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Unit V DEPRECIATION

Depreciation refers to two very different but related concepts: decline in value of assets, and allocation of the cost of assets to periods in which the assets are used.

The former affects values of businesses and entities. The latter affects net income. Generally the cost is allocated, as depreciation expense, among the periods in which the asset is expected to be used. Such expense is recognized by businesses for financial reporting and tax purposes. Methods of computing depreciation may vary by asset for the same business. Methods and lives may be specified in accounting and/or tax rules in a country. Several standard methods of computing depreciation expense may be used, including fixed percentage, straight line, and declining balance methods. Depreciation expense generally begins when the asset is placed in service. Example: a depreciation expense of 100 per year for 5 years may be recognized for an asset costing 500.

In economics, depreciation is the decrease in the economic value of the capital stock of a firm, nation or other entity, either through physical depreciation, obsolescence or changes in the demand for the services of the capital in question. If capital stock is C0 at the beginning of a period, investment is I and depreciation D, the capital stock at the end of the period, C1, is C0 + I - D.

DEPRECIATION METHODS Depreciation methods based on time


Straight line method Declining balance method Sum-of-the-years'-digits method


Sinking fund method of depreciation / Annuity method of depreciation Service output method of depreciation

Depreciation based on use (activity)

Straight Line Depreciation Method Depreciation = (Cost - Residual value) / Useful life [Example, Straight line depreciation] On April 1, 2011, Company A purchased an equipment at the cost of $140,000. This equipment is estimated to have 5 year useful life. At the end of the 5th year, the salvage value (residual value) will be $20,000. Company A recognizes depreciation to the nearest whole month. Calculate the depreciation expenses for 2011, 2012 and 2013 using straight line depreciation method.

Depreciation for 2011 = ($140,000 - $20,000) x 1/5 x 9/12 = $18,000

Depreciation for 2012 = ($140,000 - $20,000) x 1/5 x 12/12 = $24,000

Depreciation for 2013 = ($140,000 - $20,000) x 1/5 x 12/12 = $24,000

Declining Balance Depreciation Method Depreciation = Book value x Depreciation rate Book value = Cost - Accumulated depreciation

Depreciation rate for double declining balance method = Straight line depreciation rate x 200%

Depreciation rate for 150% declining balance method = Straight line depreciation rate x 150%

[Example, Double declining balance depreciation]

On April 1, 2011, Company A purchased an equipment at the cost of $140,000. This equipment is estimated to have 5 year useful life. At the end of the 5th year, the salvage value (residual value) will be $20,000. Company A recognizes depreciation to the nearest whole month. Calculate the depreciation expenses for 2011, 2012 and 2013 using double declining balance depreciation method.

Useful life = 5 years --> Straight line depreciation rate = 1/5 = 20% per year

Depreciation rate for double declining balance method = 20% x 200% = 20% x 2 = 40% per year

Depreciation for 2011 = $140,000 x 40% x 9/12 = $42,000

Depreciation for 2012 = ($140,000 - $42,000) x 40% x 12/12 = $39,200

Depreciation for 2013 = ($140,000 - $42,000 - $39,200) x 40% x 12/12 = $23,520

Double Declining Balance Depreciation Method Year Book Value at the beginning Depreciation Rate Value at the yearend 2011 $140,000 2012 $98,000 2013 $58,800 2014 $35,280 2015 $21,168 40% 40% 40% 40% 40% Depreciation Expense $98,000 $58,800 $35,280 $21,168 $20,000 Book

$42,000 (*1) $39,200 (*2) $23,520 (*3) $14,112 (*4) $1,168 (*5)

(*1) $140,000 x 40% x 9/12 = $42,000 (*2) $98,000 x 40% x 12/12 = $39,200 (*3) $58,800 x 40% x 12/12 = $23,520 (*4) $35,280 x 40% x 12/12 = $14,112 (*5) $21,168 x 40% x 12/12 = $8,467

--> Depreciation for 2015 is $1,168 to keep book value same as salvage value. --> $21,168 - $20,000 = $1,168 (At this point, depreciation stops.)

[Example, 150% declining balance depreciation] On April 1, 2011, Company A purchased an equipment at the cost of $140,000. This equipment is estimated to have 5 year useful life. At the end of the 5th year, the salvage value (residual value) will be $20,000. Company A recognizes depreciation to the nearest whole month. Calculate the depreciation expenses for 2011, 2012 and 2013 using double declining balance depreciation method.

Useful life = 5 years --> Straight line depreciation rate = 1/5 = 20% per year

Depreciation rate for double declining balance method = 20% x 150% = 20% x 1.5 = 30% per year

Depreciation for 2011 = $140,000 x 30% x 9/12 = $31,500

Depreciation for 2012 = ($140,000 - $31,500) x 30% x 12/12 = $32,550

Depreciation for 2013 = ($140,000 - $31,500 - $32,550) x 30% x 12/12 = $22,785

150% Declining Balance Depreciation Method Year Book Value at the beginning Depreciation Rate Depreciation Expense at the End 2011 $140,000 $108,500 2012 $108,500 $75,950 2013 $75.950 $53,165 2014 $53,165 $37,216 2015 $37,216 $26,051 2016 $26,051 30% 30% 30% 30% 30% 30% $31,500 (*1) $32,550 (*2) $22,785 (*3) $15,950 (*4) $11,165 (*5) $6,051 (*6) $20,000 Book Value

(*1) $140,000 x 30% x 9/12 = $31,500 (*2) $108,500 x 30% x 12/12 = $32,550 (*3) $75,950 x 30% x 12/12 = $22,785 (*4) $53,165 x 30% x 12/12 = $15,950 (*5) $37,216 x 30% x 12/12 = $11,165 (*6) $26,051 x 30% x 12/12 = $7,815

--> Depreciation for 2016 is $6,051 to keep book value same as salvage value.

--> $26,051 - $20,000 = $6,051 (At this point, depreciation stops.)

Sum-of-the-years'-digits method Depreciation expense = (Cost - Salvage value) x Fraction Fraction for the first year = n / (1+2+3+...+ n) Fraction for the second year = (n-1) / (1+2+3+...+ n) Fraction for the third year = (n-2) / (1+2+3+...+ n) ... Fraction for the last year = 1 / (1+2+3+...+ n)

n represents the number of years for useful life.

[Example, Sum-of-the-years-digits method]

Company A purchased the following asset on January 1, 2011. What is the amount of depreciation expense for the year ended December 31, 2011? Acquisition cost of the asset --> $100,000 Useful life of the asset --> 5 years Residual value (or salvage value) at the end of useful life --> $10,000 Depreciation method --> sum-of-the-years'-digits method

Calculation of depreciation expense Sum of the years' digits = 1+2+3+4+5 = 15 Depreciation for 2011 = ($100,000 - $10,000) x 5/15 = $30,000 Depreciation for 2012 = ($100,000 - $10,000) x 4/15 = $24,000 Depreciation for 2013 = ($100,000 - $10,000) x 3/15 = $18,000 Depreciation for 2014 = ($100,000 - $10,000) x 2/15 = $12,000 Depreciation for 2015 = ($100,000 - $10,000) x 1/15 = $6,000

Sum of the years' digits for n years = 1 + 2 + 3 + ...... + (n-1) + n = (n+1) x (n / 2)

Sum of the years' digits for 500 years = 1 + 2 + 3 + ...... + 499 + 500 = (500 + 1) x (500 / 2) = (501 x 500) / 2 = 125,250

Sinking fund method of depreciation

Depreciation fund method is also know as sinking fund method or amortization fund method. Under this method, a fund know as depreciation fund or sinking fund is created. Each year the profit and loss account is debited and the fund account credited with a sum, which is so calculated that the annual sum credited to the fund account and accumulating throughout the life of the asset may be equal to the amount which would be required to replace the old asset. In order that ready funds may be available at the time of replacement of the asset an amount equal to that credited to the fund account is invested outside the business, generally in gilt-edged securities. The asset appears in the balance sheet year after year at its original cost while depreciation fund account appears on the liability side. Journal Entries: The following entries are necessary to record the depreciation and replacement of an asset by this method. (a). First year (at the end)

(1). Debit profit and loss account and credit depreciation fund account with the amount of the annual depreciation charge. (2). Also debit depreciation fund investment account and credit cash account with an equal amount. (b). In subsequent years. (1). Debit depreciation fund investment account and credit depreciation fund account with the amount of interest earned and reinvested. (2). Debit profit and loss account and credit depreciation fund account with the annual depreciation installment. (3). Debit depreciation fund investment account and credit cash account with an equal amount. (c). On replacement of asset. (1). Debit cash account and credit depreciation fund investment account with the amount realized by the sale of investment. (2). Transfer any profit or loss on sale of investment to profit and loss account. (3). Debit the new asset purchased and credit cash account. (4). Debit depreciation fund account and credit the account of the old asset which has become useless. The amount of annual depreciation to be provided for by the depreciation fund method will be ascertained from sinking fund table. Sinking Fund Table Annual sinking fund installment to provide $1.Years 3% 3.5% 4% 4.5% 5% 3 0.323540 0.321934 0.320349 0.318773 0.317208 4 0.239027 0.237251 0.235490 0.233741 0.232012 5 0.188350 0.186481 0.184627 0.182792 0.180975 6 0.154598 0.152668 0.150762 0.148878 0.147017 7 0.130506 0.128544 0.126610 0.124701 0.122820 8 0.112446 0.110477 0.108528 0.106610 0.104722 Example: On 1st January, 1990 a four years lease was purchased for $20,000 and it is decided to make provision for the replacement of the lease by means of a depreciation fund, the investment yielding 4 percent per annum interest. Show the necessary ledger account. Solution:

To get $1 at the end of 4 years at 4 percent an annual investment of $2,35,490 is necessary. Therefore, for $20,000 an annual investment of $4,709.80 i.e., 2,35,490 20,000 will be necessary.

1990 Jan.1 To Cash

Lease Account 1990 20,000 Dec. 31

By Depreciation fund 20,000

Depreciation Fund Account 1990 1990 Dec. 31 To Balance c/d 4,709.80 Dec. 31 4,709.80 1991 Dec. 31 To Balance c/d 9607.99 4709.80 1991 Jan. 1

By P & L account

By Balance c/d

Dec. 31By Depreciation fund investment 188.39 " By P&L account 4709.80 9607.99 1992 Dec. 31 9607.99 1992 To Balance c/d 14702.11 Jan. 1 By Balance b/d 9607.99

Dec. 31By Depreciation fund investment 384.32 " By P & L account 4709.80 14702.11 1993 Dec. 31 To Lease account 14702.11 1993 20,000 Jan. 1 14702.11 By Balance b/d

Dec. 31By Depreciation fund investment 588.9

By P & L 20,000 20,000

4,709.80

1990 Dec. 31

To Cash

Depreciation Fund Account 1990 4709.80 Dec. 31 By Balance c/d 4709.80 By Balance c/d 9,607.99

1991 1991 Jan. 1 To Balance b/d 4709.80 Dec. 31 Dec. 31To Depreciation fund 188.39 Dec. 31To Cash 4,709.80 9,607.99 1992 1992 Jan. 1 To Balance b/d 9,607.99 Dec. 31 Dec. 31To Depreciation fund 384.32 Dec. 31 To Cash 4709.80 1993 Jan. 1 Dec. 31 Dec. 31 1993 14,702.11 588.9 4709.80 20,000 Dec. 31

9,607.99 By Balance c/d 14,702.11

By Cash

20,000.00

20,000

Note: The cash installment at the end of the last year will not be invested because there is no point in buying the investment and selling them on the same date. Advantages of Depreciation Fund Method Or Sinking Fund Method: The most important advantages of this method is that it makes available a sum of money for the replacement of the asset, which has become useless. If separate provision was not made, the sum required to purchase the new asset will have to be drawn from the business which might effect the financial position of the concern adversely. Disadvantages of the Depreciation Fund Method Or Sinking Fund Method:

The burden on profit and loss account goes on increasing as years pass by since the amount of depreciation every year remains same but the amount spent on repairs goes on increasing as the asset becomes old. It can also be said that the work of investing money is complicated.

Prices of securities may fall at the time when they are to be realized as a result of which loss may have to be suffered. Scope of Application: This method is found suitable wherever it is desired not only to charge depreciation but also to replace the asset as happens in the case of plant and machinery and other wasting assets.

ANNUITY METHOD OF DEPRECIATION

According to this method, the purchase of the asset concerned is considered an investment of capital, earning interest at certain rate. The cost of the asset and also interest thereon are written down annually by equal installments until the book value of the asset is reduced to nil or its bread up value at the end of its effective life. The annual charge to be made by way of depreciation is found out from annuity tables. The annual charge for depreciation will be credited to asset account and debited to depreciation account, while the interest will be debited to asset account and credited to interest account.

Journal Entries:
Under annuity method, journal entries have to be made in respect of interest and depreciation. As regards interest, it has to be calculated on the debit balance of the asset account at the commencement of the period, at the given rate. The entry that is passed: 1. Asset account To Interest account
(Being interest on capital sunk in asset)

With regard to depreciation the amount found out from the depreciation annuity table, the following entry is passed: 2. Depreciation account To Asset account
(Being the depreciation of asset)

It should be remembered that the interest is charged on the diminishing balance of the asset account, the amount of interest goes on declining year after year. But the amount of depreciation remains the same during the life time of the asset.

Example:
A firm purchased a 5 years' lease for $40,000 on first January. It decides to write off depreciation on the annuity method. Presuming the rate of interest to be 5% per annum. Show the lease account for the first 3 years. Calculations are to be made to the nearest dollar.

Annuity Table Amount required to write off $1 by the annuity method.

Years 3 4 5 6 7 8

3% 0.353530

3.5% 0.359634

4%

4.5%

5% 0.367209 0.282012 0.230975 0.197017 0.172820 0.154722

0.360349 0.363773 0.275490 0.278744 0.224627 0.227792 0.190762 0.193878 0.166610 0.169701 0.148528 0.151610

0.269027 0.272251 0.218355 0.221418

0.184598 0.187668 0.160506 0.163544 0.142456 0.145477

Solution:
According to the annuity table given above, the annual charge for depreciation reckoning interest at 5 percent p.a. would be: 230975 40,000 = $9,239 Lease Account
Debit Side Date 1st Year Jan. 1 Dec. 31 To Cash To Interest 40,000 2,000 $ Date 1st Year Dec. 31 By Depreciation By Balance c/d 9,239 32,761 Credit Side $

42,000 2nd Year Jan. 1 Dec. 31 To Balance b/d To Interest 32,761 1,638 34,399 3rd Year Jan. 1 Dec. 31 To Balance b/d To Interest 25,160 1,258 26,418 3rd Year Jan. 1 To Balance b/d 17,170 Dec. 31 By Depreciation By Balance c/d 2nd Year Dec. 31 By Depreciation By Balance c/d

42,000

9,239 25,160 34,399

9,239 17,179 26,418

Advantages:
1. This method takes interest on capital invested in the asset into account. 2. It is regarded as most exact and precise from the point of view of calculations; and is therefore most scientific.

Disadvantages:
1. The system is complicated. 2. The burden on profit and loss account goes on increasing with the passage of time whereas the amount of depreciation charged each year remains constant. The amount of interest credited goes on diminishing as years pass by, the ultimate consequence being that the net burden on profit and loss account grows heavier each year. 3. When the asset requires frequent additions and extensions, the calculation have to be changed frequently, which is very inconvenient.

Scope of Application:
This method is best suited to those assets which require considerable investment and which do not call for frequent additions e.g., long lease.