Depreciation is the process of allocating the cost of a fixed asset (less any residual value) over its estimated value of useful life in a rational and systematic manner. It is a measure of the wearing out, consumption, or other loss of value of depreciable assets arising from use, effluxion of time, or obsolescence through technology and market changes. Depreciation is allocated so as to charge a fair proportion of the depreciable amount in each period over the expected useful life of the asset.
CAUSES OF DEPRECIATION
As an asset is used over the years, the benefits embodied within it decrease. The 'am bundles of future series' available from it become smaller and smaller as the years pass because of the following two factors:
1. Physical factors, such as
deterioration through use; and
2. Economic factors, such as impaired utility through obsolescence.
Therefore, a decline in service potential or decline in value during the life of an asset is the result of decay or deterioration from wear and tear, time and the elements; and Ordinary obsolescence arising from technological improvements and the inadequacy of the asset for its intended purpose.
From the above, it can be comprehended that the causes of depreciation arise directly through deterioration or indirectly through obsolescence.
FACTORS IN THE MEASUREMENT OF DEPRECIATION
Following are the main factors which keep in mind at the time of calculating depreciation:
Cost of assets
It is the basis for all subsequent accounting for that asset. Generally, the cost of an asset means its acquisition cost, which is the sum of all costs incurred in acquiring the asset, and all direct expenses i.e., incidental costs involved in bringing the asset into condition as intended by management. When the business concern itself manufactures some assets, the cost of an asset will mean its production cost.
Residual value or scrap value of the asset
It is the estimated value of an asset that an entity expects to receive at the time of removal and disposal. Mainly it is estimated to get the exact amount of asset (depreciable amount) that will be consumed by the entity in future years.
The useful life of the asset
It is the number of accounting periods for which assets will be useful to the business. The basic objective of estimating the useful life of an asset is to allocate the net cost of the asset (depreciable amount) over its useful life by means of depreciation. Since there is no way to measure correctly how long an asset will be useful, the asset's useful economic life is always estimated at the start. It is generally based on the following:
(1) Extent of use (as in the plant,
machinery, etc.)
(2) Consumption or extraction (as in
mines)
(3) Physical deterioration (the physical
process of wear and tear); and
(4) Obsolescence (loss of usefulness through technological or market changes)
The estimated useful life of an asset can be expressed in terms of the following factors:
=> With respect to the time period (E-g number of years, months, or weeks).
=> With respect to the units of output that an asset is expected to produce during its lifetime.
=> Operating period (For example the number of hours the machine expected to work).
METHODS OF CALCULATING DEPRECIATION
Following are the methods by which depreciation
can be calculated
Straight-line method
Under this method, an asset is depreciated over its useful life taking into account the number of years for which the asset is expected to be used and lessening the residual value from the cost of an asset.
Example
Cost
of an asset = USD 500
Salvage
value or scrap value at the end of useful life of asset = USD 200
Useful
life of the asset is = 2 years
The
depreciation for the first year would be
Depreciation = (Cost – Salvage
Value/Scrap Value) / useful life
Depreciation = (USD 500-
USD 200)/2 = USD 150
So the first year depreciation would be USD 150 and USD 150 in second year and then asset would be sold for USD 200 at the scrap value any value received above the scrap value would be gain and less value than scrap value would be loss because the business cant estimate actually at this stage that how much it would receive for the sale of asset as its sales depends upon many factors like condition of asset and its market demand and usage etc.
Reducing Balance Method/Diminishing Balancing Method
Under this method, an asset would be depreciated taking into account the specific percentage and that specific percentage would be multiplied by the cost of an asset every year. The scrap value of the asset at the end of its life shall also be deducted from the cost of an asset. The most strange point about this method is that under this method the asset value would never ever be reduced to zero even if the business does not consider the scrap value too. It would be less than and would be carrying in the books of accounts in points like 0.00000099 but can’t be zero. The fixed rate of percentage would be applied to the book value/written down value of an asset and the later years depreciation would be less than the prior year’s depreciation because of the reason that more benefit is expected to receive from the usage of the assets in its start than later.
Book value/written down value is equal to cost less accumulated depreciated
Example
Suppose a business has an asset cost of USD-200 and its residual value at the end of its useful life would be USD.50. The business has decided its useful life as three years and the rate of depreciation is 50% Now if we want to calculate the depreciation for the first whole life of the assets then we should consider the following calculations:
Solution
|
Year |
Cost/NBV |
Scrap
value |
Rate
|
Depreciation |
Accumulated
Depreciation |
NBV |
|
1 |
200 |
(50) |
50% |
75 |
75 |
125 |
|
2 |
125 |
(50) |
50% |
37.5 |
112.5 |
87.5 |
|
3 |
87.5 |
(50) |
50% |
37.5 |
150 |
50 |
Now we can see that at the end of the useful life of an asset the Net book value (NBV) is equal to the scrap value.
Sum of year digit method
This method is rarely uses by any business in the world for calculating the depreciation expenses. Under this method the business combines the useful life of an asset and adding one to it while divide that whole number over 2. This method lead to depreciate an asset more in its early life almost two third while less depreciation in later years.
Example
Suppose cost of an asset is USD.1,000 while the scrap value is USD.200 and the useful life of an asset is 2 years.
Solution
Sum of years digit formula = n(n+1)/2
n = useful life of an asset
Sum of years’ digit = 2(2+1)/2 =3
So the Sum of years’ digit is 3 which mean the asset would be depreciated dividing the useful life over three for whole life of an asset which is in this case is 2 years.
1st year’s
depreciation = 2/3 = (USD.1, 000-USD.200) = USD.533
2nd year’s depreciation= 1/3 = (USD.1, 000-USD.200) = USD.267
Total accumulated depreciation = USD800 (533+267)
Net book value = 200 (USD.1, 000-USD.800)
Machine hour rate method
Under this method the cost of an asset is divided over the expected working hours of machine for whole of its life. Its is really important that businesses shall determine the exact or near precise working hours of an asset to calculate more precise depreciation.
Example
Suppose the cost of an asset is USD.1, 500 with a scrap value of USD.300 and with a useful life of an asset is 200 hours.
Solution
Depreciation
= (Cost – Scrap value) divided by (total working hours of an asset)
Depreciation = (USD.1, 500 –USD300)/200
Depreciation = USD.6
Each year the depreciation of USD.6 would be charged as an expense in the books of accounts. Since here in this example the total hours are more while the cost of the asset is less so it is hereby justified to see less depreciation.
Production method
Under this method the depreciation is calculated dividing the cost of an asset over the total units of production that a business is anticipated to produce from given asset.
Example
Suppose the cost of asset is USD.5,000 while the scrap value is USD.1,000 and the total production from a given asset is 4,000 units and in first year the total units to produced is anticipated as 200 units and in second year it is anticipated to produce 120 units then the depreciation for the 1ST and 2nd year would be:
Solution
Depreciation
= (Cost – Scrap value) divided by (total number of units to be produced)
Depreciation rate per unit = (USD.5,000- USD.1,000)/4,000 = 4
1st
year’s depreciation = 4*200 = 800
2nd year’s depreciation =4*120 = 480
In second year less depreciation charged to asset due to reason the asset would give less output as compared to the previous year.
DEPRECIATION POLICY
Every company has its own depreciation policy some companies charging depreciation on time basis while some companies on full year basis. Normally the companies charge the depreciation on the following basis:
1. Time basis
Under this method of depreciation mean that the exact number of days for which an asset is used are computed and depreciation is charged for such days.
2. Full year basis
Under this method full year depreciation is charged in the year of purchase irrespective of the date of purchase while no depreciation is charged in the year of disposal irrespective the date of disposal.
3. Monthly basis
Under this method the companies charging depreciation on monthly basis like if an asset is used for more than 15 days in a month then full month’s depreciation is charged on asset. Similarly, if an asset is used for less than 15 days in a month then no depreciation is charged in the month of disposal.
4. Reversal of full year basis
This
method is very rare and not in common practice. Under this method the full year
depreciation is charged in the year of disposal while no depreciation is
charged in the year of purchase. Its sound strange and have no sound logics
that’s why companies avoid to use such method for calculating depreciation.
JOURNAL ENTRIES TO RECORD DEPRECIATION, PURCHASE, SALE AND EXCHANGE OF ASSET
Purchase of asset
|
Debit |
Asset |
|
Credit |
Bank/Payable |
Recording of depreciation
|
Debit |
Depreciation
expense |
|
Credit |
Accumulated
Depreciation |
Sale of asset and loss arise
|
Debit |
Accumulated
depreciation |
|
Debit |
Bank or Receivable |
|
Debit
|
Loss on disposal |
|
Credit |
Asset account |
Sale of asset and profit arise
|
Debit |
Accumulated
Depreciation |
|
Debit |
Bank or Receivable |
|
Credit |
Profit on
disposal |
|
Credit |
Asset account |
Exchange of asset with loss and
received cash too with new asset
|
Debit |
New asset |
|
Debit |
Cash/bank |
|
Debit |
Loss on exchange |
|
Debit |
Accumulated
depreciation on old asset |
|
Credit |
Old asset account |
Exchange of asset with loss and
cash is paid too with new asset
|
Debit |
New asset |
|
Debit |
Accumulated
depreciation |
|
Debit |
Loss on
disposal of old asset |
|
Credit |
Cash or Bank |
|
Credit |
Old asset account |
Exchange of asset with Profit or
loss and cash received or paid too with new asset
|
Debit |
New asset |
|
Debit
/ (Credit) |
Cash or bank /
(Cash or Bank) |
|
(Debit)/
Credit |
(Loss) or Profit on disposal of old asset |
|
Debit |
Accumulated
depreciation |
|
Credit |
Old asset account |