asset capacity used
may vary from year to year and the expense of maintenance
and repair may become higher as the asset becomes old.
Written Down Value(WDV) Method
• Under this method, a fixed percentage of the diminishing
value of the asset is charged as depreciation each year so as
to reduce the asset to its scrap value at the end of its useful
life.

• The depreciation charge is higher during the earlier years of

the life of the asset and it decreases from year to year.

• For an asset with useful life of n years, the rate of

depreciation under this method can be determined using the
following formula:
Depreciation  1  n Re sidual Value / Cost of Asset
Written Down Value(WDV) Method
• The charge to revenue under this method is uniform from
year to year as depreciation is higher in earlier years but
expenses on repairs and maintenance is lower.

• In the later years, the charge for depreciation is lower but the
expense on repairs and maintenance is higher.

• However, under this method, the value of the asset can never
be completely extinguished even after writing off all the
installments with the result that over the life of the asset, full
depreciation may not be provided.
Written Down Value(WDV) Method
• Under the tax laws, companies are allowed to use only
the WDV method as the motive is to provide incentive to
businesses to recover their investment in an accelerated
manner and to quickly replace the assets.

• Using the information of the previous illustration , the WDV

depreciation rate is found to be 45.60%, and is calculated as
follows:
5, 000
Depreciation rate  1 5  0.4560 or 45.60%
105, 000
 Example- WDV Method
The corresponding depreciation schedule is given in the following Table
Depreciation schedule–diminishing balance method
Year Cost Annual Year-end Accumulated Year-end
Depreciation Depreciation Book Value
(Rs.) (Rs.) (Rs.) (Rs.)
1 105,000 47,880 47,880 57,120
2 105,000 26,047 73,927 31,073
3 105,000 14,169 88,096 16, 904
4 105,000 7,708 95,804 9,196
5 105,000 4,193 99,997 5,003
*
Different from Rs. 5,000 due to rounding off of the depreciation rate
 Production Units Method
• According to the production units method, the useful life of an asset is expressed
in terms of the total units of production or the expected use of the asset.

• Using this method, depreciation is charged on the basis of the number of units
produced during a period

• The per unit depreciation rate is calculated on the basis of estimated total
production.

• This method is well-suited to factory machinery.

• The life of the machinery can be expressed either in terms of units of production
or in terms of machine hours.

• The method can also be used for delivery vehicles (miles driven) and airplanes
(flying hours).
 Production Units Method
• Depreciation for a period, using this method,
is calculated as:
Production for the period/Hours worked
Depreciation for the period  Depreciableamount×
Estimated totalproduction/Totalhours

• This method cannot be used for assets such as

buildings or furniture because it is difficult to
measure activity levels for these assets.
 Example- Production Unit Method
A company acquired a new machine for Rs. 1,000,000 to produce a special product. The useful
life of the machine was estimated to be 5 years, after which it was expected to be sold at Rs.
100,000. During its useful life, the machine was expected to produce 90,000 units. The year-wise
estimated production is as given below.

Year Production (units)

1 6,250
2 12,500
3 15,000
4 25,000
5 31,250

The year-wise depreciation is calculated as follows:

Depreciation for year 1 = Rs. 900,000 × 6,250/90,000 = Rs. 62,500

Depreciation for year 2 = Rs. 900,000 × 12,500/90,000 = Rs. 125,000

Depreciation for year 3 = Rs. 900,000 × 15,000/90,000 = Rs. 150,000

Depreciation for year 4 = Rs. 900,000 × 25,000/90,000 = Rs. 250,000
Depreciation for year 5 = Rs. 900,000 × 31,250/90,000 = Rs. 312,500
 Determination of Useful Life
• The following factors are considered in determining the useful life of an asset:

• Expected usage of the asset.

• Expected physical wear and tear

• Technical or commercial obsolescence

• Legal or similar limits on the use of the asset

• The estimates may change due to new developments such as unexpected changes
in technology or due to damage to the asset.

• Except for some land assets such as quarries and landfill sites, land has
an indefinite life. It is, therefore, not depreciated
 Choice of Depreciation Method
• The entity should select a method that closely reflects the
expected pattern of consumption of the future economic
benefits embodied in the asset.
 
• The straight-line method is simple, but it fails to match the
cost of consumption of the asset with the revenue when the
use of the asset is not uniform over the life of the asset.

• It may result in the overstatement of profit and the value of

the asset in the initial years of the life of the asset when it is
used more intensively.
 Choice of Depreciation Method
• The diminishing balance method is more
consistent with the life cycle cost of most assets
as depreciation is higher in the initial years but
expenses on repairs and maintenance is lower.

• In the later years, depreciation is lower but the

expense on repairs and maintenance is higher.
The charge to revenue under this method is
uniform from year to year.
 Choice of Depreciation Method
• The units of production method provides for a better matching of costs and
revenues for most types of equipment.

• However, it requires additional record-keeping.

• In most cases, companies adopt the same method of depreciation as is used by

other companies in the same industry.
 
• Thus, the nature of industry, type of equipment, objective of the management
are some of the factors that influence the choice of the method of depreciation.

• Practically, companies may not use the same method of depreciation for all
depreciable assets
 Component Depreciation
• One of the main features of the Companies Act, 2013 relates to the provision of
component-wise depreciation.

• Each part of an item of property, plant and equipment with a cost that is
significant in relation to the total cost of the item shall be depreciated
separately.

• For example, it may be appropriate to depreciate separately the chassis and

engine of a bus.

• This is because the chassis is expected to have a relatively longer life than that of
the engine.

• Some parts may be grouped in determining the depreciation charge when these
have the same useful lives and depreciation methods
 Change in the Method of Depreciation
• The depreciation method applied to an asset should be reviewed at least
at each financial year-end.

• If there has been a significant change in the expected pattern of

consumption of the future economic benefits embodied in the asset, the
method should be changed to reflect the changed pattern.

• Such a change should be recognized prospectively by including it in the

financial performance and financial position in the current and future
periods.

• The entity expenses the depreciable amount at the time of change over
the remaining useful life of the asset.
 Example
A company bought a truck for Rs. 2,500,000. It estimated its useful life as 8 years and a residual
value of Rs. 250,000. The company followed the straight-line method of depreciation for the first
4 years and then decided to change the depreciation method to diminishing value. The
depreciation that the company will charge in the fifth year, assuming there is no change in the
residual value, is calculated below.

Depreciable amount (Rs. 2,500,000 – Rs. 250,000) Rs. 2,250,000

Annual straight-line depreciation (Rs. 2,250,000/8) 281,250

Accumulated depreciation for 4 years (Rs. 281,250 × 4) 1,125,000

Written down value at the end of 4 years (Rs. 2,500,000 – 1,125,000) 1,375,000

Rate of written-down value depreciation [1– (250,000/1,375,000)0.25] 34.70%

Depreciation charge for the fifth year (1,375,000 × 34.70%) 477,125

 Depreciation-Legal Provisions
• Schedule II of the Companies Act, 2013 requires systematic allocation of the
depreciable amount of an asset over its useful life.

• It specifies the useful life and residual value of various tangible assets.

• For this purpose, Schedule II divides companies into two categories:

 
• 1. For a prescribed class of companies, the useful lives should normally be in
accordance with the schedule. However, if a prescribed company uses a
different useful life, it should disclose a justification for doing so. The
prescribed class of companies includes those whose financial statements are
required to comply with accounting standards prescribed under Companies
Act, 2013
 
• 2. For other companies, the useful life and the residual value applied should
not be higher than that specified in Schedule II.
 Depreciation-Legal Provisions
• The useful lives of assets used on a shift-basis have been
specified in the schedule based on their single shift working.

• Except for assets in respect of which no extra shift depreciation

(NESD) is permitted, if an asset is used for any time during the
year for double shift, the depreciation will increase by 50% for
that period and in case of the triple shift the depreciation shall
be calculated on the basis of 100% for that period.

 
• The residual value of an asset is often insignificant, but it should
generally be not more than 5% of the original cost of the asset.
 Depreciation-Legal Provisions
• The Income Tax Act, 1961 allows companies to claim
depreciation on WDV at the prescribed rates.

• While companies compute depreciation for financial reporting

purposes using rates of depreciation prescribed by Company
Law, they can use higher rates of depreciation provided under
the Tax Laws to compute their taxable income.

• Higher rates of depreciation are generally allowed under the

tax laws to provide an incentive for more investment in
businesses
 When to Stop Charging Depreciation?
• Depreciation is recognized even if the fair value of the
asset exceeds its carrying amount, as long as the asset’s
residual value does not exceed its carrying amount.

• The residual value of an asset may increase to an amount

equal to or greater than the asset’s carrying amount.

• If it does, the asset’s depreciation charge is zero unless

and until its residual value subsequently decreases to an
amount below the asset’s carrying amount.
 Addition to Existing Assets
• Each part of an item of property, plant and equipment
with a cost that is significant in relation to the total
cost of the item shall be depreciated separately.

• For such items, their useful life has to be determined

separately.

• Other additions can be depreciated over the

remaining useful life of the existing asset.
 Impairment of Assets
• Impairment of assets is a sudden or
unexpected decline in the expected future
benefits from an asset such as factory, vehicle
or property.

• This might result from physical damage to the

asset, changes in law or obsolescence
resulting from technological innovation.
 Impairment Loss
• Impairment loss is the amount by which the carrying amount of an
asset or a cash-generating unit exceeds its recoverable amount.

• The recoverable amount of an asset or a cash-generating unit is the

higher of its fair value minus costs to sell and its value in use.

• Fair value minus costs to sell is the amount that can be obtained
from the sale of an asset or cash-generating unit in an arm’s length
transaction between knowledgeable, willing parties, minus the
costs of disposal.

• Value in use is the present value of future cash flows expected to

be derived from an asset or cash-generating unit.
 Cash Generating Unit
• A cash-generating unit is the smallest identifiable group of assets that
generates cash inflows that are largely independent of cash inflows from other
assets or groups of assets.

• For example, a mining entity owns a private railway to support its mining
activities.

• The private railway could be sold only for a scrap value as it does not generate
cash inflows that are largely independent of cash inflows from other assets of
the mine.

• Therefore, the entity estimates the recoverable amount of the cash-generating

unit to which the private railway belongs, that is, the mine as a whole.
 Intangible Assets
• An intangible asset is an identifiable non-monetary asset without
physical substance.

• Monetary assets are money held and assets to be received in fixed or

determinable amounts of money.

• The definition of an intangible asset requires an intangible asset to be

identifiable to distinguish it from goodwill.

• Common examples of intangible assets are computer software, patents,

copyrights, motion picture films, customer lists, mortgage servicing
rights, fishing licenses, import quotas, franchises, customer or supplier
relationships, customer loyalty, market share and marketing rights.
 Intangible Assets-Amortization
• Amortization means allocation of the depreciable amount of an
intangible asset with a finite useful life on a systematic basis over its
useful life.
 
• The amortization method used is based on the pattern in which the
asset’s future economic benefits are expected to be consumed by the
entity.

• If that pattern cannot be determined reliably, the straight-line method

is to be used.

• The amortization charge for each period is recognized in profit or loss

unless it is allowed to be included in the carrying amount of another
asset.