DEPRECIATION

By Ibrahim Mulla Sunay Khaire Shilpi Jajodia Vikas Chhabria

Definition
The allowance for WEAR and TEAR of any Capital Asset either caused due to usage or passage of time. Amount of decreasing value in a capital asset allowed to be deducted from a business tax return.

Cost Recovery.

What Can Be Depreciated?

You can DEPRECIATE ASSETS only if it meets the following requirements:
It is used in business or held for the production of income. It must be expected to last for more than one year. In other words, it must have a useful life that extends substantially beyond the year it was placed in service. It is Assets that wears out, decays, gets used up, becomes obsolete, or loses value from natural causes.

Depreciable Assets can be either tangible or intangible.

Tangible Depreciable Asset

Purchased assets you can see or touch.
Livestock (purchased). Machinery. Buildings and improvements, fences. Dams, ponds, or terraces. Irrigation systems and water wells. Partial business use.
-You can claim depreciation on the part of a vehicle used in the business (ex - 1/2 business value of a truck).

Intangible Depreciable Asset

Purchased assets that has value that you cannot readily see or touch.
Computer Software. Copyrights, patents, trademarks etc.

What Cannot Be Depreciated?

Assets placed into service and disposed of in the same year. Land (land can never be depreciated). Inventory.
You cannot depreciate property held for resale in the normal course of business.

Leased property.
The value of the lease is already showing up as a rental expense.

Raised Market Livestock (Because there is no cost to recover).

When Depreciation Begins & Ends?

Begins
When you place the assets in service. When it is ready and available for a specific use in the business.

Example
When it was bought for the business.

Ends
When the cost of the item has been recovered or when it is retired from service, whichever happens first.

Example
When it is sold or is not longer useable.

Factors In Computing Depreciation

Cost (Historical Cost, Original Cost ) All costs viz acquisition, installation ( wages), transportation, legal expenses for registration of sale/ lease agreement, improvement, additions etc which are incurred before the asset is brought into use. May include training cost. Useful Life Estimate of the expected life based on need for repair, service life, and vulnerability to obsolescence viz. lease period, level of use, degree of maintenance and technological development. USEFUL LIFE IS SHORTER THAN PHYSICAL LIFE (true even for human beings).

Factors In Computing Depreciation

Salvage / Residual Value Estimate of the assets realizable value at the end of its useful life/ commercial use.
Other Relevant Factors Replacement cost Provision of Companies Act , Income Tax Act.

Recurring Costs
Recurring costs such as licenses and insurance for an asset are NOT included with the assetinstead, they are charged as EXPENDITURE.

Depreciable Amount
Depreciable amount means historical cost less estimated residual value. Example
Cost of Asset is $5,00,000, ERV is $25,000. Then, The Depreciable Amount will be $5,00,000 $25,000 i.e. $4.75,000.

The depreciable amount of a depreciable asset should be allocated on a systematic basis to each accounting period during the useful life of the asset.

Depreciation on Addition/Extensions
Any addition or extension which becomes an integral part of the existing asset should be depreciated over the remaining useful life of that asset. The depreciation on such addition or extension provided at the rate applied to the existing asset. Where an addition or extension retains a separate identity and is capable of being used after the existing asset is disposed of, depreciation should be provided independently on the basis of an estimate of its own useful life.

Causes Of Depreciation
Time Element
Lease, patents, copyrights lose their value or effectiveness. Amortization is a better word for the gradual fall in their values.

Abnormal Events
Accident, fire, natural calamity may reduce effectiveness.

Methods of Depreciation
Fixed / Equal Installments OR Straight Line Method
A fixed portion of the cost of a fixed asset is allocated and charged as periodic depreciation. Using this method, depreciation is measured only by time. Depreciation amount is the same for each year of the assets useful life. Such depreciation becomes an equal amount in each period. Depreciation = (V-S)/n , Where,
- V= Cost of the Asset. - S= Residual value or the expected scrap value. - n= estimated life of the asset.

Straight-Line Method Example

(Cost Salvage value) = Depreciation per year Years of useful life ($30,000 $500) 5 = $5,900

Methods of Depreciation
Reducing / Diminishing Balance Method OR Written Down Value Method
Depreciation is calculated at a fixed percentage on the original cost in the first year. But in subsequent years it is calculated at the same percentage on the written down values gradually reducing during the expected working life of the asset. The rate of allocation is constant (usually a fixed percentage) but the amount allocated for every year gradually decreases.

Methods of Depreciation
Sum of Years Digit Method
It is a revised form of Reducing Balance Method. Here also the working life of an asset has to be preestimated and Total Depreciation is considered as Cost of the Asset () Residual or Scrap Value. The amount of annual depreciation goes on decreasing with the use. For calculating depreciation, the denominator becomes the sum of the digits representing the life of the asset. Thus if an asset has a life of 5 years, the denominator should be 1+ 2 + 3 + 4 + 5 or 15. Depreciation = (Remaining Life of the Asset x Depreciable Amount) Sum of the Years Digit
- Where, Depreciable Amt = Cost of Asset Estimated Scrap Value - Sum of the Years Digit = n(n+1)/2 - n = estimated life of the asset

Sum of Years Digit Method Example

If an asset costs $50,000, it has a residual value of $5,000 and working life of 5 years, the depreciation will be:
1st year 5/15 of (50,000 5,000) or $15,000; 2nd year 4/15 of (50,000 5,000) or $12,000; 3rd year 3/15 of (50,000 5,000) or $9,000; 4th year 2/15 of (50,000 5,000) or $6,000; 5th year 1/15 of (50,000 5,000) or $3,000

Methods of Depreciation
Double Declining Balance Method
Depreciation is charged at a fixed rate and it is calculated on the written down value of an asset brought forward on the opening date of an accounting year. The Rate of Depreciation becomes the double of the rate under fixed installment method. It may be illustrated as follows:
- Original Cost of an Asset 2,20,000, Scrap Value (Estimated) 20,000 ,Working Life (Estimated) 5 years Total Depreciation = $ 2,20,000 $ 20,000 =$ 2,00,000 - Annual Depreciation = $ 2,00,000 /5 =$ 40,000 - Rate of Depreciation under Straight Line Method = $ 40,000 100 = $2,00,000, = 20%

Double Declining Balance Method Example

1st Year 2nd Year 3rd Year 4th Year 5th Year Less 40% Less 40% Less 40% Opening cost Depreciation Opening bal Depreciation Opening bal Depreciation Opening bal Depreciation Opening (-) Depreciation Scrap Value $2,20,000 $88,000 $1,32,000 $52,800 $79,200 $31,680 $47,520 $19,008 $28,512 $8,512 $20,000

Less 40%
Less 40%

Methods of Depreciation
Mileage Method/ Working Hours/ Service Hours Method
(Cost Salvage value) = Cost per Unit Total units of Activity ($30,000 $500) 10000 miles = $0.295 per mile

Depreciation if truck driven 15000 miles in 2010 Expense = (Cost per mile) x (# miles) = 0.295 x 15000 = $4,425 Depreciation

Methods of Depreciation
Sinking Fund Method
Annual depreciation is considered as a source of providing the replacement cost of an asset. It becomes a means of maintaining capital. D=CXi . (1+i)n - 1
- D = Depreciation - C = Cost of the asset - I = Rate of Depreciation - n = Life of the asset

No investment is made in the last year as the investments are to be sold out. Sinking Fund Account may be called Depreciation Fund Account also. It is to be shown on the liability side of Balance Sheet. Sinking Fund Investments Account may be called Depreciation Fund Investments Account also. It is to be shown on the Asset side of the Balance Sheet. Annual Contribution (charged in lieu of annual depreciation) = Original Cost x Present Value of Re. 1 at given interest rate.

Sinking Fund Method Example

Cost of an Asset $40,000, Life:4 years, Depreciation 10% p.a. Under Sinking Fund Method: Annual Depreciation = C x i . (1+i) n -1 = $40,000 x 10 (1+10) 4 -1 = $8619 This amount shall be invested at the end of years 1,2 and 3. The amount of investment shall fetch 10% interest p.a. which will lead to accumulation of $40,000 at the end of the 4th year. The amount of $8,619 shall not be invested at the end of the 4th year.

Methods of Depreciation
Annuity Method
Cost of an asset is considered to be an investment. Such investment would earn interest if invested outside the business. D = C i (1+i)n (1+i)n -1
- D = Depreciation - C = Cost of the asset - I = Rate of Depreciation - n = Life of the asset

Annuity Method Example

Creation Of Internal Reserve Example: Cost of an Asset $40,000, Life:4 years, Depreciation 10% p.a. Under Annuity Method:
Depreciation = 40000X 10%X1.4641 = $12,619

1.4641-1
In case of Annuity Method, the amount of $12,619 shall not be invested outside the business. It shall have to be taken as an yearly appropriation. The total amount to be appropriated over a period of 4 years = $12,619 x 4 = $50,476. Cost of Capital = Total Appropriation - Actual Cost of the Asset = $50,476 - $40,000 = $10,476.

Summary of Wisdom
True False

Depreciation for asset includes tangible and intangible assets

Cost of insurance or renewal of license is part of depreciation

True False

We can depreciation extension or deletion of asset, which becomes an integral part of the asset.
True False Depreciation on an asset effect profit and loss of the company firm True False

Summary of Wisdom
To compute depreciation on an asset, we should know the three items form the below list.

Original total cost of the asset. Cost of replacement for the asset. Estimated useful economic life of the asset. Estimated scrap or residual value of the asset.
Gradual fall in the value or effectiveness with time of the intangible asset is also termed as

Immortalize Amortize EMI Degradation.

Summary of Wisdom
This method of depreciation is also termed as Source of replacement cost

Sinking fund method Single line method Double declining method Reducing balance method
This method of depreciation is also termed as Investment

Annuity method Single line method Double declining method Reducing balance method

THANK YOU!!