What is Depreciation. Types, Examples, Causes, and Numericals

 What is Depreciation?

}  The monetary value (pay for something) of an asset decreases over time due to use, wear and tear. This decrease is measured as depreciation.

Or

}  In accounting terms, depreciation is also defined as the reduction of recorded cost of a fixed asset in a systematic manner until the value of the asset becomes zero or negligible.

 Examples of Depreciation?

}  Machinery, equipment, currency are some examples of assets that are likely to depreciate over a specific period of time.

}  Fixed assets are buildings, furniture, office equipment, machinery etc.

}  Another example of depreciation is If a delivery truck is purchased a company with a cost of Rs. 100,000 and the expected usage of the truck are 5 years, the business might depreciate the asset under depreciation expense as Rs. 20,000 every year for a period of 5 years.

 

Types of Depreciation?

•       Straight Line Depreciation Method

•       Reducing Balance Methods

•       Sum Of  The Year’s Digits Method

•       Depletion Unit Method

•       Units Of Output Method

•       Machine Hour Method

• Straight line Depreciation Method:

}  Straight-line method, also known as the Original cost method, Fixed instalment method, and Fixed percentage method.

}  Under this method, an equal amount is charged for depreciation of every fixed asset in each of the accounting periods. This uniform amount is charged until the asset gets reduced to nil or its salvage value at the end of its estimated useful life.

  Formula:

   Depreciation  =   

Example

Suppose a manufacturing company purchases a machinery for Rs. 500,000 and the useful life of the machinery are 8 years and the salvage value of the machinery is Rs. 70,000

Solution:

                Annual Depreciation expense = = Rs. 53,750

Company will have Rs. 53,750 as the depreciation expense every year over the next 8 years.

• Reducing Balance Method:

}  Reducing balance method  changes the amount of depreciation charged over time. It is considered an ‘accelerated’ depreciation method.

}  It is most useful for assets that typically lose the most value in earlier years, but then experience a slowing of depreciation later on. Computer equipment is a good example of an asset that would benefit from this method.

  Formula:

                Depreciation = Book value x Depreciation Rate

                Book value = Cost – Accumulated Depreciation

            Scrap value = At the end of year’s Book value – Accumulated Depreciation 

  Example

In January 2018, Company purchased a truck at cost of Rs 10,00,000 having useful life of three years. The depreciation rate is 30%. Calculate the depreciation from 2018 to 2020 using reducing balance depreciation method. Also determine the Scrap value of the truck at the end of the year 2020

Solution:

    At the end of the year 2020 , the scrap value = 490,000 – 147,000 = Rs 343,000

• Some of the Year Method:

}  The sum of the year’s digits depreciation method is determined by adding up the total number of years of the asset’s expected useful life and then figuring out the year in which it currently falls on that scale.

}  It provides for higher depreciation to be changed early in the life of an asset with lower depreciation in the last year.

Example  

An equipment costs Rs1,500,000. At the end of its economic life of five years, its salvage value is Rs 500,000. Using Sum of the Years Digit Method of Depreciation, what will be its book value for the third year?

Solution:

• Depletion Unit Method:

}  All natural resource like fuel oil, gas, woods and mines are ending by using them. We calculate the depreciation with depletion method for such perishing(destroy) assets. Under this method first, we estimate the total value of assets. After this, we calculate the rate of depreciation per unit by dividing the estimated life in the term of production of units.

Formula :

 Total Depreciation Expense = Per Unit Depreciation × Units Produced

 Example  

Sindh Engro Coal Mining Company has acquired a coal mine for a cost of 8,000,000. No other costs are involved. The total coal expected to be extracted from the mine is 15,000 tons. During the year 2015, the total extraction of coal is 3,000 tons. There is no salvage value.

Determine:

                1) The depletion rate per tone of coal extracted = ?

                2) The depletion charge of the coal extracted during the year 2015 = ?

 Given Data:      

           Depletion base = 8,000,000

                Expected coal to be extracted = 15,000 tons

• Units of Output Method:

 }  A depreciation procedure use for properties that is not in continuous uses. the unit of production method is useful when the property’s value is more closely related to the number of units it produces than the number of years it is in use.

Formula:

 Annual Depreciation = Depreciable Value x

 

 Depreciable Value      = Original cost – Scrap value

  Example  

Oil PLC installs a crude oil processing plant costing $12 million with an estimated capacity to process 50 million barrels of crude oil during its entire life. Production during the first year of operation is 2 million barrels. Expected residual value of the processing plant is $2 million.

Solution:

  Depreciation charge for the first year is calculated as follows:

   Depreciation Expense = ($12 - $2m) x 2 / 50 = $0.4 million

• Machine Hour Method:

}  As per machine hour rate method of depreciation, we calculate the total life of any fixed assets on the basis of its working hours life. After this , we divide actual cost of fixed assets with life of fixed assets in hours. After dividing we will obtain the depreciation rate per hour. This method will apply mostly on the machines.

Formula :

Hourly depreciation rate  =  

Example  

A machine was purchased on 1^st January 2004 at a cost , of Rs 50,000 and the cost of installation Rs 8,000 his expected that its total working life will be 1,00,000 hours. The scrape value may be Rs 3,000. During the year 2004 , the machine worked for 1200 hours and in 2005 for 1350 hours. Calculate the depreciation for 2004 and 2005.

Given Data:

    Expected working life of machine =  1,00,000 hours

    Cost of machine(Rs 50,000 + Rs8,000) =  Rs 58,000

    Scrap value =  Rs 3,000

 Solution:

Hourly rate of depreciation = 

Hourly rate of depreciation = 

Hourly rate of depreciation = 0.55 cents per hour

Depreciation for 2004 = 1200 x 0.55

Depreciation for 2004 = Rs 660

Depreciation for 2005 = 1350 x 0.55

Depreciation for 2005 = Rs 742.50

 

Conclusion

}  By far the most common is the straight-line method.

Recommended for company-prepared statements to tax returns .e.g. Vehicles, Small business.

}  The least common method is the sum-of-the-years digits.

Method is desirable for a profitable business because it results in delaying the payment of taxes.

Which method of depreciation should I use?

}  The reducing balance method of depreciation is most useful when an asset has higher utility or productivity at the start of its useful life, as it results in depreciation expenses that reflect the asset‘s productivity, functionality, and capacity to generate revenue.

For Example:

Many types of machinery have higher functionality when they’re new and therefore generate more revenue in the earlier years of their lives. The reducing balance method of depreciation reflects this more accurately than other depreciation methods.