Scribd
Upload
127 views4 pages

Depreciation Notes

The document defines depreciation as the reduction in value of fixed assets like buildings, equipment, and machinery due to factors like wear and tear, obsolescence, and age. It discusses the straight line and reducing balance methods for calculating depreciation charges over the useful life of an asset. The straight line method uses equal annual depreciation amounts while the reducing balance method takes a fixed percentage of the remaining value each year, front-loading the depreciation charges. Both methods have advantages like simplicity and disadvantages like not perfectly reflecting the actual pattern of an asset's depreciation.

Uploaded by

Amit Agarwal
Copyright
© Attribution Non-Commercial (BY-NC)
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
127 views4 pages

Depreciation Notes

The document defines depreciation as the reduction in value of fixed assets like buildings, equipment, and machinery due to factors like wear and tear, obsolescence, and age. It discusses the straight line and reducing balance methods for calculating depreciation charges over the useful life of an asset. The straight line method uses equal annual depreciation amounts while the reducing balance method takes a fixed percentage of the remaining value each year, front-loading the depreciation charges. Both methods have advantages like simplicity and disadvantages like not perfectly reflecting the actual pattern of an asset's depreciation.

Uploaded by

Amit Agarwal
Copyright
© Attribution Non-Commercial (BY-NC)
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
You are on page 1/ 4

DEPRECIATION

Definition and Concept


• Buildings, equipments and machinery wear and tear with the amount of use and passage of
time.
• Their worth does not remain as much after a few years as it is today.
• This is a state of depreciation; equipments, etc., depreciate, i.e. their value falls, their worth
gets lowered, they become less efficient and ultimately are replaced as they no longer function
economically.
• Depreciation may be defined as the reduction in the value, or the effective economic life of a
product arising from the passage of time, use or abuse, wear and tear, influence of the elements,
or the ending of demand for use.
• Depreciation may be defined as a method for spreading the cost of a long-term asset over the
life, or expected years of usage, of the asset.
• Depreciation is a term applied to fixed assets such as buildings, plant, machinery and vehicles
which suffer natural deterioration in the course of time. Such deterioration can rarely be wholly
arrested by regular maintenance.
• From an accounting point of view, depreciation is an annual charge reflecting the decline in
value of an asset due to such causes as wear and tear, action of the elements, obsolescence, and
inadequacy.
• From the operating standpoint, depreciation can be thought of as the rent paid for use of the
equipment during a period of time; depreciation in effect sets aside from each year's income
enough money so that funds will be available to buy the new machine when the present one is
worn out.
• Depreciation is an overhead expense.

Causes of Depreciation
• Physical deterioration
Wear and tear –
– When a motor vehicle or machinery or fixtures and fittings are used, they eventually
wear out. Some last many years, others last only a few year.
Erosion, rust, rot and decay –
– Land may be eroded or wasted away by the action of wind, rain, sun and other elements
of nature.
– Similarly, the metals in motor vehicles or machinery will rust away.
• Economic factors
Obsolescence
– This is the process of becoming out of date.
– For instance, replacing a computer with old operating system with a new computer
with XP system.
Inadequacy
– This arises when an asset is no longer used because of the growth and changes in the
size of the firm.
– For instance, a small ferryboat that is operated by a firm at a coastal resort will become
entirely inadequate when the resort becomes more popular, to be more efficient and
economical, the firm may replace it with a large ferryboat.
Abnormal occurrences, such as
– Accidents
– Defects in materials
– Excessive wear and tear
– Contingent occurrences e.g. appearance of hairline cracks in a pressure vessel
adequately tested.
Technological developments and changes:
– New equipments which supersede the existing ones, start coming in the market
– Change in manufacturing methods which necessitates the use of another type of
equipment.
– Improved and automated machine tools which render the use of existing ones
uneconomical
– Inadequacy of the existing equipment to perform the necessary functions such as
increased output, more precision and better quality

Methods of Calculating Depreciation


• A number of methods of calculating depreciation are being employed; some of them are used
regularly whereas others are relatively uncommon.
• The method used for calculating depreciation should be simple to operate and easy to
understand.
• The method selected should be employed consistently and not varied to suit particular financial
years.
• The method should be able to help to replace the existing asset (i.e. equipment, etc.)
conveniently when it needs be replaced.
• METHODS
a) Straight line method
b) Reducing balance method
c) Production based methods (1) Per unit; and (2) Per hour
d) Repair provision method
e) Annuity method
f) Sinking fund method
g) Endowment policy method
h) Revaluation method
i) Sum of the digits method

Straight line Method


• This method provides for depreciation by means of equal periodic charges over the assumed
life of the asset.
• Thus, the method is also known as the fixed installment method or proportional method.
• The method assumes that hat the fixed asset (i.e., equipment) will wear out at precisely the same
rate over its useful life.
• According to this method, Annual Depreciation Charge,

• Where
• C - is the original cost of the asse
asset,
• S - is scrap value or residual value at the end of its useful life,
• N - is serviceable life in years
years,

Advantages
• The method is easy to understand and simple to operate.
• It is frequently used in practice.
• It recognizes that the passing of time is a major factor in depreciation and the decline in value
of an asset is directly proportional to its age.
• Uniform annual charge affords better comparative costs.
• The method requires little work for calculating depreciation amounts.

Disadvantages
• Since fixed assets do not wear out at exactly the same rate during their life, the straight line
method in many cases becomes unrealistic.
• Usually, repair and maintenance costs tend to increase in the later years of the life of an asset, it
may be better to charge a higher rate of depreciation in the earlier years.

Reducing Balance Methods


• It is also known as Diminishing balance method or Percentage on book value method.
• In many cases, the cost of maintenance of an equipment i.e., fixed asset increases towards the
end of its life.
• Therefore, it is sometimes considered desirable to calculate depreciation so that the charge
lessens towards the end of the asset's life, thus roughly equalizing the combined charge of
depreciation plus maintenance over the period.
• Reducingg balance method involves non
non-linear
linear change that is achieved by taking a fixed
percentage, p, of the un-depreciated
depreciated balance every year.
• Thus at any time , the un-depreciated
depreciated portion will be

• The method charges to the revenue account in the first year a percentage of the cost of the
asset.
• In the following year, the same percentage will be calculated on the reduced value of the asset
after the first year's depreciation has been deducted and so on year by year until the value of the
asset has been virtually reduced to nil.
• Rewriting equation

Advantages
• It is simple to understand and calculate.
• A mathematical relation can be employed to arrive at the appropriate percentage.
• The method is more logical as largest annual amount of depreciation is charged in the first year
when repair and maintenance charges are almost negli
negligible.

Disadvantages
• It is not simple to fix percentage, p, accurately.
• A standard percentage (p)) for all conditions may produce misleading results.
• It is not possible to ever write off an amount (investment) completely by this method.

You might also like