Ravi Kiran

Depreciation is the reduction in the cost of an asset used for business purposes during certain amount of time due to: usage, passage of time, wear and tear, technological outdating or obsolescence, depletion, inadequacy, rot, rust, decay or other such factors. The allowance for wear and tear on equipment and machinery Amount of decreasing value in a capital asset allowed to be deducted from a business tax return Cost Recovery

Factors in the Depreciation Process

1. What is the depreciation of the asset? 2. What is the assets useful life? 3. What method of depreciation is best for
the asset in question?

Depreciation
Depreciation is the rupee amount subject to

depreciation. It is determined as: Original cost of the asset less Estimated salvage or disposal value

Salvage value
Salvage value is the estimated value of an asset at the

end of its useful life. In accounting, the salvage value of an asset is its remaining value after depreciation. This is also known as residual value or scrap value. It is the net cash inflow that occurs when the asset is liquefied at the end of its life.

Some concepts
For historical cost purposes, assets are recorded on the

balance sheet at their original cost; this is called the historical cost. Historical cost minus all depreciation expenses recognized on the asset since purchase is called the book value Book value is the remaining unallocated cost of an asset or:
Book Value =

Historical Cost - Accumulated

Depreciation

Depreciation Methods: Overview

Depreciation Methods

Straight Line

Decreasing Charge

1. Declining Balance 2. Sum-of-the-years digits

Depreciation Methods: StraightLine

Is a function of time rather than usage
Results in an equal amount of depreciation expense

for a given period Depreciation Expense is computed as: Cost Salvage Value Estimated Life

 A vehicle that depreciates over 5 years, is purchased at a

cost of US$17,000, and will have a salvage value of US$2000, will depreciate at US$3,000 per year: ($17,000 $2,000)/ 5 years = $3,000 annual straight-line depreciation expense.
Book value at beginning of year Depreciation expense Accumulated depreciation $3,000 Book value at end of year $14,000

$17,000 (original cost) $3,000

$14,000
$11,000 $8,000 $5,000

$3,000
$3,000 $3,000 $3,000

$6,000
$9,000 $12,000 $15,000

$11,000
$8,000 $5,000

$2,000 (scrap value)

Straight-Line
Most often used in book depreciation where the object is to

minimize depreciation expense in order to maximize net income. Tax depreciation is normally not based upon straight line depreciation since other methods will generally maximize tax depreciation expense which tends to minimize taxes payable.
Straight line depreciation results in a constant depreciation

expense each year.

D. Unit of Production
Used in situations where the loss in service value is more closely related to use or number of units produced rather than time. Most commonly associated with machinery and equipment involved in producing natural resources where the physical life of the equipment exceeds the economic or production life of the natural resources.

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Depreciation Methods: Decreasing Charge

These methods result in higher depreciation expense in the earlier years and lower charges in the later years.
Two decreasing charge methods are: Declining balance Sum-of-the-years-digits

1.

2.

Declining balance
A fixed percentage of the book value is used to

calculate the depreciation, which must be written off each year. If the life span of an asset is for instance, 5 years, and is normally calculated as 20% the percentage needs to be doubled to 40% in this case. The fixed percentage must be used to calculate the percentage on the reduced or diminished balance at the beginning of the applicable year.

Diminishing balance method

Years
1 2 3 4 5

cost
15500 15500 15500 15500 15500

Deprciation
40% of 15500 =6200 40%of 9300 =3720 .40x5580 =2238 40x33488 =1340 .40x2008 =803

Accum Dep
6200 9920 12152 13492 14295

Book value
9300 5580 3348 2008 1205

Total Depreciation=14895

Declining balance
This is one of the few methods which does not take the

salvage value directly into account. It also is an accelerated method.

Most property except certain used property and real

estate has been accorded the treatment of double declining balance which may be stated as:

DDB =(2/Useful Life)(Historical Cost - Accumulated

Depreciation) A constraint is that the accumulated depreciation cannot exceed the historical cost less salvage value.

Declining balance
It is possible to find a rate that would allow for full depreciation by its end of life with the formula:

here N is the estimated life of the asset (for example, in years).

DDB Example:
$10,000 Historical Cost 1,000 Salvage Value 10 Year Useful Life A constraint is that the accumulated depreciation cannot exceed the historical cost less salvage value.
Year 1 2 3 4 5 6 7 8 9 10 Remaining Value At Beginning Of Year Factor $10,000 8,000 6,400 5,120 4,096 3,277 2,622 2,098 1,678 1,342 11 2 2 2 2 2 2 2 2 2 2 10 10 10 10 10 10 10 10 10 10 Depreciation $2,000 1,600 1,280 1,024 819 655 524 420 336 268

1,074

As one can see the use of DDB may not result in full allocation of the depreciable base (historical cost less salvage value). We never got down to our $1,000 target!

Lets assume the salvage value were equal to $3,000. The depreciation schedule under DDB would now be:
Year 1 2 3 4 5 6 7 8 9 10 Remaining Value At Beginning Of Year Factor $10,000 8,000 6,400 5,120 4,096 3,277 3,000 3,000 3,000 3,000 2 2 2 2 2 2 10 10 10 10 10 10 Depreciation $2,000 1,600 1,280 1,024 819 * 277

*constrained by $3,000 salvage value

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 The problem that we encountered in the $1,000 salvage

value case can be corrected with the combination or composite depreciation method of declining balance depreciation switching when advantageous to straight-line depreciation. The conversion occurs when the straight-line depreciation produces an equal to or greater charge in some year than with declining balance depreciation. The straight-line is based upon the book value at the beginning of that year less salvage value divided by the remaining useful life at the beginning of the year.

Thus our previous example with $1,000 salvage value: Beginning Of Year 4 Straight Line (5120 10000)/7
= $589

DDB $1,024

Switch No

Year 5 Year 6 Year 7 Year 8 Year 9

(4096 - 1000 )/6 (3277 - 1000 )/5

= $516

819 655 524 420 336

No No No No Yes

= $455

(2622 1000 )/5= (2098 - 1000 )/4 (1678 1000 )/2

$406

= $366

= $339

Year
8 9 10

Remaining Value At Beginning Of Year

$2,098 1,678 1,339 11

Factor
2 10 S.L. S.L. 1,000

Depreciation
$420 339 339

Depreciation Methods: Sum-ofthe-Years Digits

A fraction is multiplied by the depreciable base to arrive at the depreciation expense per period. The fraction is:
1. 2. 3. 4.

Numerator: number of years remaining in the assets life as of the beginning of the period. Denominator: sum of the years in the life For example, a 5 year life property would have depreciation expense for the first year as: (Cost Salvage value) X (n+1-k)/ 15 (computed as 5+4+3+2+1)

Conclusion
As previously indicated one normally wants to maximize

the depreciation for tax purposes. However, there are examples of companies that would be in a constant net operating loss condition if they used the accelerated depreciation methods. Therefore, close examination of the company situation is required when examining the methods for book and tax depreciation.