M. C. Sharma
Associate Professor
Department of Commerce
Shaheed Bhagat Singh Evening College
(University of Delhi)
Delhi
1
Learning Objectives:
Learning objectives of today’s lecture are to know and
understand :
 What is depreciation?
 What are related terms: Depletion, Amortisation and
Obsolescence?
 What are the causes of Depreciation?
 What are the objectives of charging depreciation?
 What are the factors affecting the amount of depreciation?
 What are the relevant accounting principles?
 Methods of providing or allocation depreciation
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What is depreciation?
 Depreciation means decrease in the value of fixed
assets due to their use in business, passage of time or
obsolescence.
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Depreciation as per AS 6
 Depreciation is a measure of the wearing out,
consumption or other loss of value of a depreciable
asset arising from use, effluxion of time or
obsolescence through technology and market changes.
 Depreciation is allocated so as to charge a fair
proportion of the depreciable amount in each
accounting period during the expected useful life of
the asset.
 Depreciation includes amortisation of assets whose
useful life is predetermined.
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Depreciable Asset
Depreciable assets are assets which
i. are expected to be used during more than one
accounting period; and
ii. have a limited useful life; and
iii. are held by an enterprise for use in the production or
supply of goods and services, for rental to others, or
for administrative purposes and not for the purpose
of sale in the ordinary course of business.
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What is depletion?
The term ‘Depletion’ refers to the physical deterioration
by the exhaustion of natural resources, like, quarries,
mines, oil-wells, etc. Due to mining or extraction, the
stock of minerals/oil, etc. is depleted/reduced. In case of
such assets, usually depreciation is charged on the basis
of quantity produced.
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What is amortisation?
Amortisation refers to the economic deterioration of
intangible assets like, goodwill, patents, trademark,
copyright etc. It is the practice to write off the intangible
assets over a reasonable period. When a part of an
intangible asset is written off, it is called amortisation.
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What is obsolescence?
 The term ‘Obsolescence’ refers to the economic
deterioration of assets, due to change in technology,
invention of improved equipment, market decline due
to change in taste and fashion, etc., or inadequacy of
existing plant to meet the increased business.
 Depreciation is affected
by obsolescence as it
decreases the value of asset.
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Causes of Depreciation
 Wear and tear. Fixed assets are purchased for use in
business. Due to constant use of fixed assets in
business for generating income, the value of such
assets is decreased. It is called ‘wear’ and ‘tear’. It is
main cause of depreciation.
 Passage of time. Every asset has a certain economic
useful life. With the passage of time effective life of the
assets goes on decreasing. Certain assets like a lease,
have a certain legal life. With the passage of time,
value of such assets goes down, even may not be
actually used in the business.
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Causes of Depreciation
 Depletion. Depletion is reduction of natural resources. In
case of wasting assets, depletion is also a cause of fall in the
value of assets like, mines, oils wells, quarries, etc.
 Obsolescence. Due to invention of new technology, the
assets based on old technology may become obsolete and
out of date.
 Accidents. Accidents may also cause a permanent fall in
the useful life as well as in the value of assets.
 Permanent fall in price. A permanent fall in the market
value of investments is recorded as depreciation. Other
assets are depreciated on the basis of its useful life.
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Objectives of Providing Depreciation
 To ascertain the true and fair profits
 To show the asset at its proper value
 To make arrangement of funds for replacement of
fixed asset
 Ascertaining accurate cost of production
 To comply with legal provisions
 To avail tax benefits
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Factors affecting the amount of depreciation
Assessment of depreciation and the amount to be
charged in respect thereof in an accounting period are
usually based on the following three factors:
i. historical cost or other amount substituted for the
historical cost of the depreciable asset when the
asset has been revalued;
ii. expected useful life of the depreciable asset; and
iii. estimated residual value of the depreciable asset.
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Historical Cost
 Historical cost of a depreciable asset represents its
money outlay or its equivalent in connection with its
acquisition, installation and commissioning as well as
for additions to or improvement thereof.
 The historical cost of a depreciable asset may undergo
subsequent changes arising as a result of increase or
decrease in long term liability on account of exchange
fluctuations, price adjustments, changes in duties or
similar factors.
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The useful life of a depreciable asset
The useful life of a depreciable asset is shorter than its physical
life and is:
i.
pre-determined by legal or contractual limits
ii. directly governed by extraction or consumption;
iii. dependent on the extent of use and physical deterioration
on account of wear and tear which again depends on
operational factors, such as, the number of shifts for which
the asset is to be used, repair and maintenance policy of the
enterprise etc.; and
iv. reduced by obsolescence arising from such factors as: (a)
technological changes; (b) improvement in production
methods; (c) change in market demand for the product or
service output of the asset; or (d) legal or other restrictions.
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Relevant Accounting Principles
 Cost Principle
 Matching Principle
 Going Concern Principle
 Consistency: The depreciation method selected should
be applied consistently from period to period.
 Disclosure
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Methods of Providing or Allocating Depreciation
Important Methods:
 Straight Line Methods
 Written Down Value Method
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Methods of Providing or Allocating Depreciation
 Other Methods:
 Sinking Fund Method
 Annuity Method
 Insurance Policy Method
 Revaluation Method – Loose Tools
 Depletion Method – Mines, Oil-wells, etc.
 Machine Hour Rate Method
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Straight Line Method of depreciation
 Under this method depreciation is charged by a given
rate of depreciation on the original cost of the asset
every year.
 Due to this reason depreciation charged annually
remains fixed and so the method is called ‘Fixed
Instalment Method.
 This is also called original cost method as the
depreciation is charged every year on the original cost
of the asset. estimated scrap value of the asset
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Straight Line Method of depreciation
 If rate of depreciation is not given then annual
depreciation and rate of depreciation is calculated by
applying the following formulas:
Annual depreciation
Cost of Asset  Estimated Scrap Value

Number of years (Estimated life of asset)
Rate of depreciation

Annual Depreciati on
100
Cost of Asset
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Straight Line Method of depreciation
 If rate of depreciation is not given then annual
depreciation and rate of depreciation is calculated by
applying the following formulas:
Annual depreciation
Cost of Asset  Estimated Scrap Value

Number of years (Estimated life of asset)
Rate of depreciation

Annual Depreciati on
100
Cost of Asset
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Example: A firm purchased a machine for Rs, 1,75,000
and spent installation charges Rs. 45,000. It’s economic
life is 10 years and estimated residual value after 10
years is Rs. 20,000. Charge depreciation by SLM.
Annual Depreciation=
2,20,000 −20,000
=
10
20,000
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Straight Line Method of depreciation
 When depreciation charged in various years is put on a
graph, it gives a straight line parallel to OX axis. Due to
this reason this method is called straight line method.
Depreciation
25000
20000
15000
Depreciation
10000
5000
0
0
1
2
3
4
5
6
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Merits of Straight Line Method of Depreciation
 Simple. Every year a fixed amount is charged as depreciation.
Calculation of depreciation is also very simple.
 Asset is completely written off. If an asset continues with a
firm for the whole of its useful life and depreciation is provided
by SLM, it will be completely written off. Only scrap value of the
asset, if any, will be left in the asset account.
 No window dressing. A fixed amount of depreciation is charged
to the profit and loss account every year. The effect of
depreciation on profit is equal and chances of manipulating
profits are very less.
 Knowledge of original cost and total depreciation charged.
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Calculation of Depreciation and WDV – SLM
Example: Cost of machine – Rs. 77,760, useful life – 5
years, estimated scrap value after 5 years – Rs. 31,250
Charge depreciation by SLM
Annual Depreciation=
77,760 −31,250
=
5
Rate of Depreciation =
9,302
77,760
9,302
100 = 11.92%
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Straight Line Method
Calculation of Depreciation and WDV
Year
Op. WDV Rate of Dep
(Rs.)
Dep.
(Rs.)
Clo. WDV
(Rs.)
1
77,760
11.92%
9,302
68,458
2
68,458
11.92%
9,302
59,156
3
59,156
11.92%
9,302
49,854
4
49,854
11.92%
9,302
40,552
5
40,552
11.92%
9,302
31,250
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Demerits of Straight Line Method of Depreciation
 Unequal charge against income. Total charge on account
of using fixed assets comprises depreciation plus repairing
charges. Under SLM, depreciation charged is fixed but
repairing charges go on increasing year by year. Thus total
charge against income goes on increasing.
 Year
Depreciation Repairs
Total Charge
1
20,000
nil
20,000
2
20,000
1,000
21,000
3
20,000
3,000
23,000
4
20,000
5,000
25,000
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Demerits of Straight Line Method of Depreciation
 Interest factor ignored. When a fixed asset is purchased,
the amount is invested permanently. If the amount would
have been invested outside the firm, the interest would
have been received on it. Thus, the loss of interest is
ignored, while calculating depreciation.
 Undue pressure in later years. Under fixed instalment
method, the total charge against the income goes on
increasing year by year, while efficiency of asset goes on
decreasing. Thus, the pressure in later years is unduly high.
 Difficult to estimate scrap value
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Demerits of Straight Line Method of Depreciation
 Unsuitable for long term assets. The assets having long
life, requires several addition and extension from time to
time. This method is not suitable for them. It is also not
suitable for assets having heavy investment.
 No provision of funds for replacement. In this method
amount charged as depreciation is not invested outside the
business. It is retained in the business and becomes a part
of working capital. When the asset becomes useless, the
firm has to face the problem of funds for the replacement
of asset as it becomes difficult to withdraw amount from
the working capital.
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Written Down Value Method of depreciation
 Under this method depreciation is charged at a fixed rate
on the opening balance of the asset. This balance is
reduced every year. Thus, the amount of depreciation also
goes on reducing year after year.
 Thus, it is clear that under this method value of asset as
well as depreciation charged goes on reducing every year.
Due to this reason this method is also called “Reducing
Instalment Method.” The value of asset left after charging
depreciation is called, written down value. Due to this
reason, this method is called “Written Down Value
Method.”
 The rate of depreciation charged under this method is
higher than that charged in straight line method.
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Calculation of rate of depreciation under WDV method
R=
{1 - }*100
𝑛
𝑆
𝐶
 R = Rate of Depreciation
 N = useful life of the asset
 S = Scrap value of the asset
 C = Cost of the asset
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Calculation of rate of depreciation under WDV method
R=
{1 - }*100
𝑛
𝑆
𝐶
 R = Rate of Depreciation
 N = useful life of the asset = 5 years
 S = Scrap value of the asset = 31,250
 C = Cost of the asset = 77,760
 R = {1 -
5
}*100
6
= 16.67%
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Calculation of Depreciation and WDV
Year
Op. WDV
(Rs.)
Rate of
Dep
Dep. Clo. WDV
(Rs.)
(Rs.)
1
77,760
16.67%
12,960
64,800
2
64,800
16.67%
10,800
54,000
3
54,000
16.67%
9,000
45,000
4
45,000
16.67%
7,500
37,500
5
37,500
16.67%
6,250
31,250
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Merits of Written Down Value Method of depreciation
 Simple. Calculation of depreciation is very simple as the
depreciation is charged every year on the opening balance
of the asset. Depreciation on additional assets purchased
during the year is calculated separately. There is no need to
remember original cost of the assets.
 Equal charge against income. Under this method
depreciation charged is reduced every year, while repairing
charges are increased. Thus, the total charge against
income remains the same, more or less.
 No undue pressure in later years.
 Approved by taxation authorities.
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Example: Based on the example with assumed
repairs and maintenance charges
Straight Line Method
Year
Dep Repairs
WDV Method
Total
charge
Dep Repairs
Total
charge
1
9,302
0
9,302
12,960
-
12,960
2
9,302
1,100
10,402
10,800
1,100
11,900
3
9,302
2,300
11,602
9,000
2,300
11,300
4
9,302
3,800
13,102
7,500
3,800
11,300
5
9,302
5,500
14,802
6,250
5,500
11,750
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Demerits of WDV Method of Depreciation
 Difficulty in determining the rate of depreciation. It is
very difficult to calculate a rate of depreciation which will
depreciate the asset completely. Even if an asset becomes
obsolete and useless, the books shows some balance.
 Interest factor ignored. Like, the fixed instalment
method, interest factor is ignored in diminishing balance
method also.
 No provision of funds for replacement. Like the fixed
instalment method, the amount charged as depreciation is
not invested outside the business. It creates problem, while
replacing the asset, when it becomes useless.
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Demerits of WDV Method of Depreciation
 Asset can not be completely written off. Under
diminishing balance the value of asset is not completely
written off. The asset account continues in the books, may
be a very small amount, even after the asset becomes
obsolete and useless.
 No information about original cost and accumulated
depreciation. Under this method the asset account shows
the reduced balance after charging depreciation. Assets are
grouped on the basis of rate of depreciation and it becomes
difficult to know the original cost and accumulated
depreciation on any specific fixed asset.
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