1-Fundamentals of Financial management Meig Williams Haka Bettner DEPRECIATION 1-Fundamentals of Financial management By James C Van Horne John M Wachowicz, Jr Ref Books: 3-Cost Accounting By Horngren Foster Datar 2-Accounting By Meig Williams Haka Bettner

Depreciation Depreciation may be defined as the decrease in the value of physical assets with the passage of time as a result of wear and deterioration caused by the use of asset. In accounting, the term “depreciation” means the systematic allocation of the cost of a capital asset over a period of time for financial operating purposes, tax purposes or both. It is used in the books of account for preparing a balance sheet of assets. It is also used for the purpose of tax and for costing. The depreciation lowers taxable income.

Causes of Depreciation The need to systematically allocate plant asset cost over multiple accounting periods arises from two major causes: Deterioration and (or) (2) Obsolescence Physical Deterioration Physical deterioration of a plant asset results from use, as well as, from exposure to sun, wind, or other climatic factors. When a plant asset has been carefully maintained, it is not uncommon for the owner to claim that the asset is “as good

as new. ” Such statements are not literally true as new.” Such statements are not literally true. Although a good repair and maintenance policy may greatly lengthen the useful life of a machine, every machine eventually reaches a point at which it must be discarded. In brief the making of the repairs does not eliminate the need for recognition of depreciation. Obsolescence The term “obsolescence” means the process of becoming out of date or obsolete. A computer, for example, may become obsolete even though it is in excellent physical condition; it becomes obsolete

because better computers of superior design and performance are now available in the market. Depreciation is not a Process of Valuation Depreciation is a process of cost allocation, not a process of asset valuation. Accounting records do not attempt to show the current market values of plant asset. The market value of a building , for example, may increase during some accounting periods within the building’s useful life. The recognition of depreciation expense continues, however, without regard to such

temporary increases in market values temporary increases in market values. Book Value Plant assets are shown in the balance sheet at their book values (or carrying values). The book value of a plant asset is its cost minus the related accumulated depreciation. The book value represents the portion of the asset’s cost that remains to be allocated to expense in future periods. Book Life The depreciation amount depends on the book

The amount allowable for depreciation; life of the assets and the type of depreciation method used. The book life is different for different types of assets. The state government tax rules provides a guide for book life of different types of assets. Tax laws for depreciation deduction, in most of the countries, typically cover following three factors: The amount allowable for depreciation; In most of the countries, the amount allowable for depreciation is the original cost of the asset

The time period over which the asset is to be depreciated; (initial investment). The time period over which the asset is to be depreciated; The tax authorities in various countries present 3 main criteria of determining the depreciation time period : The tax authority estimate the useful life, The tax payers estimate the useful life, Tax law specifies a table of allowable lives

Pattern of allowable depreciation; Tax authority allow 3 main depreciation patterns:- Straight-line depreciation. Accelerated depreciation methods Reducing Balance Method (depreciation using a table of allowable % ages writes off as specified by tax law).

Straight Line Depreciation A method of depreciation that allocates expenses evenly over the depreciable life of the assets (an equal amount of depreciation is taken each year). If the cost of a five years property class asset is $ 275,000, annual depreciation charges using Straight-Line Depreciation (SL) would be Annual Depreciation Charges =

The annual depreciation cost d is: Where d = Annual depreciation cost V = Cost value of the asset S = Salvage value of the asset, and N = Book life of the asset

Depreciation Schedule (Straight-Line Method) Years Computation Depreciation Expense Accumulated Depreciation Book Value 1 $ 275,000 $ 55,000 $ 55,000 $ 220,000 2 $ 110,000 $ 165,000 3 4 $ 220,000 5  

Straight Line Depreciation Amount in $ Years

Notice that the depreciation expense over the life of the asset totals $ 275,000/, the cost of the asset minus the estimated residual value (300,000 – 25,000). The residual value is not part of the cost “used up” in business operations. Instead the residual value is expected to be recovered in cash upon disposal of the asset. In practice residual values are ignored if they are not expected to be material in amount . Traditionally buildings, office equipment, furniture & fixtures seldom are considered to have significant residual value. Assets such as vehicles, aircraft, in contrast , often

do have the residual value that are material in amount do have the residual value that are material in amount. In straight line depreciation, if the asset has an estimated life of 5 years, the depreciation expense each year is 1/5 (or 20 %) of the depreciable amount. Similarly an asset with 10 years life has a depreciation rate of 1/10 (or 10 %); an asset with 8 years life has a depreciation rate of 1/8 (or 12.5 %)

Accelerated depreciation Methods Methods of depreciation in which the pattern of depreciation writes off more of the depreciable asset in the early years after investment than Straight-line. The term accelerated depreciation means that larger amount of depreciation are recognized in the early years of the asset life and smaller amounts are recognized in the later years. Over the entire life of the asset, however, both the straight line method & accelerated methods

recognize the same total amount of depreciation recognize the same total amount of depreciation. There is only one straight–line method but there are several accelerated methods, each producing slightly different results. Different depreciation methods may be for different assets. By far the most widely used accelerated depreciation methods is called “Fixed-Percentage-of-Declining-Balance Depreciation.”However this method is used primarily in Income Tax Returns, rather than financial statements. Under the declining balance method, an

accelerated depreciation rate is computed as a specified % age of the straight-line depreciation rate. Here Depreciation Expense = Remaining Book Value x Accumulated Depreciation Rate The accumulated depreciation rate remains constant throughout the life of the asset. Hence the rate represents the “fixed %age” described in the name of this depreciation method. Most often this specified % age is 200 % , meaning that the accelerated rate is exactly twice

Straight-line rate. As a result the declining-balance method of depreciation often is called Double-Declining-Balance method (or 200 % declining balance method).Tax rules, however often specify a lower % age, such as 150 % of the straight-line rate. This version of the declining-balance method may be described as “150 % declining- balance.” The highest the specified % age of the straight-line rate, the more accelerated this depreciation method becomes. Experiments and traditions have established 200 % of the straight-line rate as the maximum level.

Double Declining Balance Depreciation Method To illustrate the double declining balance method consider an example of the $ 17,000 delivery truck. The estimated useful life is 5 years; therefore the straight line is 20 % (1/5) Doubling this straight line rate indicates an accelerated depreciation rate of 40 %. Depreciation Schedule of 200 % double- declining-balance method shall be as under.

Depreciation Schedule (Double Declining Balance) Years Computation Depreciation Expense AccumulatedDepreciation Book Value 1 $ 17,000 $ 17,000 x 40% = $ 6,800 $ 6,800 $ 10,200 2 $ 10,200 x 40% = $ 4,080 $ 10,880 $ 6,120 3 $ 6,120 x 40% = $ 2,448 $ 13,328 $ 3,672 4 $ 3,672 x 40% = $ 1,469 $ 14,797  $ 2,203  5 $ 2,203 $ 2,203 x 40% = $ 203 $ 15,000  $ 2,000

Notice that the estimated residual value of the delivery truck does not enter into the computation of depreciation expense until the very end. This is because the declining balance method provides an automatic residual value. As long as each year’s depreciation expense is equal to only a portion of the undepreciated cost of the asset, the asset will never be entirely written off. However if the asset has a significant residual value, depreciation should stop at this point.

Declining Balance Depreciation This calls for an annual charge that is a fixed percentage of the asset’s net book value( acquisition cost minus accumulated depreciation) at the beginning of the year to which the depreciation charge applies. Under declining depreciation, the formula for determining the depreciation charge in any period is where m is the multiple (m = 2 for double declining method), n is the depreciable life of the asset and NBV is the net book value of the asset at the start of the year.

For a $ 200,000 asset, with 4 years life, the depreciation charge in the first year using the double declining method would be determines the fixed % age (50 %), that is applied. The depreciation charge in the 2nd year is based upon the depreciated net book value of $ 100,000 (200,000 - 100,000). The depreciation charge in the 2nd year would be The depreciation charge in the 3rd year would be and so on.

Depreciation Schedule (Double Declining Balance) Years Computation Depreciation Expense AccumulatedDepreciation Book Value 1 $ 200,000 $ 200,000 x 50% $ 100,000 2 $ 100,000 x 50% $ 50,000 $ 150,000 3 $ 50,000 x 50% $ 25,000 $ 175,000 4 $ 25,000 x 50% $ 12,500  

Depreciation Schedule (Double Declining Balance) Years Computation Depreciation Expense AccumulatedDepreciation Book Value 1 $ 17,000 $ 2 x (1/5) x 17,000 $ 6,800 $ 10,200 2 $ 2 x (1/5) x 10,200 $ 4,080 $ 10,880 $ 6,120 3 $ 2 x (1/5) x 6,120 $ 2,448 $ 13,328 $ 3,672 4 $ 2 x (1/5) x 3,672 $ 1,469 $ 14,797  $ 2,203  5 $ 2,203 $ 2 x (1/5) x 2,203 $ 203 $ 15,000  $ 2,000

Which Depreciation Method Do most of the Businesses Use The depreciation methods chosen may differ for income tax returns vs financial reporting . Most Businesses use Straight-Line method of depreciation in their financial statements and an accelerated depreciation method in their income tax returns. Accelerated depreciation method results in higher charges to depreciation expenses and

therefore lower reported net income than SL depreciation therefore lower reported net income than SL depreciation. Most publicly owned Businesses want to show profitability-certainly as profitable as their competitors. Therefore those companies use straight line depreciation in their financial statements.

Decelerated Depreciation Methods These methods recognize less depreciation in the early years of an asset useful life and more depreciation in the later years. Such methods may achieve a reasonable matching of depreciation expense and revenue, when the plant asset is expected to become increasingly productive over time.