DEPRECIATION

“-WORD OF THE LEARNING UNIT…….”

 LEARNING UNIT OBJECTIVES

• Understand the components included in the cost of an asset and how they impact the
asset's overall value
• Demonstrate the ability to calculate the cost of an asset by considering relevant
expenses and adjustments
• Explain the fundamental concepts and causes of depreciation
• Analyze and articulate the advantages and disadvantages of various depreciation
methods
• Apply the necessary calculations to determine partial year depreciation for assets
acquired or disposed of during a given accounting period
• Be able to prepare a depreciation schedule
 INTRODUCTION

• The useful life of a fixed asset (motor vehicles, plant & machinery, office equipment,
furniture & fittings, etc.) may be many years.
• Eventually, however, it will no longer be of use to the business and might only have a
scrap value.
• Accounting procedures require that the resulting loss of value be setoff against
income.
• Therefore, the cost price of the asset (less any estimated scrap or residual value)
must be distributed over its useful life. This distribution (or writing off) of the cost is
called depreciation
 COST OF THE ASSET

• The cost price of a fixed asset is arrived at by totaling all the costs to bring the
asset to working condition for its intended use. These include:
• The purchase price, including import duties and non-refundable purchase taxes
• The cost of site preparation
• The initial delivery and handling costs
• The installation costs
• Professional fees, such as for architects and engineers
 DEPRECIATION DEFINED

• Depreciation is that part of the original cost of a fixed asset that is consumed
during period of use by the business.
• The annual depreciation charge to profit and loss account is based upon an
estimate of how much of the overall economic usefulness of a fixed asset has
been used up in that accounting period.
• Because it is charged as an expenses to the profit and loss account, depreciation
reduces net profit.
 CONCEPTS OF DEPRECIATION

• Estimated Useful Life – Number of years or time periods for which the company
can use the asset.
• Book value - is the cost of the asset less any depreciation written off. The book
value is also known as the carrying value.
• Book value = Asset cost -- Accumulated depreciation
• Residual Value (Salvage Value) - Expected cash value at the end of an asset’s
useful life.
• Accumulated depreciation - is the total amount of depreciation expense allocated
to a specific asset since the asset was put into use.
• The Book value cannot be less than the residual value.
 CAUSES OF DEPRECIATION

Internal causes
▪ Wear and Tear (tangible assets, e.g. plant and equipment)
▪ Exhaustion or depletion, e.g. mines

Physical Deterioration/ Functional Obsolescence

 CAUSES OF DEPRECIATION

External causes
▪ Time factor
▪ Changes in fashion and technology, e.g. B&W TVs

Product Obsolescence
 CAUSES OF DEPRECIATION

• Physical wear and tear: Assets such as machinery, vehicles and equipment can
experience physical wear and tear over time, which can lead to a decrease in their
value.
• Technological obsolescence: As technology advances, older assets can become
outdated and less valuable. This is particularly true for assets such as computers,
smartphones and other electronics.
• Functional obsolescence: Sometimes, an asset may become less valuable due to
changes in consumer preferences or market demand. For example, a retail store
located in an area that has become less desirable may experience a decline in value.
 CAUSES OF DEPRECIATION

• Natural causes: Natural events such as floods, earthquakes and hurricanes can
damage or destroy assets, leading to a decrease in their value.
• Legal restrictions: changes in laws or regulations can also impact the value of
assets. For example, if a new law is passed that makes it illegal to use certain
types of equipment, the value of that equipment may decrease.
 OBJECTIVES OF DEPRECIATION

• To calculate proper profits

• To show the asset at its fair and true value
• Provision for depreciation
• For tax and dividend purposes
• To provide for replacement of an asset
 METHODS OF DEPRECIATION

• 1) The Straight-Line (or Fixed-Instalment) method

• 2) The Reducing (or Diminishing) Balance method
• 3) The Units of Production method
• 4) The Sum of the Years’ Digits method
 STRAIGHT-LINE METHOD

• Distributes the same amount of expense to each period of time.

• Depreciation expense = Cost - Residual value

each year Estimated useful life-time (in years)
• Also known as fixed instalment method
• This method is very simple and conceptually appropriate to employ, hence one of
the most widely used method for the calculation of depreciation charge
• The amount of depreciation will be equal each year, since depreciation is charged
at fixed rate on cost of asset.
 STRAIGHT-LINE METHOD

Advantages
• Simplicity: The straight-line method is easy to understand and calculate. It
involves a straightforward calculation of spreading the cost of an asset evenly
over its useful life.
• Predictability: The predictable and consistent nature of the method allows for
better budgeting and financial planning, as businesses can anticipate the
depreciation expenses over time.
• Equal allocation: Depreciation is allocated equally over each period of an asset's
useful life, ensuring a fair distribution of expense recognition.
 STRAIGHT-LINE METHOD

Disadvantages
• Unrelenting charge: The straight-line method charges a consistent amount of
depreciation expense each period, regardless of the actual level of usage, wear
and tear, or market value of the asset.
• Unrealistic value: As assets may decline in value more rapidly or slowly than the
straight-line method suggests, the recorded value of the asset may not accurately
reflect its true market value.
• Maintenance costs: The method does not account for variations in maintenance
costs over an asset's useful life, which may lead to inaccuracies in calculating the
true cost of using the asset.
 STRAIGHT-LINE METHOD EXAMPLE

Gupta Company bought equipment for R15 000 on 1 January 2022. The company
estimates that the equipment’s period of useful life will be 10 years. After 10 years
the residual value is R3 000. Calculate depreciation expense and complete a
depreciation schedule.

(R15 000 – R3 000) = R1 200 per year

10

100% = 100% = = 10% per year

# of yrs. 10
 DEPRECIATION SCHEDULE

Opening Annual Accumulated Closing

Depreciation
Year Carrying Carrying
rate depreciation Depreciation
Value Value
1 R15,000.00 10% R 1,200.00 R 1,200.00 R 13,800.00
2 R13,800.00 10% R 1,200.00 R 2,400.00 R 12,600.00
3 R12,600.00 10% R 1,200.00 R 3,600.00 R 11,400.00
4 R11,400.00 10% R 1,200.00 R 4,800.00 R 10,200.00
5 R10,200.00 10% R 1,200.00 R 6,000.00 R 9,000.00
6 R 9,000.00 10% R 1,200.00 R 7,200.00 R 7,800.00
7 R 7,800.00 10% R 1,200.00 R 8,400.00 R 6,600.00
8 R 6,600.00 10% R 1,200.00 R 9,600.00 R 5,400.00
9 R 5,400.00 10% R 1,200.00 R 10,800.00 R 4,200.00
10 R 4,200.00 10% R 1,200.00 R 12,000.00 R 3,000.00
 PARTIAL YEAR DEPRECIATION

When a plant asset is acquired during the year, depreciation is calculated for the
fraction of the year the asset is owned.
 PARTIAL YEAR DEPRECIATION

• Partial year depreciation refers to the depreciation expense calculated for an

asset that is not in use for the entire year.
• It is a method of calculating depreciation for an asset that is acquired or disposed
of during the year or only used for a portion of the year.
• This method involves prorating the annual depreciation expense based on the
portion of the year that the asset is in use.
• The amount of depreciation for the partial year is calculated by multiplying the
annual depreciation rate by the proportion of the year that the asset is in use.
 DEPRECIATION 15TH DAY RULE

• If the asset’s Placed-in-Service Date is before the 16th of the month, the asset will take
depreciation in the month it is Placed-in Service

• If the asset’s Placed-in-Service Date is after the 15th of the month, the asset will
NOT take depreciation in the month it is Placed-in Service
Alternatively, on disposal:
• If the asset’s Disposal Date is before the 16th of the month, the asset will NOT take
depreciation in the month of disposal

• If the asset’s Disposal Date is after the 15th of the month, the asset will take depreciation
in the month of disposal
Note: If the asset takes depreciation, it will take a full month's depreciation, not a half-month's
(15 days) depreciation.
 PARTIAL YEAR AND 15TH DAY RULE
DEPRECIATION
Assume Gupta Company bought equipment on May 6. The cost is R2,500 with an
estimated useful life of 5 years. The residual value is R500. What would be
depreciation for the first year?

R2,500 - R500 = R400 x 8 = R266.67

5 12
May, June, July,
Aug, Sept., Oct.,
Nov., & Dec.
 EXERCISE

Ajax Company bought equipment for R2,500. The company estimates that the
equipment’s period of useful life will be 5 years. After 5 years the residual value is
R500. Calculate depreciation expense and complete a depreciation schedule using
the straight-line approach.
DEPRECIATION SCHEDULE
 REDUCING BALANCE/ DIMINISHING BALANCE
METHOD
• Depreciation is charged at a fixed rate like straight line method, but the
percentage rate is not calculated on cost of asset as is done under straight line
method, it is calculated on the book value of asset
• The book value of an asset is obtained by deducting depreciation from its cost
• The book value of asset gradually reduces on account of charging depreciation
• Since the depreciation rate per cent is applied on reducing balance of asset, this
method is called reducing balance method.
• It is a popular method often used by businesses for their financial statements, as
it accelerates depreciation expenses in the early years of ownership and reduces
them gradually over the asset's useful life.
 REDUCING BALANCE/ DIMINISHING BALANCE
METHOD
• This process continues annually until the end of the asset's useful life or until the
book value is less than the salvage value.
• At this point, the depreciation expense falls to equal the difference between the
book value and salvage value.
• The diminishing balance method of depreciation is useful for businesses that
require more significant deductions in the early years of ownership.
• However, it is not appropriate for some assets that have a steadier value descent
throughout their useful life.
 REDUCING BALANCE/ DIMINISHING BALANCE
METHOD
Formula for calculating depreciation rate;
Depreciation rate = (100% / estimated useful life)
E. g. Assume a machine was bought for R500 000 and could be used
for four years and then sell it for R50 000 (salvage value), the
depreciation rate would be:
(100% / 4) = 25%
 REDUCING BALANCE/ DIMINISHING BALANCE
METHOD
Note:

• The residual value is ignored, so the carrying value at the end of the life
of the asset is considered as its residual value.

• The percentage is usually doubled (x2) and the method is then referred to
as the DOUBLE-DECLINING-BALANCE METHOD.
REDUCING BALANCE/ DIMINISHING BALANCE
METHOD
EXAMPLE:
A piece of equipment is purchased on 1st January 2023 for R40 000. Transport
costs amounted to R2 500 and installation costs were R7 500. The estimated useful
life-time is 4 years, and its expected residual value is R12 500. Calculate the cost of
the equipment and complete the depreciation schedule using the reducing balance
method.
 DEPRECIATION SCHEDULE

Year Opening Carrying Depreciation Annual Accumulated Closing

Value Rate Depreciation Depreciation Carrying
Value

1 50 000 20% 10 000 10 000 40 000

2 40 000 20% 8 000 18 000 32 000
3 32 000 20% 6 400 24 400 25 600
4 25 600 20% 5 120 29 520 20 480
5 20 480 20% 4 096 33 616 16 384
Residual
value
 DOUBLE-DECLINING BALANCE METHOD

• Accelerated method which computes more depreciation expense in the early

years of the asset’s life. Uses up to twice the straight-line rate.

• Rate = 100 / 4 years x 2 = 50%

• Depreciation expense = Book value of equipment x Depreciation

each year at beginning of year rate
 DOUBLE-DECLINING
BALANCE METHOD
Example:

• A piece of equipment is purchased on 1st January

2023 for R50 000. Transport costs amounted to R5 000
and installation costs were R7 500. The estimated
useful life-time is 4 years, and its expected residual
value is R2 500. Calculate the amounts of depreciation
to be written off using the reducing balance method.
DEPRECIATION SCHEDULE

Residual
value
EXERCISE

1. Anthony bought a new delivery

vehicle worth R80 000 for his
restaurant. It is estimated that the
assets useful life is 5 years.
Calculate and draw the
depreciation schedule of the
amounts of depreciation to be
written off using the reducing
balance method.
DEPRECIATION SCHEDULE
 UNITS OF PRODUCTION / ACTIVITY BASED /
VARIABLE CHARGE APPROACH
• The units of production method, also known as the activity-based method, is a
technique used in accounting to calculate depreciation based on the actual usage
or output of the asset, rather than the passage of time.
• This method is particularly useful when an asset's useful life is more related to the
volume of production or usage than to time.
• The units of production method calculates the depreciation rate per unit of output,
which is then multiplied by the actual number of units produced or used during an
accounting period.
• The depreciation expense charged to the income statement depends on how
many units were produced or used
 UNITS OF PRODUCTION / ACTIVITY BASED /
VARIABLE CHARGE APPROACH
Advantages
▪ It matches costs with revenues.
▪ Accurate depreciation calculation: The units of production method provides a more
accurate reflection of the wear and tear on the asset because depreciation is directly
tied to its actual production or usage.
▪ This method is well-suited for assets that experience fluctuating levels of usage or
production as the depreciation expenses are aligned with the asset’s actual use.
▪ Incentive for efficient production: Since the depreciation expense is directly tied to
production levels, this method can provide an incentive for efficient production
practices.
 UNITS OF PRODUCTION / ACTIVITY BASED /
VARIABLE CHARGE APPROACH
Disadvantages
▪ Not appropriate in situations in which depreciation is a function of time instead of
activity e.g. a building is subject to a great deal of steady deterioration from the
elements (time) regardless of its use.
▪ The units of production method requires tracking and monitoring of usage or
output levels, which can be complex and time-consuming
 UNITS OF PRODUCTION / ACTIVITY BASED /
VARIABLE CHARGE APPROACH
• Depreciation expense = Cost - Residual value
per unit Total estimated units produced

• Depreciation = Unit x Units

amount depreciation produced
 EXAMPLE

Ajax Company buys equipment (R2,500), and the company estimates how many
units the equipment can produce. Let’s assume the equipment has a useful life of
4,000 units. The machine is expected to produce the follow units in the subsequent
years: 300, 400, 600, 2 000 and 700 respectively. After 5 years the residual value is
R500. Calculate depreciation expense and complete a depreciation schedule.
 DEPRECIATION SCHEDULE

Opening Units Depreciation Annual Accumulated Closing

Year Carrying Carrying
Produced per unit depreciation Depreciation
Value Value
1 R 2,500.00 300 R 0.50 R 150.00 R 2,350.00
300*R0.50=R150
2 31 250,00 400 R 0.50 R 200.00 R 350.00 R 2,150.00
3 15 625,00 600 R 0.50 R 300.00 R 650.00 R 1,850.00
4 7 812,50 2,000 R 0.50 R 1,000.00 R 1,650.00 R 850.00
5 7 812,50 700 R 0.50 R 350.00 R 2,000.00 R 500.00
 EXERCISE

• ABC company purchased a 270 000 piece of machinery on January 1 2022. It is estimated
that the piece of machinery will have a 30 000 salvage value at the end of its life and will
produce 480 000 units. Actual units produced as follows:
• Year 1- 121 000
• Year 2- 123 000
• Year 3- 119 000
• Year 4- 117 000
• Calculate the annual depreciation using the Units of Production method.
DEPRECIATION SCHEDULE
 SUM OF YEARS’ DIGITS METHOD

• The sum of years digits (SYD) depreciation method is an accelerated depreciation

method that calculates depreciation expense based on the sum of the years of the
asset's useful life.
• This method assigns a higher percentage to the first few years of an asset's life,
resulting in greater depreciation expense during the early years of ownership and
lower expense in later years.
• It is an improvement over diminishing balance method of depreciation.
• The depreciation charge constantly reduces but unlike the diminishing balance
method, a constantly decreasing rate is applied on the original cost.
• The determination of rate of depreciation; simply sums up the years in an asset's
lifespan to be used as denominator, and reverses the individual year numbers to be
used as numerator.
 SUM OF YEARS’ DIGITS METHOD

SOYD = 1 + 2 + 3 + … + N
= N(N+1)
2

Dn = ( N – n + 1 ) ( C – S )
SOYD Cost--Residual
Fraction
 SUM OF YEARS’ DIGITS METHOD

• C = Cost Basis; Initial Price plus installation expenses.

• S = Salvage Value
• Dn = Depreciation in Year n
• Bn = Book Value remaining in Year n
• N = estimated years of useful life
• n = the year currently under consideration
 SUM OF YEARS’ DIGITS METHOD

• For example, let's say a business purchases a machine for R50 000 with a useful life
of 5 years and a salvage value of R5 000. The sum of the years of useful life for this
asset would be calculated as follows:
• SOYD = 5(5 +1) = 15
2
 SUM OF YEARS’ DIGITS METHOD

In the first year, the depreciation expense would be calculated as follows:

• Depreciation expense = (R50 000 - R5 000) x (5 / 15) = R13 333
In the second year, the remaining useful life would be 4 years, and the depreciation expense
would be calculated as follows:
• Depreciation expense = (R50 000 - R5 000) x (4 / 15) = R10 667
• This process would continue annually until the end of the asset's useful life or when the
carrying amount reaches its salvage value.
 EXAMPLE

A machine is bought for R17 000 and has an expected residual value of R2 000. Its
estimated useful life-time is 5 years. Calculate the annual depreciation to be written off
using the Sum of the Years’ Digits method.

The Sum of the Years’ Digits = N(N + 1) = 5(5 + 1) = 30 = 15

2 2 2
 DEPRECIATION SCHEDULE

Opening Carrying Year Annual Depreciation Accumulated Closing

Year Cost-Residual Fraction
Value digit amount depreciation Carrying Value
5
1 15000 17 000 5 /15 of cost 5 000 5 000 12 000
4
2 15000 12 000 4 /15 of cost 4 000 9 000 8 000
3
3 15000 8 000 3 /15 of cost 3 000 12 000 5 000
2
4 15000 5 000 2 /15 of cost 2 000 14 000 3 000
1
5 15000 3 000 1 /15 of cost 1 000 15 000 2 000