Chapter no 6: Depreciation.

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Depreciation

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A Key Concept in Accounting and Finance

Depreciation is a fundamental concept in accounting and finance that allows businesses to allocate the cost of a tangible asset over its useful life. As assets like machinery, equipment, and vehicles age, they lose value due to wear and tear, technological advancements, or market changes. Depreciation not only reflects this loss of value but also impacts financial statements, tax calculations, and business planning. In this article, we will explore the purpose of depreciation, methods used to calculate it, and its role in business operations and financial analysis.

Why Depreciation Matters

Depreciation serves several essential functions in accounting:

  1. Reflecting Asset Value Over Time: Assets like buildings, machinery, and vehicles gradually lose their value. Depreciation accounts for this decline, offering a more accurate picture of an asset’s current worth.
  2. Matching Expenses with Revenues: Depreciation aligns with the accounting principle of matching expenses with revenues. By spreading the cost of an asset over its useful life, depreciation ensures that expenses related to the asset are recorded in the same periods when the asset is generating revenue.
  3. Reducing Taxable Income: Depreciation is often considered a non-cash expense because it doesn’t involve an actual cash outflow each year. However, it reduces taxable income, as businesses can deduct depreciation expenses from their revenue. This tax benefit makes depreciation an essential part of tax planning.
  4. Supporting Financial Planning: Depreciation helps businesses plan for the replacement of assets by providing an estimate of how long they will last. It allows companies to budget for future investments in new equipment or facilities as existing assets reach the end of their useful life.

Methods of Calculating Depreciation

Several methods can be used to calculate depreciation, each with its approach to spreading the cost of an asset over its useful life. The choice of method depends on factors like the type of asset, its expected usage, and financial goals.

1. Straight-Line Depreciation

The Straight-Line Method is the simplest and most widely used approach. This method spreads the cost of an asset evenly over its useful life.

Example: If a machine costs $10,000 and has a useful life of 5 years, its annual depreciation expense would be $2,000.

The straight-line method is easy to calculate and is suitable for assets that experience a consistent rate of usage over time.

2. Declining Balance Method

The Declining Balance Method applies a fixed percentage rate to the asset's book value, resulting in higher depreciation expenses in the early years and lower expenses as the asset ages. This approach is useful for assets that lose value quickly, such as technology or vehicles, which are more valuable when new.

This method reflects how some assets may provide greater benefits in their early years, aligning with their actual economic usefulness.

3. Units of Production Method

The Units of Production Method calculates depreciation based on the actual usage of an asset, rather than time. It’s ideal for assets whose wear and tear depend on usage levels. For example, a manufacturing machine may be depreciated based on the number of units it produces each year.

This method is most accurate for assets with varying usage, as it directly ties depreciation to the asset's operational performance.

4. Sum-of-the-Years'-Digits Method

The Sum-of-the-Years'-Digits Method is an accelerated depreciation method where the asset depreciates faster in the initial years and slower in the later years. It calculates depreciation by applying fractions based on the asset's remaining life to the depreciable amount. This method is suitable for assets that may lose value or become obsolete quickly.

Depreciation and Financial Statements

Depreciation affects several financial statements, which gives a comprehensive view of a business's financial health.

  1. Income Statement: Depreciation is recorded as an expense, which reduces net income. Though it doesn’t involve cash outflow, it reflects the asset's usage cost and is critical for accurately reporting earnings.
  2. Balance Sheet: Depreciation reduces the book value of an asset on the balance sheet over time. This adjustment provides a realistic value of assets as they age, giving stakeholders a better understanding of the company’s actual asset worth.
  3. Cash Flow Statement: Since depreciation is a non-cash expense, it doesn’t directly impact cash flow. However, it is added back to net income in the operating activities section, giving a clearer picture of actual cash generated by the business.

Depreciation and Tax Implications

Depreciation plays a significant role in tax planning. By reducing taxable income, depreciation lowers the amount of income tax a business owes. This is especially important for capital-intensive businesses with high asset values, as they benefit more from depreciation deductions. Many tax authorities allow businesses to use accelerated depreciation methods for tax purposes, enabling them to deduct larger depreciation amounts in the early years of an asset’s life, reducing taxable income even further.

Depreciation vs. Amortization

It’s essential to distinguish depreciation from amortization. While both spread costs over a period, they apply to different types of assets:

  • Depreciation is used for tangible assets—physical items like machinery, buildings, and vehicles.
  • Amortization applies to intangible assets, such as patents, copyrights, and trademarks. Amortization works similarly to straight-line depreciation, spreading the cost evenly over the asset’s useful life.

Challenges in Depreciation

Despite its usefulness, calculating and applying depreciation comes with challenges:

  1. Estimating Useful Life: Determining the accurate useful life of an asset can be challenging, as it requires predicting future usage and maintenance. Incorrect estimates can lead to over- or under-depreciation.
  2. Obsolescence: Technological advancements can render assets obsolete faster than anticipated, affecting their actual useful life and value. This challenge is especially relevant in industries with rapid technological change.
  3. Different Depreciation Methods: Choosing the appropriate depreciation method requires careful consideration. The selected method impacts financial reporting and tax obligations, and some methods may be more beneficial for certain assets.

Practical Example: Depreciation in a Manufacturing Business

Consider a manufacturing company that purchases a $50,000 machine with an estimated useful life of 10 years. If the business uses straight-line depreciation, it would record $5,000 of depreciation annually. This amount is reported as an expense on the income statement and reduces the asset’s book value on the balance sheet each year.

However, if the company anticipates heavy use in the initial years, it might opt for declining balance depreciation, resulting in higher depreciation expenses in the first few years. This method aligns with the machine’s actual usage, helping the business match expenses with revenue more accurately.

The Future of Depreciation in an Evolving Economy

As technology evolves, so does the approach to depreciation. For example, cloud computing and software as a service (SaaS) models have introduced new types of assets, which may require different treatment than traditional capital assets. Furthermore, with advancements in artificial intelligence and automation, assets may have shorter useful lives, and companies may need to adapt their depreciation practices to reflect these changes.

In addition, some businesses are moving toward sustainable practices, where assets are designed to be reused or repurposed, potentially extending their useful life. These trends may influence how depreciation is calculated and reported in the future.

Conclusion

Depreciation is a vital concept in accounting and finance that reflects the gradual loss of value in tangible assets. It aligns costs with revenue, reduces taxable income, and provides businesses with valuable insights for planning and budgeting. Understanding different depreciation methods and their applications is crucial for accurate financial reporting, tax planning, and asset management.

While it presents challenges, such as estimating useful life and adapting to technological changes, depreciation remains a cornerstone of financial accounting, ensuring that businesses accurately represent asset values and maintain financial health. As the business landscape continues to evolve, so too will the approaches to handling depreciation, making it an essential area of knowledge for accountants, managers, and investors alike.

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1. Revenue expenditure:

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2. Which of the following is/are correct?
(I) Revenue expenditure is considered as an expense
(II) Capital expenditure is considered as expense as its effect is for long term.

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3. Which of the following is/are correct?
(I) Repair expense on large monetary amount are capital expenditure.
(II) Under accrual concept income is recognised when it is earned instead of
when it is received.

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4. Which of the following is not capitalized as a directly attributable cost of a
machine?

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5. Which of the following is not a direct cost of using a motor bike?

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6. Which of the following is not a component of the cost of an asset?

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7. Tom Limited runs a sports equipment manufacturing business with a year end of
31 December 2019. On 1 April 2019, Tom Limited acquired a delivery truck at a cost
of Rs. 4,800,000. The expected life of the truck is 8 years and residual value is
expected to be nil. What is depreciation charge for 2019 on straight line basis?

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8. Which of the following is correct?
1. An asset is a resource controlled by the entity.
2. Equity is the residual interest in the assets of the entity after deducting all its
liabilities

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9. Which one of the following is correct definition of an asset?

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10. Find depreciation expense in third year of an asset from using the following data:
Cost of asset= 25 million, residual value=2 million, reducing balance method
having rate of 20%
After two years’ company shifted its method to straight line with revised residual
value 3 million and remaining useful life 6 years.

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11. Find depreciation expense for the year ended 31 December 2021 from using the
following data:
Cost of asset= 40,000 bought on 1 January 2015, residual value=10,000, useful
life=10 years, Company used Straight lines method for depreciation.
On 1 January 2021 company changes its total useful life from 10 to 8 years.

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12. In output method, Depreciation is charged on which basis?

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13. Which of the following cost is capitalized?

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14. A company purchased a machine for Rs. 25 million having residual value of 2
million. The machine is being depreciated @ 15% using reducing balance method.
After two years, the company decided to change its depreciation estimate to straight
line method. The remaining useful life of the machinery is 5 years with residual value
of Rs. 3 million. The NBV (net book value) at third year is approximately
Select the most appropriate answer

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15. A company purchased a manufacturing plant for Rs. 25 million having residual
value of 3 million. The plant is being depreciated at 20% per annum using reducing
balance method. What would be the NBV (net book value) of the plant after third
year?
Select the most appropriate answer

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16. A motor vehicle was purchased for Rs. 1,395,000 on 1 July 2018. It has an
estimated useful life of 5 year and residual value of Rs. 255,000. If the sum of digit
method is used for depreciation what will be the carrying amount of the motor
vehicle as at 30 June 2020

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17. A motor vehicle was purchased for Rs. 1,400,000 on 1 January 2019. It has an
estimated useful life of 3 years and residual value of Rs. 200,000. If the reducing
balance method is used for depreciation, what will be the carrying amount of the
motor vehicle as at 31 December 2021

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18. If a PPE remains idle for whole year, the depreciation expense for the year will
be NIL under:

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19. Which of the following is not an asset that falls under the scope of IAS 16 PPE?

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20. In depreciation formula, as we decrease useful life, depreciation value will

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21. If a property, plant and equipment remains idle for whole year, the depreciation
expense for the year will be NIL under:

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22. An entity acquired laptops in exchange of desktops which have carrying amount
of Rs. 450,000 and fair value of Rs. 300,000 at the date of exchange. The list price
of the laptops acquired is Rs. 600,000. The entity is also required to pay cash of Rs.
275,000 in this exchange transaction.
The laptops should be initially recognized at:

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23. A company purchased a delivery van for Rs. 1,700,000 with a salvage value of
Rs. 260,000 on 1 October 2021. It has an estimated useful life of 4 years. Using the
straight line method of depreciation, how much depreciation expense should the
company recognize on 31 December 2021?

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24. A company uses the reducing balance method to depreciate its fixed assets. the
annual rate is 20%. After three years the proportion of original cost still
underappreciated will be:

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25. ___________Is the amount at which an asset is recorded in the balance sheet,
after deducting any accumulated depreciation and accumulated impairment losses?

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26. If an asset remains idle throughout the year, then under sum of digit method, the
depreciation will be:

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27. The purpose of depreciation is to:

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28. What from the following is NOT a capital expense?

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29. Long term assets without any physical existence but, possessing a value are
called

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30. A machine is purchased for 45 Million and has a residual value of 4.5 million and
useful life of 8 years. Calculate the rate of depreciation and amount of depreciation
for 1st year.

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