TYPES OF DEPRECIATION

The causes of depreciation may be physical or functional.

Physical depreciation is the term given to the measure of the decrease in value
due to changes in the physical aspects of the property. Wear and tear, corrosion,
accidents, and deterioration due to age or the elements are all causes of physical
depreciation. With this type of depreciation, the serviceability of the property is
reduced because of physical changes.
functional depreciation
Depreciation due to all other causes is known as functional depreciation. One
common type of functional depreciation is obsolescence. This is caused by
technological advances or developments which make an existing property
obsolete. Even though the property has suffered no physical change, its economic
serviceability is reduced because it is inferior to improved types of similar assets
that have been made available through advancements in technology.
Other causes of functional depreciation could be (1) change in demand for the
service rendered by the property, such as a decrease in the demand for the
product involved because of saturation of the market, (2) shift of population
center, (3) changes in requirements of public authority, (4) inadequacy or
insufficient capacity for the service required, (5) termination of the need for the
type of service rendered, and (5) abandonment of the enterprise. Although some
of these situations may be completely unrelated to the property itself, it is
convenient to group them all under the heading of functional depreciation.
Because depreciation is measured by decrease in value, it is necessary to consider all
possible causes when determining depreciation. Physical losses are easier to evaluate
than functional losses, but both of these must be taken into account in order to make fair
allowances for depreciation.
Depletion
Capacity loss due to materials actually consumed is measured as depletion. Depletion
cost equals the initial cost times the ratio of amount of material used to original amount
of material purchased. This type of depreciation is particularly applicable to natural
resources, such as stands of timber or mineral and oil
deposits.
Costs for Maintenance and Repairs
The term maintenance conveys the idea of constantly keeping a property in good
condition; repairs connotes the replacing or mending of broken or worn parts of a
property. The costs for maintenance and repairs are direct operating expenses which
must be paid from income, and these costs should not be confused with depreciation
costs. The extent of maintenance and repairs may have an effect on depreciation cost,
because the useful life of any property ought to be increased if it is kept in good
condition. However, a definite distinction should always be made between costs for
depreciation and costs for maintenance and repairs.
SERVICE LIFE
The period during which the use of a property is economically feasible is known
as the service life of the property.
Both physical and functional depreciation are taken into consideration in
determining service life, and, as used in this book, the term is synonymous with
economic or useful life.
In estimating the probable service life, it is assumed that a reasonable amount of
maintenance and repairs will be carried out at the expense of the property owner.
As discussed earlier, the recovery of investment by way of depreciation needs to be
understood the various types of values.

1. Salvage value
2. Present value
3. Book value, or Unamortized cost
4. Market value
5. Replacement value

SALVAGE VALUE & JUNK VALUE

Salvagevalue is the net amount of money obtainable from the sale of used
property over and above any charges involved in removal and sale.
If a property is capable of further service, its salvage value may be high. This is
not necessarily true, however, because other factors, such as location of the
property, existing price levels, market supply and demand, and difficulty of
dismantling, may have an effect. The term salvage value implies that the asset
can give some type of further service and is worth more than merely its scrap or
junk value.
If the property cannot be disposed of as a useful unit, it can often be dismantled
and sold as junk to be used again as a manufacturing raw material. The profit
obtainable from this type of disposal is known as the scrap, or junk value.

PRESENT VALUE

The present value of an asset may be defined as the value of the asset in its
condition at the time of valuation. There are several different types of present
values, and the standard meanings of the various types should be distinguished.
BOOK VALUE, OR UNAMORTIZED COST

The difference between the original cost of a property, and all the depreciation charges
made to date is defined as the book value (sometimes called unamortized
cost). It represents the worth of the property as shown on the owners accounting
records.

MARKET VALUE

The price which could be obtained for an asset if it were placed on sale in the open
market is designated as the market value. The use of this term conveys the idea that the
asset is in good condition and that a buyer is readily available.

REPLACEMENT VALUE

The cost necessary to replace an existing property at any given time with one at
least equally capable of rendering the same service is known as the replacement
value.
It is difficult to predict future market values or replacement values with a high
degree of accuracy because of fluctuations in market demand and price
conditions.?
On the other hand, a future book value can be predicted with absolute accuracy as
long as a constant method for determining depreciation costs is used.
It is quite possible for the market value, replacement value, and book value of a
property to be widely different from one another because of unrealistic
depreciation allowances or changes in economic and technological factors.
Taxes and Depreciation

METHODS FOR DETERMINING DEPRECIATION

WHAT IS DEPRECIATION?
( HTTP://TAXADDA.COM/ACCOUNTING/DEPRECIATION-MEANING-METHODS-
CALCULATIONS/)

Depreciation is the reduction in the value of assets due to wear and tear. It is a
method of allocation of cost of the asset over its useful life.

Every asset is subject to wear and tear in the normal course of its use and also
with passage of time. The cost of the asset is allocated over time and
considered as expense.

It is applied on long term assets which give benefits for many years. For
example on plant & machinery, vehicles, computers, furniture, building etc.
Land is not subject to wear and tear and thus depreciation is not levied on land
but applicable on building.

Considering depreciation as expense is very much required for successful

finance management. For example a driver gives his car for tourism purpose,
he has to consider the fact that car has a limited useful life and he needs to
replace that after some years. For that while calculating its operation cost, he
has to consider cost of car, its life, resale value after useful life and add it to
other expenses for calculating total cost.

Depreciation is also allowed as a deduction from profits as per income tax act
and also as per companies act. Although method of calculation is different
under both acts and this difference also leads to creation of Deferred tax asset
or deferred tax liability.

COMMON METHODS OR TYPES OF DEPRECIATION

In India, the methods and rates for depreciation are governed by law under the
Companies Act, 1956 and the Income Tax Act. The two main methods of
calculating depreciation are the Straight Line Method and the Written-Down
Value Method. The choice of method depends on a number of factors, including
legal requirements, the type of asset and current business conditions.
The Straight Line Method is simpler and more popular than other methods. It
provides the same or fixed amount of depreciation for each year of the useful
life of the asset. This is often expressed as a fixed percentage of the original
cost of the asset.

Under the Written-Down Value method, a fixed percentage is applied on the

written-down value of the asset; the depreciation amount will be highest in the
first year and decline over the useful life of the asset.

Estimate Initial Cost, Useful Life and Residual Value

Step 1
Calculate the initial cost of the asset. The initial cost is the cost of acquiring the
asset plus the other costs for making it operational, such as taxes, freight and
installation.

Step 2
Estimate the useful life of the asset. Useful life is the period of time over which
the asset is expected to be used before it needs to be replaced. The useful life
can also be the number of production or similar units expected to be obtained
from the use of the asset.

Step 3
Estimate the residual value or salvage value of the asset. Residual value is the
amount you expect to receive from the disposal of the asset after its useful life.
Like the useful life, estimating the residual value requires some judgment, since
it may not be possible to precisely know what an asset is likely to be worth at
the end of its useful life.

Use the Straight Line Method

Step 4
Calculate the depreciable base by subtracting the estimated residual value from
the initial cost of the asset. For example, if the initial cost of the asset is Rs.
50,000, and the residual value is expected to be Rs. 5,000, the depreciable
base would be Rs. 50,000 minus Rs. 5,000, or Rs. 45,000.
 Step 5
Divide the depreciable base by the useful life of the asset to get the annual
depreciation amount. If the estimated useful life of the asset is 15 years, then
the annual depreciation amount is equal to 45,000 divided by 15, or Rs. 3,000.

Step 6
Calculate the rate of annual depreciation by dividing the annual depreciation by
the initial cost of the asset and multiplying that number by 100. As per our
example, 3,000 divided by 50,000 times 100 is equal to 6 percent per year.

Use the Written-Down Value Method

Step 7
Calculate the annual depreciation amount by multiplying the rate of depreciation
by the written-down value of the asset. For the first year, the depreciation rate
will be multiplied by the initial cost, since the asset has not been depreciated
yet, so there is no written-down value. Using a depreciation rate of 6 percent,
the depreciation amount for year 1 equals 6 percent of Rs. 50,000, or Rs.
3,000.

Step 8
Calculate the written-down value of the asset. The written-down value is
calculated by subtracting the depreciation per year from the (new) value of the
asset. Rs. 50,000 minus Rs. 3,000 equals Rs. 47,000.

Step 9
Calculate annual depreciation for the second year based on the new or written-
down value of the asset: 6 percent of 47,000 equals Rs. 2,820. The new
written-down value will now be Rs. 47,000 minus Rs. 2,820, or Rs. 44,180. The
annual depreciation for the third year will now be calculated as 6 percent of Rs.
44,180, and so on.

1. Written Down Value (WDV)

 WDV method of depreciation is the most common used method of
depreciation. Also in income tax act, depreciation is allowed as per WDV
method only.
In this method depreciation is charged on the book value of asset and
book value is decreased each year by the depreciation. For e.g-

Asset is purchased at Rs. 1,00,000 and depreciation rate is 10%

First year depreciation is Rs. 10,000(10% of rs. 1,00,000),
Second year depreciation is Rs. 9,000 ( 10% of 90,000 [1,00,000
10,000]) and
Third year depreciation is rs. 8,100 ( 10% of Rs. 81,000 [90,000
9,000]).
This method is also called reducing balance method. In WDV method the
amount of depreciation goes on reducing with time. An asset gives more
value to business in initial years then later year therefore this method is
considered as most logical method of depreciation.

Formula for calculating depreciation

(WDV) = {1 (s/c)^1/n } x 100

n = Remaining useful life of the asset (in years)

s = Scrap value at the end of useful life of the asset
c = Cost of the asset/Written down value of the asset

2. STRAIGHT LINE METHOD (SLM)

In this method equal amount of depreciation is charged on asset over its useful life.
For eg
Formula for calculating depreciation rate
(SLM Rate) = (100 % of resale value of purchase price)/Useful life in years

Depreciation = Purchase Price * Depreciation Rate or (Purchase price Salvage

Value)/Useful Life

Asset is purchased for rs. 1,00,000 and useful life is 10 years with salvage value of rs.
10,000
10000
100 (100000 x 100)
SLM depreciation rate = ( )
10
100 10
SLM depreciation rate = ( ) = 9%
10

Depreciation =100000 x 9/100 =9000

 then depreciation is charged at rs. 9,000 for each of the 10 years.

In companies act the depreciation rate is also based on the number of shifts. Logically an
asset is expected to be have a shorter life if it used extensively.

Example

Cost of asset = 2,00,000

Salvage value = 30,000
Useful Life = 10 Years
A(SLM)nd thus

Straight Line Method

30000
100 (200000 x 100) 100 15
SLM depreciation rate = ( )= = 8.5%
10 10
.
= = .

Thus depreciation is charged at Rs.17000 for 10 years= Rs.170000

OR

Depreciation = (Purchase price Salvage Value)/Useful Life

=(200000-30000)/10 =170000/10 = Rs.17000

Depreciation rate = (17000/200000) x 100 =8.5%

Double declining method

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, 2014,2105 and
2016 using Double declining balance method.
Useful life = 5
SLM Rate) = (100 % of resale value of purchase price)/Useful life in years
14000
100 (100000 x 100) 100 14 86
SLM depreciation rate = ( )= = = 17.2
5 5 5
OR Depreciation = (Purchase price Salvage Value)/Useful Life

=(100000-14000)/5 =86000/5 = Rs.17200

Depreciation rate = (17200/100000) x 100 =17.2%

Depreciation rate = 17.2% * 2 = 34.4% per year

Depreciation for the year 2012 = Rs. 100,000 * (34.4/100) * 9/12 = Rs. 12900=25800
Depreciation for the year 2013 = (Rs. 100,000-Rs. 25800) * 0.344 * 12/12 = Rs.25525
Depreciation for the year 2014 = (Rs. 100,000 Rs.( 25800 +25525 ) * 0.344% * 12/12 = Rs. 16745
Depreciation for the year 2015=(Rs. 100,000 Rs.( 25800 +25525+16745 ) * 0.344% * 12/12 =
Rs.10983
Depreciation for the year 2016=(Rs. 100,000 Rs.( 25800 +25525+16745+10983 ) * 0.344% * 12/12
= Rs.4110

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
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 for the year 2015
Depreciation for the year 2016
 Depreciation table is shown below:
Book value
Book value at Depreciatio Depreciation
Year at the end
the beginning n rate Expense
of the year
2012 Rs. 100,000 40% 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).

BENEFITS/NEED OF CHARGING DEPRECIATION

1. Tax Benefit

Depreciation is allowed as an expense under Income tax and therefore it is

important to consider it to save income tax

2. Mandatory under companies act

It is mandatory to charge depreciation in profit and loss account in companies

act 2013.

3. Real Profit

If it is not considered then expenditure on behalf of fixed assets is not

considered and the profit may be shown as high number especially in industries
required large plant and machinery. And this may lead to high distribution of
profits to shareholders and thus non availability of funds when company is in
need to replace the asset.