Chapter 30

Depreciation

1. Explain the concept of depreciation.

 The systematic allocation of the depreciable amount of the property, plant and equipment over the
useful life.
 Not so much a matter of valuation as it is a matter of cost allocation in recognition of the exhaustion
of the life of an item of property, plant and equipment used in business operations.

2. What are the two kinds of depreciation?

a. Physical depreciation
 Related to the depreciable asset’s wear and tear and deterioration over a period.
 May be caused by wear and tear, passage of time, accident, action of the elements such as rain
or dust, and disease or decay.
b. Functional or economic depreciation
 Arises from inadequacy, supersession and obsolescence.
 Inadequacy arises when an asset is no longer useful because of an increase in the volume of
operations.
 Supersession arises when a new asset becomes available and the new asset can perform the same
function more efficiently and economically or for substantially less cost.
 Obsolescence arises when there is no future demand for the product which the asset produces.
 An asset becomes obsolete if it is inadequate or superseded.

3. Explain the three factors of depreciation.

 Depreciable amount – the cost of an asset or other amount substituted for cost less its residual value.
 Residual value of an asset – the estimated amount that an entity would currently obtain from disposal of
the asset, after deducting the estimated cost of disposal, if the asset were already of the age and
condition expected at the end of the useful life.
Residual value is the estimated net amount currently obtained if the asset is at the end of the useful life.
 Useful life or service life – either the period of time over which an asset is expected to be used by the
entity or the number of production or similar units expected to be obtained from the asset by the entity.
As distinguished from useful life, physical life refers to how long the asset would last.
The useful life of an asset may be expressed in years, units of output and service hours.

4. What are the factors that should be considered in determining the useful life of an asset?
 Expected usage of the asset
 Expected physical wear and tear
 Technical obsolescence - arises from changes or improvements in production or change in the market
demand for the product output of the asset
 Legal limits for the use of the asset, such as the expiry date of the related lease.

5. What are the methods of depreciation?

 Equal or uniform charge methods – straight line, composite method and group method.
 Variable charge or use-factor methods – service hours and output or production method.
 Decreasing charge or accelerated or diminishing balance methods – sum of years’ digits, declining
balance and double declining balance.
 Other methods – inventory, retirement and replacement method.

6. Explain the straight line method of depreciation.

 The annual depreciation charge is calculated by allocating the depreciable amount equally over the
number of years of estimated useful life.
 Straight line depreciation is a constant charge over the useful life of the asset.
 It is widely used in practice because of simplicity.
 This method is adopted when the principal cause of depreciation is passage of time.
 It considers depreciation as a function of time rather than as a function of usage.
  Examples of assets which depreciate principally because of passage of time are: buildings, other
structures such as radio and TV towers, dams, bridges, and office equipment such as typewriters, adding
machines, computers.

7. Explain the variable charge methods of depreciation.

 The variable methods assume that depreciation is more a function of use rather than passage of time.
 The useful life of the asset is considered in terms of the output it produces or the number of hours it
works.
 The variable methods are working hours method and output or production method.
 Such methods are adopted if the principal cause of depreciation is usage and based on the following:
a. Assets depreciate more rapidly when used full time or overtime.
b. There is a direct relationship between utilization of assets and realization of revenue.
If assets are used more intensively in production, greater revenue is expected.
 The variable methods are found to be appropriate for assets such as machineries.

8. Explain the accelerated methods of depreciation.

 The decreasing charge or accelerated methods provide higher depreciation in the earlier years and lower
depreciation in the later years of the life of the asset
 This is on the philosophy that new assets are generally capable of producing more revenue in the earlier
years than in the later years.
 The decreasing charge methods are sum of years’ digits, declining balance and double declining balance.

9. Explain the inventory method of depreciation.

 Consists of merely estimating the value of the asset at the end of the period.
 The difference between the balance of the asset account and the value at the end of the year is then
charged off as depreciation for the year.
 In recording depreciation, no accumulated depreciation account is maintained. The depreciation is
credited directly to the asset account.
 This depreciation approach is applied generally to assets which are small and relatively inexpensive such
as hand tools or utensils.
 The inventory method is defended on practical grounds.

10. Explain the retirement and replacement method of depreciation.

 Under the retirement method, no depreciation is recorded until the asset is retired.
 The amount of depreciation is equal to the original cost of the asset retired minus salvage proceeds.
 Under the replacement method, no depreciation is recorded until the asset is retired and replaced.
 The amount of depreciation is equal to the replacement cost of the asset retired minus salvage
proceeds.
If the asset retired is not replaced, the original cost of the asset retired but not replaced is charged off as
depreciation.
The retirement and replacement method may be used in much the same situations as the inventory
method.