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Depreciation
is a measure of the wearing out, consumption or other loss of value of a depreciable asset arising from
use, effluxion of time or obsolescence through technology and market changes.
Characteristics It is the decrease in the value of the asset. Depreciation word is used for the decrease in the value of tangible fixed asset. Value decreases gradually due to charge of depreciation.
Applicability
This Statement applies to all depreciable assets,
except :
(i) forests, plantations; (ii) wasting assets, Minerals and Natural Gas; (iii) expenditure on research and development; (iv) goodwill; (v) live stock Cattle, Animal Husbandry.
Causes of Depreciation
By constant use Effect of time By expiry of legal rights Accident Human mistake Obsolescence Fall in prices Depletion
Depreciation Accounting
To ascertain the true & fair profit or loss of the
organisation
organisation
Contd
The term Depreciation is used broadly in the following 2 senses:
1.
ECONOMIC DEPRECIATION: It is economic loss due to both physical deterioration and technological obsolescence. It may be
2.
ACCOUNTING DEPRECIATION: It is a systematic allocation of cost basis over a period of time. It may be
BOOK DEPRECIATION
TAX DEPRECIATION
Initial Cost
Factor #1
Factor #2
Residual Value
Depreciable Cost
Useful Life
amount and it is this amount that has to be allocated as depreciation over the estimated life of an asset.
Depreciable Amount of a depreciable asset is its
historical cost, or other amount substituted for historical cost in the financial statements, less the estimated residual value.
BASE.
Methods of Depreciation
The following four depreciation methods are acceptable for Financial Accounting purposes: 1. Straight-Line 2. Declining-Balance 3. Sum-of-Years-Digits 4. Units-of-Production Declining-balance and sum-of-years-digits are known as Accelerated Depreciation Methods.
stream, that is, service provided is equal in each year of the assets life.
Rate is reciprocal of estimate service life
It charges an expense, an equal fraction of net cost of
Straight-Line Method Cost estimated residual value Estimated life = Annual depreciation
Example
Original Cost....... Rs.24,000
Estimated Life in years.. 5 years Estimated Residual Value... Rs.2,000
For example, an equipment worth $1m with an estimated life of five years and salvage value of $100,000 would have the following depreciation schedule and asset value after each year as shown below.
Straight-Line Method
The straight-line method is widely used by firms because it is simple and it provides a reasonable transfer of cost to periodic expenses if the asset is used about the same from period to period.
ACCELERATED METHOD
This method allows companies to write off more of
their assets in the earlier years and less in the later years.
The biggest benefit of this method is the tax benefit.
Contd
Stream of benefits provided by a fixed asset may not be
level. Rather the benefits provided maybe great in first year of assets life and least in last year. This is because the assets mechanical efficiency tends to decline with age, because maintenance cost increases with age. Thus earlier periods would benefit more than later period and depreciation method will reflect this.
Two Types
1. Double declining balance method 2. Sum-of-the-years digit
In both these methods, we write off approx. 2/3rd of assets cost in first half of its estimated life.
straight line depreciation expense of the first year. The same percentage is then applied to the non depreciated amount in the subsequent years.
Here each year depreciation is found by applying rate
to the net book value of the asset as of the beginning of that year.
Contd
This is stated % of straight line rate. Thus for an asset
with a useful life of 10 years, Straight line rate = 10% 200% declining balance would use a rate of 20%. Similarly 150 % declining balance would use a rate of 15%. The 200% declining balance method is called Double declining balance method because the deprecation rate is double the straight line rate.
Balance Sheet)
Sum-of-years-digits
Here the number 1,2,3,4.n are added where
denominator is the sum of these digits and numerator for the first year is N, second year is (N-1), then (N-2) and so on.
That is, 10/55, 9/55, 8/55 and so on.
and they bought several new computers for their staff. The purchase value of the computers is $10,000 Computers do not have a long useful life, but five years is realistic and adequate. So, n=5 Computers also deteriorate in value much quicker in the first year than the later years so an accelerated depreciation method is more than satisfactory. At then end of five years, computers are generally worthless so the salvage value will be $0.
Contd
One of the benefits to accelerated depreciation is the
reduction of taxes, but another point of great benefit is if the equipment requires maintenance.
Accelerated depreciation will offset the increasing
maintenance cost and essentially equalizes the combined charges of both maintenance and depreciation.
The graph below is a simplified view of how the accelerated depreciation and maintenance cost works out to give a straight line total expense
If the straight line method was used, the depreciation would be constant and the maintenance cost would increase which would increase the total expenses.
To see this side by side, we get the following table using the same assumptions as before but with the added maintenance expenses.
obviously costs more but towards the later stages of the useful life, the expenses become much less.
In the example with maintenance cost included, just
after one year, the depreciation expense is already close to equal to the straight line method. By year three, the expense is much less compared to the straight line method, and so more revenue can be recognized without any improvements in business.
alter the performance of the business. It can be seen as a revenue smoothing method.
the type of company. If you are looking at a rapid tech company where assets lose most of the value within the first year, needs to be replaced regularly, and costs a lot to maintain, the accelerated method is the right choice. This brings us to the big red flag related to depreciation. By depreciating assets too slowly, the company is using aggressive accounting. Sounds contradictory, but the result is that earnings are being manipulated by being artificially inflated.
asset such as impaired assets and/or obsolete inventory. When you go through the financial statements, check what type of accounting method is used. Then compare it to a competitor and see whether it is inline with industry standards and suitable for the business model.
actual usage of the asset i.e. high depreciation is charged when there is high activity and less depreciation is charged when there is low activity. Zero depreciation is charged if the system is idle for the whole period This method is similar to Straight line method except that, life of an asset is estimated in terms of no. of operations or no. of machine hours instead of no. of years.
60,000/ 3,00,000 = 20 cents per mile So depreciation expense in a year in which the truck travelled 50,000 miles would be, $10,000.
Units-of-Production Method
(Cost estimated residual value) No. of Units Produced Estimated life in units, hours, etc.
Example
Original Cost....... Rs.24,000
Estimated Life in hours.. 10,000 Estimated Residual Value... Rs.2,000
Units-of-Production Method Rs.24,000 Rs.2,000 10,000 hours = Depreciation per unit, hour, et = Rs.2.20 per hour
Units-of-Production
The units-of-production method is more appropriate than the straight-line method when the amount of use of a fixed asset varies from year to year.
Physical Depreciation
Physical
Depreciation of the
occurs weather
from and
the
action
environmental conditions.
Functional Depreciation
Functional Depreciation occurs when a fixed
Book Depreciation
Book Depreciation is provided as per the prevailing
Tax Depreciation
Tax Depreciation is provided as per the prevailing
taxation laws.
Minimum Depreciation
The Department of Company Affairs has clarified that the
rates contained in Schedule XIV to the Company Act, 1956 should be viewed as the minimum rates, and, therefore, company cannot charge depreciation at rates lower than specified in the Schedule in relation to the assets. However, if on technical evaluation, higher rate of depreciation are justified, the higher rates should be applied.
depreciation if its individual value does not exceed Rs. 5000. The 100% provision cannot be avoided by arguing that the furniture can be used only as a set, i.e. a set of chairs, which in aggregate cost more than Rs. 5000.
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Query
Info ltd. Has acquired on a 999 year lease a huge piece of land for Rs. 999 lakhs from the Government. The land along with any
construction thereon will revert to the Government after 999 years. Since the said period is very long and is akin to owning the land, Info Ltd does not wish to amortize the consideration. Is that acceptable under Indian GAAP.
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Response
AS- 19 Leases does not apply to lease agreement to use lands. AS 6 Depreciation Accounting, does not apply to land unless it has a limited useful life for the enterprise. In other words, if the life of land is limited than AS 6 would apply. In the given case, 999 years though very long is still limited. Therefore, AS 6 would apply. Therefore each year Info Ltd will have to charge Rs. 1 lakh to the income statement as amortization expenses.
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T H A N K Y O U !!!
- Kanika Monga (140) - Nishant Sharma (189) - Karan Batheja (190)
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