Accounting for depreciation

THE SYSTEM OF ACCOUNTING

WRITTEN BY:SYED AQEEL RAZAMASTER OF COMMERCE & POLITICS

DEPRECIATION

The depreciation in accounting is an income tax deduction that allows recovering the cost of an asset used in a trade or business or for the production of income under depreciation expense allowed annually allowance for the wear and tear, deterioration, or obsolescence of the asset.

Most types of tangible assets except land such as building, machinery, vehicles, furniture, equipment etc come under depreciation and likewise, certain intangible asset like patent, copyright, computer software etc. is depreciable.

Therefore, the decrease in value of tangible/non-current assets or the allocation of the cost of assets to the period in which they are used for accounting or tax purposes comes under depreciation involves in;

- Cost of the asset- Expected salvage value/residual value of the asset- Estimated useful life of the asset- Method of calculating the cost over such life.

COST OF ASSETS

Examples of fixed assets are building, furniture, plant and machinery, office equipment, vehicles, etc. that can be depreciated when the land is non-current assets but does not depreciate because of its natural value. The cost of fixed asset is declined by depreciation as depreciation expense which affects revenue and the declined amount is shown by accumulated depreciation as contra asset.

The cost of an asset contains purchase price excluding trade discount, cash discount and direct expenses like insurance in transit, transporting, installation charges, foundation of plant, additional part as replacement etc. <THE SYSTEM OF ACCOUNTING < VOLIUM 1< SYED AQEEL RAZA<[email protected]>

DEPRECIATION

SALVAE VALUE/RESIDUAL VALUE OF THE ASSET

When the estimated life of an asset is timed out, the company disposes of and sells it for some reduced amount which is salvage value based on asset cost, less any estimated salvage value and if the salvage value is expected to be quite small, it is generally ignored for the purpose of calculating depreciation.

ESTIMATED USEFUL LIFE OF THE ASSETS

The depreciation is recognized over the estimated useful life of an asset and the estimated useful life of an asset is expected to be productive and on ending useful life of the asset is expected to be disposed off.

THE METHOD OF COMPUTING DEPRECIATION

There are several methods for calculating depreciation but most common;

Straight line depreciationSum of years digit methodUnits of output depreciationProduction hour’s methodDiminishing/declining balance methodDouble declining balance method

<THE SYSTEM OF ACCOUNTING < VOLIUM 1< SYED AQEEL RAZA<[email protected]>

DEPRECIATION

STRAIGHT LINE DEPRECIATION

The straight line depreciation method is the simples method used widely. In this method an equal portion of the cost of an asset is allocated to each year or month and may call it constant annual depreciation.

The annual depreciation according to this method is calculated as under;

Depreciation = cost - Salvage/Residual value / useful life.Or depreciation = cost-salvage/residual value

Useful life

Assume that on April 2010, a company purchased furniture at the cost of Rs.100, 000/=. The useful life of the furniture is estimated for five years. At the end of useful life, the salvage value or residual value will be Rs.20, 000/=.

Suppose that the furniture includes on list price Rs. 100,000/= at 10% trade discount, 5% cash discount and direct charges amounting to Rs.3,960/= including insurance in transit, transportation, labor charges, fixing charges etc.

= LIST PRICE 100,000LESS: 2% trade discount 2,000

----------98,000

Less: 2% cash discount 1,960---------96,040

Add: direct expenses 3,960---------

Net cost of the furniture 100,000======


DEPRECIATION

STRAIGHT LINE DEPRECIATION CALCULATION

Depreciation for April 2010; = (100, 000 - 20,000 = 80,000) x 1/5 = 16,000 x 9/12 = 12,000Depreciation 2011; = (100, 000 - 20,000 = 80,000) x 1/5 = 16,000 x 12/12 = 16,000Depreciation 2012; = (100, 000 - 20,000 = 80,000) x 1/5 = 16,000 x 12/12 = 16,000Depreciation 2013; = (100, 000 - 20,000 = 80,000) x 1/5 = 16,000 x 12/12 = 16,000Depreciation 2014; = (100, 000 - 20,000 = 80,000) x 1/5 = 16,000 x 12/12 = 16,000Depreciation Jan-Mar 2015 = (100, 000 - 20,000 = 80,000) x 1/5 = 16,000 x 3/12 = 4,000

Sum of years digit method

In this method, the depreciation rate is used as to life of asset is 5 years which fraction is 1+2+3+4+5=15 which means that 5 years is the remaining life of the asset and 15 is the sum total of its useful life.

Assume that an asset was purchased at Rs.5000/= which has estimated residual value Rs.500/= and estimated life 5 years. Under the method of sum of year digit method, it is computed as under;

Depreciation Schedule: Sum of year digits method

Year Computation depreciation Accumulated Book ValueExpense Depreciation

Cost 5000

1st 5/15 x 4500 1500 1500 35002nd 4/15 x 4500 1200 1200 23003rd 3/15 x 4500 900 900 14004th 2/15 x 4500 600 600 8005th 1/15 x 4500 300 300 500


DEPRECIATION

Units of output depreciation

In this method, a more equitable distribution of the cost of some assets can be obtained by dividing the original depreciation cost with the estimated life in units rather than year of useful life. This method states the capacity of machinery to produce units.

Suppose that a machine was purchased at Rs.100,000 when its residual value is estimated by Rs.10,000 and production capacity by 100,000 units with normal repair and maintenance. In this method, the depreciation can be made as;

Depreciation rate per unit = cost – salvage valueEstimated life in units

Depreciation rate per unit = 100,000 – 10,000 = 90,000------------------------ ----------

100,000 100,000= 0.90 Paisa per unit/depreciation expenses

DATA FOR DEPRECIATION BY UNITS OF OUTPUT METHOD

COST OF DEPRECIABLE ASSET 100,000LESS: ESTIMATED SCRAP VALUE 10,000TOTAL AMOUNT TO BE DEPRECIATED 90,000ESTIMATED USEFUL LIFE IN UNITS 100,000DEPRECIATION EXPENSE PER UNNIT = 90,000/10000 = 0.90 PAISA

SCHEDULE OF DEPRECIATION ON MACHINERY

Life Depreciation Units depreciation Accumulated Written down Rate Produced Expense Depreciation Value

Cost………………………………………………………………………………………………… 1000001 0.90 8000 7200 7200 928002 0.90 8000 7200 14400 856003 0.90 8000 7200 21600 784004 0.90 11000 9900 31500 685005 0.90 10000 9000 40500 595006 0.90 15000 13500 54000 460007 0.90 15000 13500 67500 325008 0.90 10000 9000 76500 235009 0.90 15000 13500 90000 10000


DEPRECIATION

PRODUCTION HOURS METHOD

In this method, plant or machinery is depreciated by hourly under estimated life in hours.

Suppose that; Machine cost Rs.30000, salvage value Rs.10, 000, estimated life for 50,000 hours with normal maintenance

Production hours rate = cost – scrap valueEstimated life in hours

Production hours rate = 30000 – 10000 = 20000 = 0.40 50000 50000

SCHEDULE OF DEPRECIATION

Life Depreciation Hours depreciation Accumulated Written down Rate/hour worked Expense Depreciation Value

Cost………………………………………………………………………………………………… 300001 0.40 5000 2000 2000 280002 0.40 5000 2000 4000 260003 0.40 5000 2000 6000 240004 0.40 5000 2000 8000 220005 0.40 5000 2000 10000 200006 0.40 5000 2000 12000 180007 0.40 5000 2000 14000 160008 0.40 5000 2000 16000 140009 0.40 10000 4000 20000 10000


DEPRECIATION

DIMINISHING/DELINING BALNACE METHOD

In this method a certain percentage is determined to fix rate of calculating the depreciation on any asset which applied to the total cost of asset of the amount kept in balance year wise or in other words the rate will be applied to the total cost of asset and in second year the same rate will be applied to the total cot minis the first year depreciation and so on.

Assume that cost of an asset is Rs.100, 000 and the fixed percentage applicable to this asset is 10%, the depreciation will be as shown in schedule;

SCHEDUE OF ASSEST DEPRECIATION

Life Rate Depreciation Accumulated Written down Depreciation Expense Depreciation Value

Cost………………………………………………………………………………………………………… 1000001 10% 10000 10000 90000

2 10% 9000 19000 810003 10% 8100 27100 729004 10% 7290 34390 656105 10% 6561 40951 590496 10% 5905 46856 531447 10% 4214 51070 489308 10% 4893 55963 44037

DOUBLE DECLINING/DMINISHING BALNAE METHOD

The double declining balance method also known as diminishing balance method is the same method as

declining or diminishing balance method but in this method a the percentage as of diminishing balance method will be double to calculate depreciation of an asset. If the rate of depreciation is not known the straight line method help to find out the rate with the formula;

Amount of yearly depreciation x 100 Depreciation amount


DEPRECIATION

The rate will be multiplied by 2 to make it rate double which will be applied in this method to depreciate an asset;

Suppose that a company purchased an equipment which cost to Rs.200000 and estate it life for 10 years and salvage value Rs.20000 and used they used double declining balance method for this equipment.

COMPUTATION OF DEPRECIATION

STEP 1Straight line depreciation = Cost-Salvage value = Depreciation per year

Estimate life in year

= 200000-20000 = 200000 = 20000 depreciation per year 10 10

STEP 2COMPUTATION OF RATE OF DEPRECIATION

Depreciation per year x 100 = rate of depreciation Depreciable cost

20000 x 100 2000000 = 10% 200000 200000

STEP 3DOUBLE RATE

Depreciation rate 10% x 2 = 20% double rate

STEP 4COMPUTATION OF DEPRECIATION

Cost 200000First year depreciation @ 20% -20000

W.D. Value 1800002nd year depreciation @ 20% -36000

W.D. value 144000


DEPRECIATION

The depreciation expense account is debited and the accumulated depreciation account credited. The accumulated depreciation is a contra account to non-current asset or the conversion value account of an asset from where the amount reduced from an asset migrates into it which appears in balance sheet as a deduction from the original purchase price of an asset.

On disposing of an asset, the fixed asset account in which the asset was originally recorded is credited and debit the account accumulated depreciation which will remove the amount shown in shown in balance sheet.

If an asset not fully depreciated at the time of its disposal, it will be recorded as a loss on un-depreciated portion and on sale of the asset, the loss will be reduced.

A taxpayer must use Form 4562, Depreciation and Amortization, to report depreciation on a tax return.


WRITER’S VIEW

Suppose that the life of an asset is expected for ten years and was purchased one hundred thousand rupees but after ten years it sells one hundred twenty five thousand rupees when the life of it was ten years and is would be scraped according to depreciation rules but increase in rates even though scraped tells us that the asset will work for further years and if sells gives profit. So, it comes to mind that the depreciation is allowed to reduce income by income tax to business man to save income tax and does not mean to life because the depreciation expense reduces to gross profit and after ten years the depreciation expense relief would be ended. If the value of the asset comes to income and/or remains in business will give benefit to it but do not apply on depreciation.

Therefore, the depreciation is the relief to operate the business reducing income which saves income tax.

WRITTEN BY:SYED AQEEL RAZAMASTER OF COMMERCE & POLITICS

Education

Accounting for depreciation