DEPRECIATION:

The term depreciation is derived from the Latin words ‘do’ meaning down
and ‘pretium’ meaning price. In common use it means putting down the
value of an asset due to wear and tear, passage of time, obsolescence, etc.It
is very difficult to give a single definition of the term depreciation because
under different situation this is handled differently and whatever seems to be
correct in one situation may be improper in another. But even then some
definitions are worth mentioning.
“Depreciation refers to the process of estimating and recording the
periodic charges to expense due to expiration of the usefulness of a capital
asset”– Malchman and Slavin.
According to J.N. Carter, “Depreciation is the gradual and permanent
decrease in the value of an asset from any cause,” J.R. Batiliboi defined
depreciation as follows:
“Depreciation represents loss or diminution in the value of an asset
consequent upon wear and tear, obsolescence, effluxion of time, or fall in the
market value.”
The Institute of Chartered Accountants of England and Wales has
described depreciation as thus:
“Depreciation represents that part of the cost of fixed asset to its owner
which is not recoverable when the asset is finally put out of use by him.
Provision against this loss of capital is an integral cost of conducting the
business during the effective commercial life of the asset and is not
dependent upon the amount of profit earned.”
The definition given by A.N. Agrawal is as under:
“Depreciation is a permanent, continuing and gradual shrinkage in the
value of a fixed asset.”

From the above definitions it is clear that depreciation is the gradual,

continuing and permanent fall in value of fixed assets. The main causes for
this fall in value are wear and tear of assets accidents, passage of time,
obsolescence, inadequacies, ‘depletion etc.
Even in the recent editions of English language dictionaries the world
‘depreciation’ has been described as decline in the value of an asset due to
such causes as wear and tear, action of elements, obsolescence and
inadequacy.” Although these traditional views are under pressure because of
the recognition of the changes in the value of rupee and replacement costs,
even then they have their historical significance.
Some Characteristics of Depreciation include:
The depreciation charged on fixed assets has the following features:
(i) Depreciation is always a fall in the value of asset.
(ii) This fall is always gradual.
(iii) The fall is of permanent character and it cannot be recouped afterwards.
(iv) The depreciation is a continuous process and it does not matter whether
the asset was put to use during the period or not.
(v) Depreciation is always on fixed assets and not on current or floating
assets.
(vi) Depreciation is the fall in the book value of the asset and not in market
or exchange value.
(vii) Depreciation is the result of the use of assets, passage of time and
obsolescence.
CAUSES OF DEPRECIATION:
(i) Use of the Assets or Wear and Tear: The main cause of depreciation is the
wear and tear of assets when they are put to use in the enterprise. It reduces
the future technical capacity as well as earning power of the asset with the
result that it brings reduction in the value of asset.
(ii) Accident: Another important contributing factor to depreciation is
accident such as plant break down, loss by fire, etc.
(iii) Expiration of Certain Legal Rights: In case of patents, leases and licenses
depreciation is a time function as by the expiration of time for which legal
right to use is created lapses.
(iv) Obsolescence: Because of technological developments, the asset in use
may become outdated and lose a large part of its value. This fall may also be
the result of changes in tastes and habits of customers, changes in the
supply and location of material resources, etc.
(v) Inadequacy: Sometimes there may be a necessity of putting the assets
out of use despite the fact that the asset is in good physical condition. It is
because of inadequacy. Inadequacy refers to the termination of the use of an
asset because of growth and changes in the size of the firm. For the needs of
the firm the asset may not be adequate and another firm of small size may
buy it.
(vi) Depletion: Where the asset is of wasting character, due to the extraction
of some materials, such as mines, forests, quarries and oil wells, the asset
will be depleted.
Basic Factors in Estimating Depreciation:
To determine the amount of depreciation of a fixed asset, the following
factors are to be taken into consideration:
(a) Cost of the asset;
(b) Useful life of the asset, and
(c) Salvage value.

(a) Cost of Asset:

The cost of the asset includes all reasonable expenses that are
incurred to bring the asset in a ‘workable condition. For example, if old
machinery is purchased, the cost will include the purchase price paid, cost of
overhauling, polishing and installation.
The main test whether an expense is to be included towards cost price or
not, is that whether the expenditure was reasonable and necessary to make
the asset in a workable condition.
If the answer is in affirmative, it will become the part of cost, otherwise
not. Further, if the firm constructs its own asset, the amount of cost will
include all the expenses incurred on its construction. The cost of the asset
minus salvage value is the base because this will be the total amount which
is to be written of as depreciation throughout the useful life of the asset.

(b) Useful Life of the Asset:

The determination of the useful life of an asset is of great importance
because it is the useful life over which the whole cost of the asset is to be
written off by way of depreciation.
The useful serviceable life is estimated either from depreciation rates
published by income tax authorities or from opinions of engineers or
experience with similar assets, guess work, etc. However the intensity of use
of the asset, wear and tear, obsolescence and maintenance are the main
factors which are taken into consideration for estimating the useful life of the
asset.

(c) Salvage Value:

Salvage value is the amount that can be recovered from the sale of the
asset after the expiry of its useful serviceable life. In those cases where this
amount is insignificant, it is ignored altogether but when this amount is quite
substantial, the depreciation is calculated on net cost of the asset, i.e.
original cost less salvage value.

Types and How to Calculate Depreciation

1) Straight-line depreciation method
This is the simplest method of all. It involves simple allocation of an even
rate of depreciation every year over the useful life of the asset. The formula
for straight line depreciation is:
Annual Depreciation expense = (Asset cost – Residual Value) /
Useful life of the asset.

Example – Suppose a manufacturing company purchases a machinery for

Rs. 100,000 and the useful life of the machinery are 10 years and the
residual value of the machinery is Rs. 20,000.
Annual Depreciation expense = (100,000-20,000) / 10 = Rs. 8,000
Thus the company can take Rs. 8000 as the depreciation expense every year
over the next ten years as shown in depreciation table below.
Year Original cost – Residual value Depreciation expense
1 Rs. 80000 Rs. 8000
2 Rs. 80000 Rs. 8000
3 Rs. 80000 Rs. 8000
4 Rs. 80000 Rs. 8000
5 Rs. 80000 Rs. 8000
6 Rs. 80000 Rs. 8000
7 Rs. 80000 Rs. 8000
8 Rs. 80000 Rs. 8000
9 Rs. 80000 Rs. 8000
10 Rs. 80000 Rs. 8000

2) Unit of Production method

This is a two-step process, unlike straight line method. Here, equal expense
rates are assigned to each unit produced. This assignment makes the
method very useful in assembly for production lines. Hence, the calculation
is based on output capability of the asset rather than the number of years.
The steps are:
Step 1: Calculate per unit depreciation:
Per unit Depreciation = (Asset cost – Residual value) / Useful life in units of
production.
Step 2: Calculate the total depreciation of actual units produced:
Total Depreciation Expense = Per Unit Depreciation * Units Produced
Example: ABC company purchases a printing press to print flyers for Rs.
40,000 with a useful life of 180,000 units and residual value of Rs. 4000. It
prints 4000 flyers.
Step 1: Per unit Depreciation = (40,000-4000)/180,000 = Rs. 0.2
Step 2: Total Depreciation expense = Rs. 0.2 * 4000 flyers = Rs. 800
So the total Depreciation expense is Rs. 800 which is accounted. Once the
per unit depreciation is found out, it can be applied to future output runs.

3) Double declining method

This is one of the two common methods a company uses to account for the
expenses of a fixed asset. This is an accelerated depreciation method. As the
name suggests, it counts expense twice as much as the book value of the
asset every year.
The formula is:
Depreciation = 2 * Straight line depreciation percent * book value at
the beginning of the accounting period
Book value = Cost of the asset – accumulated depreciation
Accumulated depreciation is the total depreciation of the fixed asset
accumulated up to a specified time.
Example: On April 1, 2012, company X purchased an equipment for Rs.
100,000. This is expected to have 5 useful life years. The salvage value is Rs.
14,000. Company X considers depreciation expense for the nearest whole
month. Calculate the depreciation expenses for 2012, 2013, 2014 using a
declining balance method.
Useful life = 5
Straight line depreciation percent = 1/5 = 0.2 or 20% per year
Depreciation rate = 20% * 2 = 40% per year
Depreciation for the year 2012 = Rs. 100,000 * 40% * 9/12 = Rs. 30,000
Depreciation for the year 2013 = (Rs. 100,000-Rs. 30,000) * 40% * 12/12 =
Rs. 28,000
Depreciation for the year 2014 = (Rs. 100,000 – Rs. 30,000 – Rs. 28,000) *
40% * 9/12 = Rs. 16,800.
Depreciation table is shown below:
Year Book value at the beginning Depreciation rate Depreciation Expense
Book value at the end of the year
2012 Rs. 100,00040% Rs. 30,000 * (1) Rs. 70,000
2013 Rs. 70,000 40% Rs. 28,000 * (2) Rs. 42,000
2014 Rs. 42,000 40% Rs. 16,800 * (3) Rs. 25,200
2015 Rs. 25,200 40% Rs. 10,080 * (4) Rs. 15,120
2016 Rs. 15,120 40% Rs. 1,120 * (5) Rs. 14,000

Depreciation for 2016 is Rs. 1,120 to keep the book value same as salvage
value.
Rs. 15,120 – Rs. 14,000 = Rs. 1,120 (At this point the depreciation should
stop).

Three main inputs are required to calculate depreciation:

Useful life – this is the time period over which the organisation considers the
fixed asset to be productive. Beyond its useful life, the fixed asset is no
longer cost-effective to continue the operation of the asset.
Salvage value – Post the useful life of the fixed asset, the company may
consider selling it at a reduced amount. This is known as the salvage value of
the asset.
The cost of the asset – this includes taxes, shipping, and preparation/setup
expenses.
Unit of production method needs the number of units used during
production. Let’s take a look at each type of Depreciation method in detail.
 FACULTY OF AGRICULTURE,
AMBROSE ALLI UNIVERSITY, EKPOMA.
DEPARTMENT OF AGRIC ECONS & EXTENSION.

NAME: EKHORUTOMWEN IYOBOSA GIFT

MAT NO: FAG/ANS/14/01869
LECURER: DR. E.E. IKHELOA

ANS 518 ASSIGNMENT

 Meaning of depreciation
 Types of depreciation
 How to calculate depreciation.