Financial Management

B. Pharm MBA Semester 7

SVKM’s NMIMS Deemed-to-be University

Unit 4
Depreciation Accounting

Ashique Ali K A
Assistant Professor (Finance)
School of Law
SVKM’s NMIMS Deemed-to-be University
Hyderabad
 Depreciation
• Tangible assets are assets that have a physical substance, i.e., they can be
seen and touched, held for use in the production or supply of goods or
services.
• Fixed assets (Property, Plant and Equipment), which are tangible in nature,
are expected to be used in a business for more than a period of 12 months
• Since the life of such fixed assets exceeds one year, it is necessary that a
part of the acquisition cost of such fixed assets be treated or allocated as
an expense in each of the accounting period in which the asset is utilized
(Refer to Matching Principle).
• The decrease in the value of fixed assets due to wear and tear, efflux of
time, accident or obsolescence is called Depreciation.
 Depreciation
• As per Schedule II under the Companies Act, 2013, Depreciation is the
systematic allocation of the depreciable amount of an asset over its useful
life.
• The useful life of an asset is the period over which an asset is expected to
be available for use by an entity, or the number of production or similar
units expected to be obtained from the asset by the entity.
• There are 3 important factors for computing depreciation:
• Estimated useful life of the asset
• Cost of the asset
• Residual value/Scrap value of the asset at the end of its estimated useful life.
• Charging depreciation every year reduces the distributable profits thereby
ensuring the availability of funds whenever the replacement is required.
• It is a non-cash expense
 Some Concepts
• The term ‘depreciation’ is used only in respect of fixed assets
• Depreciation is a charge against profit
• Depreciation is different from maintenance expenses. Maintenance
expenses are incurred for keeping the machine in a state of efficiency.
• All fixed assets, except Land, Antiques, etc. suffer depreciation.
• Depletion implies removal of an available but irreplaceable resource
such as extracting coal from a coal mine or oil out of an oil well.
• Amortization is the process of writing off intangible assets like
Patents, Copyrights, etc.
 Objectives for providing depreciation
• Correct income measurement
• True position statement
• Funds for replacement
• Ascertainment of true cost of production
 Cost of Property, Plant, and Equipment (PPE)
• Its purchase price, including non-refundable import duties and
purchase taxes, after deducting trade discounts and rebates.
• Any cost directly attributable to bring the asset to the location and
condition necessary for it to be capable of operating in a manner
intended by the business.
• The initial estimate of the costs of dismantling, removing, the item
and restoring the site on which an asset is located
 Cost of Property, Plant, and Equipment (PPE)
• Any cost directly attributable to bring the asset to the location and
condition necessary for it to be capable of operating in a manner
intended by the business.
• Cost of employee benefits (wages or salary) arising directly from acquisition
or construction of an item of PPE
• Cost of site preparation
• Initial delivery and handling costs
• Installation and assembly costs
• Costs of testing whether the asset is functioning properly
• Professional fees (e.g. engineers hired for installing a machine)
 Methods of Providing Depreciation

Declining Charge or
Uniform charge methods Accelerated Depreciation Other Methods
Methods
• Fixed Instalment Method • Diminishing Balance • Group Depreciation
• Depletion Method Method Method
• Machine Hour Rate • Sum of years digits • Inventory System of
Method method Depreciation
• Double Declining • Annuity Method
Method • Depreciation Fund
Method
• Insurance Policy Method
Methods of Providing Depreciation
 Fixed Instalment Method
• Also known as Straight Line Method (SLM).
• Depreciation is charged evenly every year throughout the effective life of
the asset.
𝑂𝑟𝑖𝑔𝑖𝑛𝑎𝑙 𝐶𝑜𝑠𝑡 −𝑆𝑐𝑟𝑎𝑝 𝑉𝑎𝑙𝑢𝑒
• Annual Depreciation =
𝐸𝑠𝑡𝑖𝑚𝑎𝑡𝑒𝑑 𝐿𝑖𝑓𝑒 𝑜𝑓 𝑡ℎ𝑒 𝐴𝑠𝑠𝑒𝑡
• Life of the asset is expressed in terms of number of years.
𝐴𝑛𝑛𝑢𝑎𝑙 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛
• Percentage of Depreciation = ∗ 100
𝑂𝑟𝑖𝑔𝑖𝑛𝑎𝑙 𝐶𝑜𝑠𝑡
• If the asset is used for part of the year (say 6 months), then depreciation
shall be charged only for such part of the year (6 months). Here, multiply
annual depreciation by 6/12 for 6 months, 9/12 for 9 months, and so on.
• The asset may be purchased or sold in the middle of the year where the
adjustment of annual depreciation is required.
 Merits and Demerits of SLM
Demerits
Merits • The method does not take into
consideration the effective utilisation of
• The method is simple to the asset. The same amount of
understand and easy to apply depreciation is charged every year
irrespective of the use of the asset
• The value of the asset can be • The total charge for use of the asset
(Depreciation + Repairs) goes on
reduced to zero or scrap value increasing from year to year though the
asset might have been used uniformly
• The method is very suitable, from year to year. Because, the amount
particularly in case of those of repair will be more in later years.
assets which get depreciated • The method tends to report an increasing
rate of return on assets (ROA)
more on account of expiry of
period
 Format of Schedule of Depreciation
Year (A) Original Cost Opening Annual Depreciation Accumulated Book Value (F)
(B) Balance (C) (D) Depreciation (E)
1 = As per the method = (D) of year 1 = (B) – (E)
OR
= (C) – (D)
2 = (F) of year 1 = (E) of year 1 +
(D) of year 2
3 = (F) of year 2 = (E) of year 2 +
(D) of year 3
Question 1

• A firm purchases a plant for sum of Rs. 100,000 on 1st January 2017.
Installation charges are Rs. 20,000. Plant is estimated to have a scrap
value of Rs. 10,000 at the end of its useful life of 5 years. Prepare a
schedule of depreciation for five years charging depreciation under
SLM.
Question 2

• A firm writes off 95% of the cost of machinery acquired over a period
of 10 years by the SLM., leaving 5% as estimated scrap value. On 1st
July 2014, the original cost of the machinery was Rs. 120,000. On 1st
February 2024, the machine was sold for 5000. Prepare a schedule of
depreciation for 10 years.
 Diminishing Balance Method
• Also known as Reducing Balance Method or Written Down Value Method
(WDV).
• Depreciation is charged on the book value of the asset (Opening Balance)
each year.
• Thus, the amount of depreciation goes on decreasing each year.
• Annual Depreciation = Book Value of the Asset * Annual rate of
depreciation
𝑛 𝑆𝑐𝑟𝑎𝑝 𝑉𝑎𝑙𝑢𝑒
• Annual Rate of Depreciation = 1 −
𝑂𝑟𝑖𝑔𝑖𝑛𝑎𝑙 𝐶𝑜𝑠𝑡
• If the asset is used for part of the year (say 6 months), then depreciation
shall be charged only for such part of the year (6 months).
 Merits and Demerits of SLM
Merits Demerits
• The method puts an equal • The value of the asset cannot be
burden for use of the asset on brought down to zero
each subsequent year. Because, • The determination of a suitable
the repair charges goes on
increasing year to year, the rate of depreciation is also
amount of depreciation goes difficult
down on the other hand to
make it even.
• This method is simple to
understand and easy to apply
Question 3

• A firm purchases a Plant and Machinery on 1st January 2019 for Rs.
10,00,000. Prepare a schedule of depreciation charging depreciation
@ 10% p.a. according to WDV method.
 Double Declining Balance Method
• This is similar to WDV
• But, the rate of depreciation charged is twice the straight-line rate
• The method is prevalent is USA
• Find out the annual depreciation and rate of depreciation as per SLM
and double it to find the rate of depreciation as per this method.
Then charge depreciation on the book value of the asset just similar
to WDV method.
• The total cost should not be reduced by charging the depreciation to
an amount lower than the estimated scrap value of the asset.
Question 4

• A firm purchases a Plant and Machinery having a useful life of 5 years

on 1st April 2019 for Rs. 100,000. The P&M has an estimated salvage
value of Rs. 20,000. Prepare a schedule of depreciation charging
depreciation according to Double Declining method.
 Unit of Output Method
• Also known as Production Units Method
• Depreciation is determined by comparing the annual production with
the estimated total production
𝑃𝑟𝑜𝑑𝑢𝑐𝑡𝑖𝑜𝑛 𝑑𝑢𝑟𝑖𝑛𝑔 𝑡ℎ𝑒 𝑝𝑒𝑟𝑖𝑜𝑑
• Annual Depreciation = 𝑂𝑟𝑖𝑔𝑖𝑛𝑎𝑙 𝑐𝑜𝑠𝑡 − 𝑆𝑐𝑟𝑎𝑝 𝑉𝑎𝑙𝑢𝑒 ∗ ( )
𝐸𝑠𝑡𝑖𝑚𝑎𝑡𝑒𝑑 𝑡𝑜𝑡𝑎𝑙 𝑝𝑟𝑜𝑑𝑢𝑐𝑡𝑖𝑜𝑛

• The method is applicable to machines producing product of uniform specifications

Question 5

• A machine is purchased for Rs. 20,00,000. Its estimated useful life is

10 years with a residual value of Rs. 200,000. The machine is
expected to produce 150,000 units during its lifetime. The expected
distribution pattern of production is as follows:
Year Production
1–3 20,000 units per year
4–7 15,000 units per year
8 – 10 10,000 units per year

Determine the value of depreciation for each year using

production units method:
Solution 5
 Machine Hour Method
• Where it is practicable to keep a record of the actual running hours of
each machine, depreciation may be calculated on the basis of hours that
the concerned machine worked.
• This is a variation of SLM, as here depreciation is calculated per machine
hour rather than per year
• Depreciation is determined by comparing the annual production with
the estimated total production
𝑀𝑎𝑐ℎ𝑖𝑛𝑒 ℎ𝑜𝑢𝑟 𝑢𝑠𝑒𝑑 𝑝𝑒𝑟 𝑦𝑒𝑎𝑟
• Annual Depreciation = 𝑂𝑟𝑖𝑔𝑖𝑛𝑎𝑙 𝑐𝑜𝑠𝑡 − 𝑆𝑐𝑟𝑎𝑝 𝑉𝑎𝑙𝑢𝑒 ∗ ( )
𝐸𝑠𝑡𝑖𝑚𝑎𝑡𝑒𝑑 𝑡𝑜𝑡𝑎𝑙 𝑚𝑎𝑐ℎ𝑖𝑛𝑒 ℎ𝑜𝑢𝑟𝑠
Question 5

• A machine is purchased for Rs. 30,00,000 having an estimated total

working of 24,000 hours. Its residual value is Rs. 200,000. The
expected distribution pattern of effective hours per year is as follows:

Year Production
1–3 3,000 hours per year
4–7 2,600 hours per year
8 – 10 1,800 hours per year

Determine the value of depreciation for each year using

machine hour rate method: