Depreciation Rk

8/22/2019 Depreciation Rk

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Ravi Kiran


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Depreciation is the reduction in the cost of

an asset used for business purposes during certainamount of time due to:

usage, passage of time, wear and tear, technologicaloutdating 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 allowedto be deducted from a business tax return

Cost Recovery


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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?

Factors in the Depreciation

Process


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Depreciation is the rupee amount subject todepreciation.

It is determined as:

Original cost of the asset less

Estimated salvage or disposal value

Depreciation


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

end of its useful life. In accounting, the salvage valueof 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 isliquefied at the end of its life.


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

balance sheet at their original cost; this is called thehistorical cost. Historical cost minus all depreciation

expenses recognized on the asset since purchase iscalled the book value

Book value is the remaining unallocated cost of anasset or:

Book Value = Historical Cost - AccumulatedDepreciation


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DepreciationMethods

1. Declining Balance2. Sum-of-the-years digits

DecreasingCharge

Depreciation Methods: Overview

StraightLine


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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

Depreciation Methods: Straight-

Line


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A vehicle that depreciates over 5 years, is purchased at acost of US$17,000, and will have a salvage value

of US$2000, will depreciate at US$3,000 peryear: ($17,000 $2,000)/ 5 years = $3,000 annualstraight-line depreciation expense.

Book value atbeginning of year

Depreciationexpense

Accumulateddepreciation

Book value atend of year

$17,000 (original cost) $3,000 $3,000 $14,000

$14,000 $3,000 $6,000 $11,000

$11,000 $3,000 $9,000 $8,000

$8,000 $3,000 $12,000 $5,000

$5,000 $3,000 $15,000$2,000 (scrap

value)


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

minimize depreciation expense in order to maximize netincome.

Tax depreciation is normally not based upon straight linedepreciation since other methods will generally maximizetax depreciation expense which tends to minimize taxespayable.

Straight line depreciation results in a constant depreciationexpense each year.


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D. Unit of Production

Used in situations where the loss in servicevalue is more closely related to use or numberof units produced rather than time.

Most commonly associated with machinery andequipment involved in producing naturalresources where the physical life of theequipment exceeds the economic or productionlife of the natural resources.


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These methods result in higher depreciationexpense in the earlier years and lower charges

in the later years.

Two decreasing charge methods are:

1.Declining balance2. Sum-of-the-years-digits

Depreciation Methods: Decreasing

Charge


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A fixed percentage of the book value is used tocalculate the depreciation, which must be written offeach year.

If the life span of an asset is for instance, 5 years, and isnormally calculated as 20% the percentage needs to bedoubled to 40% in this case.

The fixed percentage must be used to calculate thepercentage on the reduced or diminished balance atthe beginning of the applicable year.

Declining balance


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Diminishing balance methodYears cost Deprciation Accum Dep Book value

1 15500 40% of 15500=6200

6200 9300

2 15500 40%of 9300=3720 9920 5580

3 15500 .40x5580=2238

12152 3348

4 15500 40x33488=1340

13492 2008

5 15500 .40x2008=803

14295 1205

Total Depreciation=14895


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

salvage value directly into account. It also is anaccelerated method.

Most property except certain used property and realestate has been accorded the treatment of doubledeclining balance which may be stated as:

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

A constraint is that the accumulated depreciationcannot exceed the historical cost less salvage value.


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Declining balanceIt 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).


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DDB Example:

$10,000 Historical Cost1,000 Salvage Value

10 Year Useful LifeA constraint is that the accumulated depreciation cannot exceed

the historical cost less salvage value.

As one can see the use of DDB may not result in full allocation of thedepreciable base (historical cost less salvage value). We never got

down to our $1,000 target!

Year Remaining Value At Beginning Of Year Factor Depreciation

1 $10,000 2 10 $2,000

2 8,000 210 1,6003 6,400 2 10 1,280

4 5,120 2 10 1,0245 4,096 2 10 8196 3,277 2 10 6557 2,622 2 10 5248 2,098 2 10 4209 1,678 2 10 33610 1,342 2 10 268

11 1,074


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Lets assume the salvage value were equal to$3,000. The depreciation schedule under DDB

would now be:Year Remaining Value At Beginning Of Year Factor Depreciation

1 $10,000 2 10 $2,0002 8,000 2 10 1,6003 6,400 2 10 1,2804 5,120 2 10 1,024

5 4,096 210 8196 3,277 2 10 277*

*constrained by $3,000 salvage value

7 3,0008 3,0009 3,00010 3,000


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

value case can be corrected with the combination orcomposite depreciation method of declining balancedepreciation switching when advantageous to straight-linedepreciation.

The conversion occurs when the straight-line depreciationproduces 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 theremaining useful life at the beginning of the year.


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Thus our previous example with $1,000 salvage value:

Beginning Of Straight Line DDB Switch

Year Remaining Value At Beginning Of Year Factor Depreciation

8 $2,098 2 10 $4209 1,678 S.L. 339

10 1,339 S.L. 339

11 1,000

Year 4 (5120 10000)/7 = $589 $1,024 No

Year 5 (4096 - 1000 )/6 = $516 819 No

Year 6 (3277 - 1000 )/5 = $455 655 No

Year 7 (2622 1000 )/5= $406 524 No

Year 8 (2098 - 1000 )/4 = $366 420 No

Year 9 (1678 1000 )/2 = $339 336 Yes


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A fraction is multiplied by the depreciable base toarrive at the depreciation expense per period.

The fraction is:

1. Numerator: number of years remaining in the assetslife as of the beginning of the period.

2. Denominator: sum of the years in the life

3. For example, a 5 year life property would havedepreciation expense for the first year as:

4. (Cost Salvage value) X (n+1-k)/

15 (computed as

5+4+3+2+1)

Depreciation Methods: Sum-of-

the-Years Digits


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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 theaccelerated depreciation methods.

Therefore, close examination of the company situation isrequired when examining the methods for book and tax

depreciation.

Depreciation Rk

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