DEPRECIATION

MEANING
Depreciation refers to two very different but related concepts:

1. the decrease in value of assets fair value depreciation!" and 2. the allocation of the cost of assets to periods in which the assets are used
depreciation with the #atchin$ principle!% The for#er affects values of businesses and entities% The latter affects net inco#e% &enerally the cost is allocated" as depreciation e'pense" a#on$ the periods in which the asset is e'pected to be used% (uch e'pense is reco$ni)ed by businesses for financial reportin$ and ta' purposes% *ethods of co#putin$ depreciation #ay vary by asset for the sa#e business% *ethods and lives #ay be specified in accountin$ and+or ta' rules in a country% (everal standard #ethods of co#putin$ depreciation e'pense #ay be used" includin$ fi'ed percenta$e" strai$ht line" and declinin$ balance #ethods% Depreciation e'pense $enerally be$ins when the asset is placed in service% E'a#ple: a depreciation e'pense of ,-- per year for . years #ay be reco$ni)ed for an asset costin$ .--% In econo#ics" depreciation is the $radual decrease in the econo#ic value of the capital stoc/ of a fir#" nation or other entity" either throu$h physical depreciation" obsolescence or chan$es in the de#and for the services of the capital in 0uestion% If capital stoc/ is C- at the be$innin$ of a period" invest#ent is I and depreciation D" the capital stoc/ at the end of the period" C," is C- 1 I 2 D% Depreciation is a #easure of the wearin$ out" consu#ption or other loss of value of a depreciable asset arisin$ fro# use" efflu'ion of ti#e or obsolescence throu$h technolo$y and #ar/et chan$es% Depreciation is allocated so as to char$e a fair proportion of the depreciable a#ount in each accountin$ period durin$ the e'pected useful life of the asset% Depreciation includes a#ortisation of assets whose useful life is predeter#ined%

3hen a co#pany purchases assets that will produce benefits in so#e way #a/e #oney for the co#pany! over a lon$ period they should be re$arded as invest#ents% This #eans that their cost can not fairly si#ply be char$ed i##ediately to the P 4 5%

*any assets a co#pany buys as invest#ents firstly are #eant to produce a return over a period of ti#e" but have a li#ited useful life% In order to follow the accrual principle" the cost shown on the P 4 5 should be spread out over the years of an assets useful life% The solution is to depreciate the cost over a nu#ber of years and ta/e each year6s depreciation as that year6s cost% The #ost co##only used #ethod is strai$ht line depreciation which char$es a fi'ed a#ount of depreciation every year% The depreciation for each year is: cost 7 residual value! 8 e'pected life If a co#pany spends 9,--"--- on a #achine that is e'pected to last ,- years and have ne$li$ible value after ,- years then" usin$ strai$ht line depreciation" each year the co#pany would:

reduce its value as shown on the balance sheet by 9,-"--show that 9,-"--- as a cost in the profit and loss account

This is by far the co##onest #ethod used in the accounts" but it is not the #ethod used for ta' purposes% This is one reason why ta'able profits are often very different fro# accountin$ profits% The reducin$ balance #ethod is often used for ta'" but infre0uently for reportin$% Intan$ible assets are a#ortised rather than depreciated" but the principle is #uch the sa#e% Certain assets such as land and invest#ents are not depreciated% In theory" depreciation should be separately calculated for each asset" and even for co#ponents of an asset% :or e'a#ple" if a buildin$ contains lifts that have a shorter e'pected life than the buildin$" they should be depreciated separately% In addition" the the residual value and useful life should be reviewed at least! annually" and the rate of depreciation chan$ed in necessary% In reality" the hu$e a#ount of wor/ this i#plies #eans that the way in which depreciation is actually applied is li/ely to be so#ewhat si#plified" and be closer to

the old practice of assu#in$ the sa#e useful life and proportionate fall in value for each asset class% It is i#portant to understand that depreciation is not directly related to the replace#ent costs of assets" which investors #ay need to consider separately% Depletion is a si#ilar to depreciation but applied to assets that are used up in a directly #easurable way%

Depreciable assets are assets which i! are e'pected to be used durin$ #ore than one accountin$ period; and ii! have a li#ited useful life; and iii! are held by an enterprise for use in the production or supply of $oods and services" for rental to others" or for ad#inistrative purposes and not for the purpose of sale in the ordinary course of business% <%< =seful life is either i! the period over which a depreciable asset is e'pected to be used by the enterprise; or ii! the nu#ber of production or si#ilar units e'pected to be obtained fro# the use of the asset by the enterprise% <%> Depreciable a#ount of a depreciable asset is its historical cost" or other a#ount substituted for historical cost, in the financial state#ents" less the esti#ated residual value

BRIEF OVERVIEW OF DEPRICIATION.

Depreciation is an inco#e ta' deduction that allows a ta'payer to recover the cost or other basis of certain property% It is an annual allowance for the wear and tear" deterioration" or obsolescence of the property% *ost types of tan$ible property e'cept" land!" such as buildin$s" #achinery" vehicles" furniture" and e0uip#ent are depreciable% 5i/ewise" certain intan$ible property" such as patents" copyri$hts" and co#puter software is depreciable%

In order for a ta'payer to be allowed a depreciation deduction for a property" the property #ust #eet all the followin$ re0uire#ents:

The ta'payer #ust own the property% Ta'payers #ay also depreciate any capital i#prove#ents for property the ta'payer leases% A ta'payer #ust use the property in business or in an inco#e7producin$ activity% If a ta'payer uses a property for business and for personal purposes" the ta'payer can only deduct depreciation based only on the business use of that property% The property #ust have a deter#inable useful life of #ore than one year%

Even if a ta'payer #eets the precedin$ re0uire#ents for a property" a ta'payer cannot depreciate the followin$ property:

Property placed in service and disposed of in sa#e year% E0uip#ent used to build capital i#prove#ents% A ta'payer #ust add otherwise allowable depreciation on the e0uip#ent durin$ the period of construction to the basis of the i#prove#ents% Certain ter# interests%

Depreciation be$ins when a ta'payer places property in service for use in a trade or business or for the production of inco#e% The property ceases to be depreciable when the ta'payer has fully recovered the property?s cost or other basis or when the ta'payer retires it fro# service" whichever happens first% A ta'payer #ust identify several ite#s to ensure the proper depreciation of a property" includin$:

The depreciation #ethod for the property The class life of the asset 3hether the property is @5isted PropertyA 3hether the ta'payer elects to e'pense any portion of the asset 3hether the ta'payer 0ualifies for any @bonusA first year depreciation The depreciable basis of the property

The *odified Accelerated Cost Recovery (yste# *ACR(! is the proper depreciation #ethod for #ost property% Additional infor#ation about *ACR(" and the other co#ponents of depreciation are in Publication B>C" Dow to Depreciate Property% A ta'payer #ust use :or# >.CE" Depreciation and A#orti)ation" to report depreciation on a ta' return% :or# >.CE is divided into si' sections and

the Instructions for :or# >.CE contain infor#ation on how" and when to fill out each section%

EXPLANATION
Depreciation has a si$nificant effect in deter#inin$ and presentin$ the financial position and results of operations of an enterprise% Depreciation is char$ed in each accountin$ period by reference to the e'tent of the depreciable a#ount" irrespective of an increase in the #ar/et value of the assets Assess#ent of depreciation and the a#ount to be char$ed in respect thereof in an accountin$ period are usually based on the followin$ three factors: , This standard does not deal with the treat#ent of the revaluation difference which #ay arise when historical costs are substituted by revaluations% i! historical cost or other a#ount substituted for the historical cost of the depreciable asset when the asset has been revalued; ii! e'pected useful life of the depreciable asset; and iii! esti#ated residual value of the depreciable asset% % Distorical cost of a depreciable asset represents its #oney outlay or its e0uivalent in connection with its ac0uisition" installation and co##issionin$ as well as for additions to or i#prove#ent thereof% The historical cost of a depreciable asset #ay under$o subse0uent chan$es arisin$ as a result of increase or decrease in lon$ ter# liability on account of e'chan$e fluctuations" price adFust#ents" chan$es in duties or si#ilar factors% The useful life of a depreciable asset is shorter than its physical life and is: i! pre7deter#ined by le$al or contractual li#its" such as the e'piry dates of related leases; ii! directly $overned by e'traction or consu#ption; iii! dependent on the e'tent of use and physical deterioration on account of wear and tear which a$ain depends on operational factors" such as" the nu#ber of shifts for which the asset is to be used" repair and #aintenance policy of the enterprise etc%; and iv! reduced by obsolescence arisin$ fro# such factors as: a! technolo$ical chan$es; b! i#prove#ent in production #ethods; c! chan$e in #ar/et de#and for the product or service output of the asset; or d! le$al or other restrictions

Deter#ination of the useful life of a depreciable asset is a #atter of esti#ation and is nor#ally based on various factors includin$ e'perience with si#ilar types of assets% (uch esti#ation is #ore difficult for an asset usin$ new technolo$y or used in the production of a new product or in the provision of a new service but is nevertheless re0uired on so#e reasonable basis% Deter#ination of residual value of an asset is nor#ally a difficult #atter% If such value is considered as insi$nificant" it is nor#ally re$arded as nil% On the contrary" if the residual value is li/ely to be si$nificant" it is esti#ated at the ti#e of ac0uisition+installation" or at the ti#e of subse0uent revaluation of the asset% One of the bases for deter#inin$ the residual value would be the realisable value of si#ilar assets which have reached the end of their useful lives and have operated under conditions si#ilar to those in which the asset will be used% The 0uantu# of depreciation to be provided in an accountin$ period involves the e'ercise of Fud$e#ent by #ana$e#ent in the li$ht of technical" co##ercial" accountin$ and le$al re0uire#ents and accordin$ly #ay need periodical review% If it is considered that the ori$inal esti#ate of useful life of an asset re0uires any revision" the una#ortised depreciable a#ount of the asset is char$ed to revenue over the revised re#ainin$ useful life% There are several #ethods of allocatin$ depreciation over the useful life of the assets% Those #ost co##only e#ployed in industrial and co##ercial enterprises are the strai$htline #ethod and the reducin$ balance #ethod% The #ana$e#ent of a business selects the #ost appropriate #ethod s! based on various i#portant factors e%$%" i! type of asset" ii! the nature of the use of such asset and iii! circu#stances prevailin$ in the business% A co#bination of #ore than one #ethod is so#eti#es used% In respect of depreciable assets which do not have #aterial value" depreciation is often allocated fully in the accountin$ period in which they are ac0uired

The #ethod of depreciation is applied consistently to provide co#parability of the results of the operations of the enterprise fro# period to period% A chan$e fro# one #ethod of providin$ depreciation to another is #ade only if the adoption of the new #ethod is re0uired by statute or for co#pliance with an accountin$ standard or if it is considered that the chan$e would result in a #ore appropriate preparation or presentation of the financial state#ents of the enterprise% 3hen such a chan$e in the #ethod of depreciation is #ade" depreciation is recalculated in accordance with the new #ethod fro# the date of the asset co#in$ into use% The deficiency or surplus arisin$ fro# retrospective reco#putation of depreciation in accordance

with the new #ethod is adFusted in the accounts in the year in which the #ethod of depreciation is chan$ed% In case the chan$e in the #ethod results in deficiency in depreciation in respect of past years" the deficiency is char$ed in the state#ent of profit and loss% In case the chan$e in the #ethod results in surplus" the surplus is credited to the state#ent of profit and loss% (uch a chan$e is treated as a chan$e in accountin$ policy and its effect is 0uantified and disclosed% The depreciation #ethods used" the total depreciation for the period for each class of assets" the $ross a#ount of each class of depreciable assets and the related accu#ulated depreciation are disclosed in the financial state#ents alon$with the disclosure of other accountin$ policies% The depreciation rates or the useful lives of the assets are disclosed only if they are different fro# the principal rates specified in the statute $overnin$ the enterprise

MAIN PRINCIPLES
The depreciable a#ount of a depreciable asset should be allocated on a syste#atic basis to each accountin$ period durin$ the useful life of the asset The depreciation #ethod selected should be applied consistently fro# period to period% A chan$e fro# one #ethod of providin$ depreciation to another should be #ade only if the adoption of the new #ethod is re0uired by statute or for co#pliance with an accountin$ standard or if it is considered that the chan$e would result in a #ore appropriate preparation or presentation of the financial state#ents of the enterprise% 3hen such a chan$e in the #ethod of depreciation is #ade" depreciation should be recalculated in accordance with the new #ethod fro# the date of the asset co#in$ into use% The deficiency or surplus arisin$ fro# retrospective reco#putation of depreciation in accordance with the new #ethod should be adFusted in the accounts in the year in which the #ethod of depreciation is chan$ed% In case the chan$e in the #ethod results in deficiency in depreciation in respect of past years" the deficiency should be char$ed in the state#ent of profit and loss% In case the chan$e in the #ethod results in surplus" the surplus should be credited to the state#ent of profit and loss% (uch a chan$e should be treated as a chan$e in accountin$ policy and its effect should be 0uantified and disclosed% The useful life of a depreciable asset should be esti#ated after considerin$ the followin$ factors: i! e'pected physical wear and tear;

ii! obsolescence; iii! le$al or other li#its on the use of the asset Any addition or e'tension which beco#es an inte$ral part of the e'istin$ asset should be depreciated over the re#ainin$ useful life of that asset% The depreciation on such addition or e'tension #ay also be provided at the rate applied to the e'istin$ asset% 3here an addition or e'tension retains a separate identity and is capable of bein$ used after the e'istin$ asset is disposed of" depreciation should be provided independently on the basis of an esti#ate of its own useful life% % 3here the historical cost of a depreciable asset has under$one a chan$e due to increase or decrease in lon$ ter# liability on account of e'chan$e fluctuations" price adFust#ents" chan$es in duties or si#ilar factors" the depreciation on the revised una#ortised depreciable a#ount should be provided prospectively over the residual useful life of the asset 3here the depreciable assets are revalued" the provision for depreciation should be based on the revalued a#ount and on the esti#ate of the re#ainin$ useful lives of such assets% In case the revaluation has a #aterial effect on the a#ount of depreciation" the sa#e should be disclosed separately in the year in which revaluation is carried out% The followin$ infor#ation should be disclosed in the financial state#ents: i! the historical cost or other a#ount substituted for historical cost of each class of depreciable assets; ii! total depreciation for the period for each class of assets; and iii! the related accu#ulated depreciation%