TOPIC 6

Depreciation
Deprecation is the allocation of depreciable amount of an asset over its estimated useful
life. It is a measure of wearing out, consumption or other loss of value of a depreciable
asset arising from use or obsolescence through technology and market changes.

It’s the allocation of the cost of the Asset to the years in which the benefit is expected
from its use. It is a method of spreading the loss in value of a capital asset over several
periods.

Important terms and issues in Depreciation:

1. Depreciable assets: These are assets which are expected to be used during more than
accounting period with limited useful life and are held by the entity for use in production
or supply of goods and services for rental to others or for administrative purposes and not
for the purpose of sale in the ordinary course of business.

2. Useful life: This is the period over which the depreciable asset is expected to be used
by the enterprise. It is the life span of the asset.

3. Depreciable amount: It is the historical cost or other amounts substituted for

historical cost in the financial statements less the estimated residual value.

4. Historical cost: This represents money on outlay or its equivalent in connection with
its acquisition, installation and commissioning as well as additions to the improvements
thereof. Capital assets are recorded at historical cost.

5. Residual /scrap/ salvage: This is the net amount which the enterprise is expected to
obtain from the asset at the end of its useful life after deducting the expected costs of
disposal. It can be either called scrap value or salvage value.

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Note: All the non current assets/fixed assets are depreciated except land as land does not
depreciate but appreciates in value.

Consistency and disclosure requirements

Once a depreciation method is selected for a particular asset. It becomes and accounting
policy. It should therefore be used consistently and that similar items are treated using a
similar method. The method of depreciation should be applied consistently so as to
enhance the comparability of the results of the operations of the enterprise from period to
period.

Changing the method of depreciation is discouraged because it distorts financial reports

but a change can be made only if the adoption of such a method is required by statute or
for compliance with accounting standard or the change would result in appropriate
presentation and preparation of financial statements of the entity.

Capital and revenue expenditure distinguished

Capital expenditure: Expenditure incurred in acquiring a fixed asset. This also includes
the expenditure that lengthens the life span of an asset and improves the efficiency and
ability of the asset to earn more income. Examples of capital expenditure include;
(1) Purchase of machines
(2) Installation costs
(3) Commissions costs
(4) Freight costs incurred in transporting the fixed assets. etc

Revenue expenditure: It is the expenditure incurred in the maintenance and repair of

fixed assets and operating expenditures necessary to carry on the business for example
rent, salaries and wages. Revenue expenditures does not increase the value of the assets
and therefore it is not depreciated but is expensed off.

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Reasons for providing for Depreciation

(1) Depreciation is the cost that reduces profits and if not provided income will be
overstated and tax liability will also be overstated.

(2) To portray a true and fair view of the state of affairs of a business by subtracting the
accumulated depreciation from the cost of the asset. The book values in the balance
sheet are therefore fairly accurate.

(3) It guides the policy for planning, maintenance and replacement of assets.

Factors considered in determining/calculating Depreciation

(1) Historical cost of the asset
(2) Estimated salvage/scrap/residual value
(3) Estimated useful life.

Causes of depreciation
(1) Physical deterioration
(a) Wear and tear – wearing out of fixed assets after they have been in use for a
number of years.
(b) Rust, Rot and decay – materials in vehicles or machines eventually rust; wood
eventually rots or decays after having been used for some time.
(c) Accidents – may cause depreciation of fixed assets through physical damage say
by fire, explosion etc.

(2) Economic factors

(a) Obsolescence – this refers to fixed assets becoming outdated for example due to
changes in technology i.e. computers have reduced the value of typewriters; CD
players have reduced the value of tapes.
(b) Inadequacy this arises when an asset is no longer used because of the growth or
changes in the size of the firm.

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 Depreciation Methods
(1) Straight line method/ fixed installments method
It is the most widely used method and it is based on simple average principle, i.e. it
involves dividing the total cost by an estimate of how many years we think the asset will
remain usable and apply the result year in year out. It is given by

Depreciation expense per annum =

For example;
An asset was purchased on 1st January 2018 at UGX 1,000,000 and it is estimated that the
asset will have a useful life of 5 years and will be disposed off at UGX 200,000.
(a) What is the annual depreciation for the asset?
(b) Show the depreciation schedule for this asset.

Example II
An equipment was purchased from UK at CIF Namanve at a value of UGX 10M
installation costs was UGX 2,000,000 while trial runs and commissioning amounted to
2.6M. The equipment is expected to be useful for six years after which it is estimated to
have a salvage value of UGX 2,600,000/=
Calculate the depreciation charge for each year and accumulated depreciation up to
year 6.

(2) Reducing Balance method

This is called diminishing or declining method. Under this method more depreciation is
allocated to earlier years than to later years of the asset. That is depreciation charge or
allocation reduces as the assets gets older.
Under this method depreciation charge is on the book value at the beginning of the year

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and not the original cost reducing balance method is of two types.
(a) Normal reducing balance method
(b) Double declining balance method

(a) Normal Reducing balance method

Under this method annual depreciation is calculated as
Depreciation Per.annum = Book value x Depreciation percentage.
= (Cost – Accumulated depreciation) x Depreciation percentage

Depreciation percentage = (1 - ) x 100

Where n = estimated number of useful life

R = Residual or scrap value
C = Cost.
Example I
An asset costing UGX 20M with a 10 year life and small residual value of UGX 60.000.
What is the depreciation percentage?

Example II
A machine was bought at a cost of UGX 6,500,000/= Total taxes paid on the purchase
transaction amounted to 1,500,000/= while installation costs were 2,000,000/= the scrap
value is estimated at 200,000 at the end of the estimated life of 4 years.
Required:
Using normal reducing balance method, calculate the depreciation expense and
accumulated depreciation at the end of each year on the machine.
b) Double Declining Balance Method
Under this method depreciation percentage is got by doubling the rate (Depreciation %)
on straight line method that is;
Depreciation percentage = 2 x Depreciation percentage using SLM
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Recall that;

Depreciation rate (SLM) =

However, Depreciable cost = Cost – Salvage value

Therefore Depreciation %age = ( ) x 100 x 2

DDBM Depreciation %age = x 100 x 2

Using the previous example,

Calculate the depreciation %age under Double declining method.

(3) Sum of year’s digits method: Under this method depreciation is computed by
dividing the number of years remaining in the useful life of the asset (counting from
the beginning of the year) by the sum of years of useful life.
The rate of depreciation got is then multiplied by the depreciable cost (Cost – salvage
value)

Depreciation expense = x Depreciable cost

Example

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An equipment was bought at a cost of UGx 50M. It has an estimated useful life of five
years at the end of which the residual value is estimated to be 5M.
Required:
Calculate the depreciation expense for each year using the sum of year’s digits method.

(4) Units of output method.

Depreciation under this method is computed in proportion to the use of the asset for
production that is; it is based on the number of units estimated to be produced by the
asset in its useful life.

Depreciation expense P.a = x Depreciable cost

Example
A machine is expected to produce 400,000 units in its useful life. It produces 75,000 units
in its 1st year of existence. if the machine was bought at 5,500,000/= and its salvage value
is estimated at 500,000/=
Calculate the depreciation in the 1st year using the units of output method.

(5) Working hours method (Hourly rate method)

This method takes into account the running time of the machine for depreciation
purposes. Depreciation is computed basing on the number of hours the asset is
expected to run in its useful life.

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 Depreciation expense = x Depreciable cost

Example
A machine is expected to work for 100,000 hours during its useful life. It ran for 40,000
hours during its 1st year of use. It had been bought at UGX 22,000,000 and estimated to
have a salvage value of 2,000,000/= at the expiry of 100,000 hours.
Required: Calculate the depreciation expense in year 1 Using working hours
method.
(6) Revaluation method: Under this method professional valuers or experts are used to
value non current assets/fixed assets such as land and buildings, livestock. At the end
of the year the value of the asset is compared with the value at the beginning of the
year and the difference is the depreciation expense. This method is discouraged in
accounting because it is subjective.

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