Financial Accounting

Unit-3
 Depreciation
 The monetary value of an asset decreases over time due
to use, wear and tear or obsolescence.
 This decrease is measured as depreciation.
 In accountancy, depreciation refers to two aspects of
the same concept:
1. First, the actual decrease of fair value of an asset,
such as the decrease in value of factory equipment
each year as it is used and wears.
2. Second, the allocation in accounting statements of
the original cost of the assets to periods in which the
assets are used (depreciation with matching
principle).
 Machinery, equipment, currency are some examples of assets
that are likely to depreciate over a specific period of time.
 How to calculate depreciation for small business?
There are three methods commonly used to calculate depreciation. They are:
1. Straight line method
2. Unit of production method
3. Double-declining balance method
Three main inputs are required to calculate depreciation:
4. Useful life
5. Salvage value
6. Cost of the Asset
Useful life – this is the time period over which the organisation considers the fixed asset to be productive.
 Beyond its useful life, the fixed asset is no longer cost-effective to continue the operation of the asset.

Salvage value – Post useful life of the fixed asset, the company may consider selling it at a reduced amount.
 This is known as the salvage value of the asset.

The cost of the asset – this includes taxes, shipping, and preparation/setup expenses.
 Unit of production method needs the number of units used during production.
 How is depreciation calculated?
Generally the following Methods are used to calculate depreciation:
Various Depreciation Methods
1. Straight Line Depreciation Method.
2. Diminishing Balance Method.
3. Sum of Years' Digits Method.
4. Double Declining Balance Method.
5. Sinking Fund Method.
6. Annuity Method.
7. Insurance Policy Method.
8. Discounted Cash Flow Method.
9. Use Based Method
a) Output Method
b) Working Hours Method
c) Mileage Method
10.Other Methods
d) Depletion Method
e) Revaluation Method
f) Group or Composite Method
 Straight Line Depreciation Method
 This is the most commonly used method to calculate depreciation.
 It is also known as fixed instalment method.
 Under this method, an equal amount is charged for depreciation of every fixed asset for each accounting
period.
 This uniform amount is charged until the asset gets reduced to nil or its salvage value at the end of its
estimated useful life.
 So, this method derives its name from a straight line graph.
 This graph is deduced after plotting an equal amount of depreciation for each accounting period over the
useful life of the asset.
Straight Line Depreciation Formula
The formula for annual depreciation under straight line method is as follows:
Annual Depreciation Expense = (Cost of an asset – Salvage Value)/Useful life of an asset.
Where,
 Cost of the asset is purchase price or historical cost
 Salvage value is value of the asset remaining after its useful life
 Useful life of the asset is the number of years for which an asset is expected to be used by the business
Example :-A manufacturing company purchases a machinery for Rs. 100,000 and the useful life of the machinery
are 10 years and the residual value of the machinery is Rs. 20,000
Annual Depreciation expense = (100,000-20,000) / 10 = Rs. 8,000
 The residual value, also known as salvage value, is the estimated value of a fixed asset at the end of its lease
term or useful life.
 Thus the company can take Rs. 8000 as the depreciation expense every year over the next ten years as shown
in depreciation table below.
Year Original cost – Residual value Depreciation expense
1 Rs. 80000 Rs. 8000
2 Rs. 80000 Rs. 8000
3 Rs. 80000 Rs. 8000
4 Rs. 80000 Rs. 8000
5 Rs. 80000 Rs. 8000
6 Rs. 80000 Rs. 8000
7 Rs. 80000 Rs. 8000
8 Rs. 80000 Rs. 8000
9 Rs. 80000 Rs. 8000
10 Rs. 80000 Rs. 8000
 2. Diminishing Balance Method
This method is also known as reducing balance method, written down value method or declining balance
method.
 A fixed percentage of depreciation is charged in each accounting period to the net balance of the fixed
asset under this method.
 This net balance is nothing but the value of asset that remains after deducting accumulated depreciation.
 Thus, it means that depreciation rate is charged on the reducing balance of the asset.
 This asset is the one reflected in the books of accounts at the beginning of an accounting period.
 So, the book value of the asset is written down so as to reduce it to its residual value.
 Now, value of the asset reduces every year, Accordingly higher amount of depreciation is charged during
the early years of the asset as compared to the later stages.
 As an asset forays into later stages of its useful life, the cost of repairs and maintenance of such an asset
increase.
 Hence, less amount of depreciation needs to be provided during such years.

Diminishing Balance Method Formula

Depreciation Expense = (Book value of asset at beginning of the year x Rate of Depreciation)/100
 3. Sum of Years’ Digits Method
Another accelerated depreciation method is the Sum of Years’ Digits Method.
 This method recognizes depreciation at an accelerated rate.
 Thus, the depreciable amount of an asset is charged to a fraction over different accounting periods under
this method.
 This fraction is the ratio between the remaining useful life of an asset in a particular period.
 Thus, this fraction indicates that the capital blocked or the benefit derived out of the asset is the highest in
first year.
 If an asset moves towards the end of its useful life, the benefit gained out of such an asset declines.
 Accordingly, least amount of depreciation should be charged in the last year as major portion of capital
invested has been recovered.
 Sum of Years’ Digits Depreciation Formula
 Following is the formula for sum of years’ digits method.
Depreciation Expense = Depreciable Cost x (Remaining useful life of the asset/Sum of Years’ Digits)
Where depreciable cost = Cost of asset – Salvage Value
Sum of years’ digits = (n(n+1))/2 (where n = useful life of an asset)
 4. Double Declining Balance Method
This method is a mix of straight line and diminishing balance method.
This is one of the two common methods a company uses to account for the expenses of a fixed
asset.
This is an accelerated depreciation method.
As the name suggests, it counts expense twice as much as the book value of the asset every year.
The formula is:
Depreciation = 2 * Straight line depreciation percent * book value at the beginning of the
accounting period.
Book value = Cost of the asset – accumulated depreciation.
 Accumulated depreciation is the total depreciation of the fixed asset accumulated up to a
specified time.
Example:  On April 1, 2012, company X purchased an equipment for Rs. 100,000. This is expected to have 5
useful life years. The salvage value is Rs. 14,000.
Company X considers depreciation expense for the nearest whole month.
Calculate the depreciation expenses for 2012, 2013, 2014 using a declining balance method.
Useful life = 5

Straight line depreciation percent = 1/5 = 0.2 or 20% per year

Depreciation rate = 20% * 2 = 40% per year
Depreciation for the year 2012 = Rs. 100,000 * 40% * 9/12 = Rs. 30,000
Depreciation for the year 2013 = (Rs. 100,000-Rs. 30,000) * 40% * 12/12 = Rs. 28,000
Depreciation for the year 2014 = (Rs. 100,000 – Rs. 30,000 – Rs. 28,000)  * 40% * 9/12 = Rs.
16,800
Depreciation for 2016 is Rs. 1,120 to keep the book value same as salvage value.
Rs. 15,120 – Rs. 14,000 = Rs. 1,120 (At this point the depreciation should stop).
 Depreciation table is shown below:

Book value at the Book value at the end

Year Depreciation rate Depreciation Expense
beginning of the year

2012 Rs. 100,000 40% Rs. 30,000 * (1) Rs. 70,000

2013 Rs. 70,000 40% Rs. 28,000 * (2) Rs. 42,000

2014 Rs. 42,000 40% Rs. 16,800 * (3) Rs. 25,200

2015 Rs. 25,200 40% Rs. 10,080 * (4) Rs. 15,120

2016 Rs. 15,120 40% Rs. 1,120 * (5) Rs. 14,000

 5.Unit of Production method
 This is a two-step process, unlike straight line method.
 Here, equal expense rates are assigned to each unit produced.
 This assignment makes the method very useful in assembly for production lines.
 Hence, the calculation is based on output capability of the asset rather than the number of years.
The steps are:
Step 1: Calculate per unit depreciation:
Per unit Depreciation = (Asset cost – Residual value) / Useful life in units of production
Step 2: Calculate the total depreciation of actual units produced:
Total Depreciation Expense = Per Unit Depreciation * Units Produced
Example: ABC company purchases a printing press to print flyers for Rs. 40,000 with a useful life of
1,80,000 units and residual value of Rs. 4000. It prints 4000 flyers.
Step 1: Per unit Depreciation = (40,000-4000)/180,000 = Rs. 0.2
Step 2: Total Depreciation expense = Rs. 0.2 * 4000 flyers = Rs. 800
 So the total Depreciation expense is Rs. 800 which is accounted.
 Once the per unit depreciation is found out, it can be applied to future output runs.
 Depreciation Calculation Example

Kapoor Pvt Ltd. purchased machinery worth Rs. 1,00,000 on March 31st, 2018.
However, in 2018 a new variant of the same machinery comes to market due to innovation in technology.
As a consequence, the machinery purchased by Kapoor Pvt. Ltd. becomes outdated.
This technological innovation causes the value of the old machinery to decline.
Say, the profit before depreciation and tax for Kapoor Pvt. Ltd for the year ended December 2018 is
Rs.50,000.
And depreciation for the same accounting period is Rs. 10,000.
Hence, depreciation for plant and machinery is shown as under:
Profit before depreciation and tax Rs. 50,000(-) Depreciation Rs. 10,000=Profit Before Tax Rs. 40,000
 Factors for Estimating Depreciation
Now, there are a host of factors that need to be considered in order to calculate the amount of depreciation to be
charged in each accounting period. These include:
Cost of the Asset
 The cost of the asset is also known as the historical cost.
 It comprises of the purchase price of the fixed asset and the other costs incurred to put the asset into working
condition.
 These costs include freight and transportation, installation cost, commission, insurance, etc.
Salvage Value
 Salvage value is also known as the net residual value or scrap value.
 It is the estimated net realizable value of an asset at the end of its useful life.
 This value is determined as a result of the difference between the sale price and the expenses necessary to
dispose of an asset.
Estimated Useful Life
 The commercial or economic life of an asset is termed as the useful life of an asset.
 Now, for estimating the useful life of an asset, its physical life is not taken into consideration.
 This is because an asset might be in good physical condition after a few years but it may not be used for
production purposes.
Single Line Method - Written Down Value (WDV)
 Written Down Value (WDV) methods are the most used
methods for calculating depreciation.
Income-tax Act requires calculation of depreciation by
WDV Method only.
The formula used to calculate WDV rates is –
Rate of Depreciation (R) = 1 – [s/c]1/n
Where,
s = scrap value at the end of period ‘n’;
c = Written down value at present; and
n = Useful life of the assets (Schedule II of Companies Act
provides this useful life period for different classes of assets)
Illustration 1 – Suppose a Plant is purchased for ₹ 10 lakhs and its estimated useful life is 10 years.
The scrap value at the end of the useful life is estimated to be ₹ 2.5 lakhs. Calculate the WDV Rates.
Here, we can use the above formula and accordingly,
WDV Rate = 1 – [2.5/10]1/10
i.e. 1 – 0.250.1 = 12.95% (approx.)
Now, you can use this WDV rate to calculate depreciation.
Depreciation for the year is the rate in percentage multiplied by the WDV at the beginning of the year.
 WDV at beginning Depreciation WDV at end
Year
( ₹ in lakhs) ( ₹ in lakhs) ( ₹ in lakhs)

0 10 – 10
For example, for Year I – Depreciation =
10,00,000 x 12.95% i.e. 1,29,500. 1 10 1.295 8.705

2 8.705 1.127 7.578

New WDV for subsequent year will be previous
WDV minus Depreciation already charged. 3 7.578 0.981 6.597

4 6.597 0.854 5.743

i.e. WDV for year II will be 10,00,000 – 1,29,500
i.e., 8,70,500. 5 5.743 0.744 4.999

6 4.999 0.647 4.352

Accordingly, WDV and Depreciation for all years
is as below: 7 4.352 0.564 3.788

8 3.788 0.491 3.297

9 3.297 0.427 2.870

10 2.870 0.370 2.500