CONCEPT AND METHODS OF DEPRECIATION

Professor V. Thiruvengadam

1. CONCEPT OF DEPRECIATION
When assets are purchased it is a capital expenditure. Purchase of assets
involves capital expenditure which is not allowed as business related expense as
per accounting standards. But recognising the fact that the assets become
obsolete with passage of time and require replacement, accounting standards
like GAAP allows spreading the cost of the asset over the useful life of the asset
through Depreciation method and treating the Depreciation amount as
permissible business expenditure.

2. DECLINING BALANCE OR REDUCING BALANCE DEPRECIATION METHOD

This method is also known as Written-Down Value (WDV) Method of
Depreciation. In this method no scrap value is considered, rather it is ignored.
WDV becomes Zero with passage of time. Since Depreciation amounts are
recognized as allowed expenditure, it is considered as Tax Shield.
3. CONCEPT OF COST, PRICE AND VALUE
Cost of a product and service is money spent on the material, labour, equipment
and other charges to produce the product or render the services. Cost of a
building excluding the land constitutes the expenditures making the building.
This definition is not applicable to a land but the cost of developing a land
means the expenditures incurred to improve the physical condition of the land
with infrastructure services.
Price means the sale price of a product or service and includes cost plus the
profit. A builder fixes the sale price of a building by adding suitable profit for the
efforts to construct the building.
Value in economic terms depends upon the demand and supply position. A
scarce material is more valuable than easily available material. Besides scarcity
there could be many other aspects that influence the value.
Besides monetary value, there could be other kinds of value like Emotional
value, Social Value, Aesthetic Value etc.
4. DEPRECIATION

CONCEPT AND METHODS OF DEPRECIATION

Professor V. Thiruvengadam

Depreciation refers to the loss of monetary value over time. The rate of
depreciation depends upon the type of asset under consideration. Some assets
depreciate slowly while some depreciate rapidly. Certain class of assets like
buildings normally appreciate. Land assets do not come under the purview of
depreciation and their value usually appreciate due to demand and betterment
in the infrastructure services, urbanisation etc.
Treatment of depreciation under tax consideration is usually different from the
actual depreciation of the assets. The actual depreciation of an asset is the
manner their depreciation is considered under tax laws. Usually under the tax
particulars, the assets are allowed to depreciate at a higher rate than the actual
condition of deterioration. This is to enable to accumulate money rapidly for the
replacement of the asset.
The assets like plants and machineries, Buildings procured for carrying out the
business are treated as Capital Expenditures and then early depreciation values
are treated as permissible business expenditures reducing the profits and thus
reducing the tax liabilities. Assets which become obsolete in a relatively shorter
period like Computers, Hardware etc. are considered to depreciate rapidly with
higher annual percentage rate of depreciation. Software purchases are not
considered as Capital Expenditures but normal business expenses.
The depreciation values of assets considered under tax laws are generally
different from the actual depreciation of the assets. Usually under tax provisions
higher rate of depreciation depending on the class of assets are allowed. This is
to encourage the business to accumulate money to meet the replacement cost
of the older assets.
The depreciation value of certain assets under the current provision of the
Income Tax Act is given below.
In the Finance related calculations of construction equipment the monetary
effect of depreciation are considered similar to the maintenance related
Expenditures in working out the hire charges or for arriving at the unit cost of
production and in the decisions related to owing vs. hiring of the equipment.
while projecting the capital structure of the company in the balance sheet, the
assets are shown with depreciation.

CONCEPT AND METHODS OF DEPRECIATION

Professor V. Thiruvengadam

5. METHODS FOR CALCULATION OF DEPRECIATION

The purpose of depreciation method is to spread the initial cost of the asset
over the useful life of the period. There are different methods of calculating the
depreciation amount and they differ in the manner of considering the rate of
depreciation over the time. Assets like Plants and Equipment have higher
depreciation in the earlier periods compared to their lower depreciation in the
later periods. Hence the depreciation method needs to recognise this aspect of
the rate of depreciation as applicable to different asset categories.
As far as possible the depreciation method should tally with the actual condition
of the asset over the passage of time. And also comply with the approach
prescribed in the tax laws in order to treat the depreciation amounts as business
expenses against the profits.
The following two methods are usually accepted in the accounting standards.
I.

Straight Line Method

II.

Reducing Balance or Declining Balance Method

The other types of depreciation methods are:

I.

III.

Sinking Fund Method

IV.

Depreciation Fund Method

V.

Method based on the Assessment of the actual condition of the Asset

STRAIGHT LINE METHOD

This method considers a linear rate of depreciation which equals to the initial
cost minus salvage cost divided
Cost by the useful life of the asset.
Initial Cost (I)

CONCEPT AND METHODS OF DEPRECIATION

Professor V. Thiruvengadam

Salvage Cost (S)

Useful Life (N)

Yearly Rate of Depreciation = ( I S )

N
The limitation of this method is that the assumption of linear rate of
depreciation unlikely to reflect the actual depreciating condition of the asset.
However, for accounting standards this approach for certain types of assets are
acceptable.

II. REDUCING BALANCE (DECLINING BALANCE) METHOD

In this method a fixed yearly depreciation percentage is adopted for the asset.
Since a fixed percentage of depreciation is applied in each year on the
reduced/declining value of the asset, the amount of depreciation decreases with
the passage of time. This method is applied wherein the asset depreciates at a
higher rate in the earlier periods and this method does not consider any salvage
value. The depreciated value of the asset which progressively reduces is called
as Written Down Value (WDV) of the asset. The fixed depreciation percentage is
assumed on the characteristics of the asset. A higher percentage is assumed for
rapidly depreciation assets and short life assets. The following example
illustrates the application of the method for a motor car with an initial cost of 5
lakhs and a fixed depreciation percentage of 15% (per year as per tax rules).
Initial Cost = 5,00,000/Rate of Depreciation = 15% per annum

CONCEPT AND METHODS OF DEPRECIATION

Professor V. Thiruvengadam

YEAR

COST

DEPRECIATION AMOUNT

W.D.V AT YEAR END

5,00,000/-

75,000/-

4,25,000/-

4,25,000/-

63,750/-

3,61,250/-

3,61,250/-

54,188/-

3,07,062/-

3,07,062/-

46,060/-

2,61,007/-

2,61,007/-

39,151/-

2,21,856/-

III. SINKING FUND METHOD

In this method an amount of depreciation per year is calculated as a percentage
of initial cost depending upon the type of asset (say 10% - 20%). An amount
equal to this depreciation is deposited at regular intervals in a fund called
sinking fund over the life period of the asset. This fund earns compound interest
and provides a sum at the end of the period to meet the replacement cost of the
asset. The formula for calculating the future value of a series of equal annuity
payments with the specific investment rate is used to calculate the future sum
accumulated by the fund.

Future Sum = A [( I +r )n - 1 ]
r
Where,
A = Equal payments of Depreciation Amount;
r = rate of Interest;
n = Life period of the Asset

CONCEPT AND METHODS OF DEPRECIATION

Professor V. Thiruvengadam

Here, due to the effect of inflation, the sum acquired may not be sufficient to
meet the cost of replacement. As an alternative to the process, the likely cost of
the new asset at the end of the life period of an old asset could be considered
and the equal annuity payment (A) to be made to the fund can be calculated.

IV. DEPRECIATION FUND METHOD

This method is similar to the Sinking Fund Method except that the amounts
deposited during the life period of the asset at regular intervals are not equal
and would be varying. The accumulated fund at the end of the life period with
compound or simple interest is utilised for the replacement of the asset.
The actual depreciation method is based on the assessment of the actual
condition and utility of the asset carried out periodically during its life period.
The following example illustrates the unit rate of production of a concrete
bathing plant taking into consideration the depreciation of the equipment.
EXAMPLE 1
The cost of a Tube-well Pump set is Rs.25,000/-. Economic life of the pump-set is
5 years. The annual instalment of the sinking fund assuming a prevailing rate of
interest of 10% is as under:
(Effect of Inflation Neglected)
A

25000 X 0.10
[(1+0.1)5 -1]
=

Rs. 4,095/- per annum