TOPIC 8:DEPRECIATION ANALYSIS

Depreciation is the decrease in value of physical properties with the passage

of time and use. Most assets are worthless as they age. Production equipment
gradually becomes less valuable through wear and tear. This lessening in
value is recognised in accounting practices as an operating expense. Instead
of charging the full purchase price of a new asset as one time expense, the
outlay is spread over the life of the asset in the accounting records. Annual
depreciation deductions arc intended to match the yearly fraction of value
used by an asset in the production of income over the assets actual economic
life. The actual amount of depreciation can never be established until the
asset is retired from service.

Depreciation can be defined in three senses like physical depreciation, which

is caused due to physical decay. Economic depreciation is the loss of value of
an asset due to outdated technology and in accounting sense depreciation is
the estimated value of fall in the worth of an asset. In accounting,
depreciation charge is included in the cost of production of the asset.
Depreciation is a permanent continuing and gradual shrinkage in the book
value of a fixed asset.

Causes of depreciation:
Assets depreciate its value for several reasons.

1. Physical depreciation
Depreciation resulting in physical impairment of an asset is known as
physical depreciation. This type of depreciation results in the lowering of the
ability of a physical asset to render its intended service. The primary causes
of physical depreciation are (a) deterioration due to action of the elements
including the corrosion of pipe, the rotting of timbers, chemical
decomposition and so on. (b) Wear and tear charges (c) Physical decay, (d)
Time factors etc.

2. Functional depreciation
Functional depreciation results not from a deterioration in the assets ability to
serve its intended purpose, but from a change in the demand for the services
it can render. The demand for the services of an asset may change it is more
profitable to use a more efficient, unit, there is no longer work for the asset to
do, or the work to he done exceeds the capacity of the asset.

3. Technological depreciation
Due to advancement of new technology, the old technology becomes
outdated, so it loses its value. Obsolescence resulting from the discovery of
another asset that is sufficiently superior to make it uneconomical to
continue using the original asset. Assets also become obsolete when they are
no longer needed.

4. Depreciation due to accident

Sometimes due to accident or sudden failure the asset loses its technological
characteristic inherent in it.

5. Depreciation due to depletion

Consumption of an exhaustible natural resources to produce product or
services is termed as depletion. Removal of oil, timber, rock or minerals from
a site decreases the value of the holding. This decrease is compensated by a
proportionate reduction in earnings derived from the resources.

6. Monetary depreciation
A change in the price level also decreases the value of owned assets. If prices
rise during the life of an asset, then comparable replacement become more
expensive. This means that the capital recovered will be insufficient to
provide an adequate substitute for the worn out asset.

7. Depreciation due to time factor

There are some assets, which loses its values after a particular time period.
Particularly the assets having lease, copyrights and patents right loses its
value after the time is over.

8. Depreciation due to deferred maintenance

Sometimes the loss of value of asset begin very quickly due to deferred
maintenance. If proper materials are not used or instructions to operate the
machine are not properly obeyed the loss of value start.

9. Depreciation Accounting
Before going through the different method involved in the calculation of
depreciation we should have sufficient knowledge about the depreciable
property. Depreciable property is that property which can amortized or
depreciated. Depreciable property may be tangible and intangible. Tangible
property is any property that can be seen or touched. Intangible property are
property which are not tangible like copyrights and patent rights.
Depreciable tangible property is of two types i.e. Real and personal. Personal
property are those property which is not real estate, they are machinery and
equipments. Real property is land and anything that is erected on. Land is
never depreciable.

Property is depreciable if it fulfills the following requirements:

a) The property must be used in business or help to produce income
 b) The property must be something that wears out, decays, deteriorates,
becomes obsolete, or loses value from natural causes.
c) It must have determinable life and that life must be longer than 1 year.

In general, if property does not fulfill the above conditions can’t be regarded
as depreciable property.
Depreciation Methods
There are various depreciation method have evolved form time to time but
there are three basic methods to understand the various calculation of
depreciation schedules that are presently, in effect, it is first necessary to
become acquainted with the three methods on which the current schedules
are based. Some current depreciation schedules are based on straight line
depreciation and other are based on a combination of straight line
depreciation and declining balance depreciation.

Before going to discuss the basic methods and other methods of depreciation
we should know some additional terms for clear understanding of the
problem.

P = Purchase price (unadjusted basis) of assets. (This is the initial cost of

occurring an asset (purchase price + sales taxes) including transportation
expenses.
S= Salvage value or future value at end of asset’s life. It is the expected selling
price of a property when the asset can no longer be used by its owner.
N = useful (tax) life of asset - The expected period of time that a property will
be used in a trade or business or to produce income.
N = number of years of depreciation
Dt (n) = Annual depreciation
charges.
Bt(n) = Book value shown on accounting records at end of year. It is the
original cost, basis of the property, including any adjustment.
Bt(0)=p

Straight line method

The most widely used and simplest method for the calculation of
depreciation is straight line method. The straight line method assumes that
the value of an asset decrease at a constant rate. Thus if an asset has a first
cost of Rs.5,000
and an estimated salvage value of Rs.500, the total depreciation and over its
life will be
Rs. 4,500. If the estimated life in 5 years, the depreciation per year will be
4,5005 = 900. This is equivalent to a depreciation rate of 15 = 20% per year.

General expression for the calculation of depreciation and hook value may be
developed for the straight line method.

The depreciation in any year PF

is Dt  n

General expression for the straight line method

End of year Depreciation charge Book value at end of
year
0 - P
1 PF PF
P  
n  n 
2 P PF
P  2 
Fn  n 
3 PF PF
P  3 
n  n 

End of year Depreciation charge Book value at end of

year
N PF PF
P  t 
n  n 
N PF PF
P  n 
n  n 
The book value
is PF 1
Bt  P  t and the depreciation rate per year is
 
 n  n

Example: From the following data find out

a) The depreciation charge during year 1
 b) The depreciation charge during year 2
c) The depreciation reserve accumulated by the end of year 3
d) The book value at the end of year
3 Initial con of the asset = Rs. 5000
Life time = 5 years
Salvage value = 0
The cost of capital 5%

Solution
(a) &. (b) In case of straight line method as the depreciation charge is constant,
the depreciation charges for year 1 and 2 is constant.
P  F 5000
Dt (1)  Dt (2)   = 1000 per year
n 5
(c) The depreciation reserve at the end of the third year is the sum of the
annual depreciation charges for the first three years and is equal to 3 (1000) =
Rs. 3000
 5000 
(d) The book value at the end of third year is =  5000  3  2000
 
 5 
Bt (3) = 5000- 3000 = Rs. 2000

Declining balance Method

Value of an asset diminishes at a decreasing rate. The declining balance
depreciation assumes that an asset decreases in value-faster early rather than
in the latter portion of its service life. By this method a fixed percentage is
multiplied times the book value the asset at the beginning of the year to
determine the depreciation charge for that year. Thus as the book value of the
asset decreases through time, so does the size of the depreciation charge.
For example - First cost Rs. 5,000 Salvage value
=Rs.l000 life of the asset five year, Depreciation rate
30% per year.

Declining Balance method

 End of year Depreciation charge Bank value at end of
during year year Rs.
0 5000
1 (0.30) (50000) = 1,500 3,1500
2 (0.30) (3,500) = 1,050 2,450
3 (0.30) (2,450) = 735 1,715
4 (0.30) (1,7115) = 515 1,200
5 (0.30) (1,200) = 360 840

For a depreciation rate a, the general relationship expressing the depreciation

charge in any year for declining balance depreciation is:
D(t)= a.BV(t-1)
We know book value
BV(t)= Bt-1 – Dt
Therefore, declining-balance depreciation.
B(t)= Bt-1 – a.Bt-1

Using this recursive expression, we can determine the general expression for
the depreciation charge and the book value for any point of time. These
calculations are shown in the table.
D(t) = a(1-a)t-1 P
and the book value BV(t) = (1 - R) P

BV(t) = P(1-a)t

General expression for the declining balance method of depreciation

End of Depreciation charge during Book value at end of year
year Year
0 - P
1 a x B0 = a (P) (1-a) B0 = (1-a) P
2 a x B1 = a (1-R) P (1-a) B1 = (1-a)2 P
3 a x B2 = a (1-R)2 P (1-a) B2 = (1-a)3 P
T a x Bt-1 = a (1-R)t-1 P (1-a) Bt-1 = (1-a)t P
N a x Bt-1 = a (1-R)n-1 P (1-a) Bn-1 = (1-a)n P

If the declining balance method of depreciation is used for income tax

purposes the maximum rate that may be used is double the straight
line rate that would be allowed to a particular asset a group of asset
being depreciated. Thus for an asset with an estimated life of N years
the maximum rate that may be used with this method is R = 2/N.
Many firms and individuals choose to depreciate their assets using
declining balance depreciation with the maximum allowable rate.
Such a depreciation method is commonly known as the Double
Declining Balance method of depreciation.