Scribd
Upload
7 views

Lecture - 6

The document discusses methods of depreciation, which is the decrease in value of physical assets over time. It outlines several methods including the Straight Line Method, Declining Balance Method, Sum-of-the-Years-Digits Method, Sinking-Fund Method, and Service Output Method, providing formulas and examples for each. The document also includes questions to test understanding of these concepts.

Uploaded by

Mona Sayed
Copyright
© © All Rights Reserved
Available Formats
Download as PDF, TXT or read online on Scribd
7 views

Lecture - 6

The document discusses methods of depreciation, which is the decrease in value of physical assets over time. It outlines several methods including the Straight Line Method, Declining Balance Method, Sum-of-the-Years-Digits Method, Sinking-Fund Method, and Service Output Method, providing formulas and examples for each. The document also includes questions to test understanding of these concepts.

Uploaded by

Mona Sayed
Copyright
© © All Rights Reserved
Available Formats
Download as PDF, TXT or read online on Scribd
You are on page 1/ 34

Chapter (6): Methods of Depreciation

Introduction:
Any equipment which is purchased today will
not work for ever. This may be due to wear and
tear of the equipment or obsolescence of
technology. Hence, it is to be replaced at the
proper time for continuance of any business.
The replacement of the equipment at the end
of its life involves money.
This must be internally generated from the earnings
of the equipment. The recovery of money from the
earnings of an equipment for its replacement
purpose is called depreciation fund since we make
an assumption that the value of the equipment
decreases with the passage of time. Thus, the word
“depreciation” means decrease in value of any
physical asset with the passage of time.
Methods of Depreciation:
There are several methods of accounting
depreciation fund. These are as follows:
1. Straight line method of depreciation.
2. Declining balance method of depreciation.
3. Sum of the years—digits method of depreciation.
4. Sinking-fund method of depreciation.
5. Service output method of depreciation.
These are now discussed in detail:
Straight Line Method of Depreciation
In this method of depreciation, a fixed sum is
charged as the depreciation amount
throughout the lifetime of an asset such that
the accumulated sum at the end of the life of
the asset is exactly equal to the purchase
value of the asset.
Here, we make an important assumption that inflation
is absent. Let:
P= first cost of the asset,
F= salvage value of the asset,
n = life of the asset,
= book value of the asset at the end of the period t,
= depreciation amount for the period t.
The formulae for depreciation and book value are as
follows: = (P– F)/n
=
Example.1:
A company has purchased an equipment whose first
cost is Rs. 1,00,000 with an estimated life of eight
years. The estimated salvage value of the equipment
at the end of its lifetime is Rs. 20,000. Determine the
depreciation charge and book value at the end of
various years using the straight line method of
depreciation.
Solution:
P= Rs. 1,00,000
F= Rs. 20,000
n = 8 years
= (P– F)/n
= (1,00,000 – 20,000)/8 = Rs. 10,000
In this method of depreciation, the value of
is the same for all the years.
The calculations pertaining to for different
values of tare summarized in Table.1.
Table.1 and Values under Straight line Method of Depreciation:
End of year (t) Depreciation Book value( = – )
0 10,000 100,000
1 10,000 90,000
2 10,000 80,000
3 10,000 70,000
4 10,000 60,000
5 10,000 50,000
6 10,000 40,000
7 10,000 `30,000
8 10,000 20,000
If we are interested in computing and for a specific period (t),
the formulae can be used. In this approach, it should be noted that the
depreciation is the same for all the periods.
Example.2: Consider Example.1 and compute the
depreciation and the book value for period 5.
P= Rs. 1,00,000
F= Rs. 20,000
n= 8 years
= (P– F)/n = (1,00,000 – 20,000)/8
= Rs. 10,000 (This is independent of the time period.)
= P– t x (P– F)/n

= 1,00,000 – 5 x (1,00,000 – 20,000)/8 = Rs. 50,000


Declining Balance Method of Depreciation:
In this method of depreciation, a constant percentage
of the book value of the previous period of the asset
will be charged as the depreciation amount for the
current period. This approach is a more realistic
approach, since the depreciation charge decreases
with the life of the asset which matches with the
earning potential of the asset.
The book value at the end of the life of the asset may
not be exactly equal to the salvage value of the asset.
This is a major limitation of this approach. Let:
P= first cost of the asset,
F= salvage value of the asset,
n= life of the asset,
= book value of the asset at the end of the period t,
K= a fixed percentage, and
= depreciation amount at the end of the period t.
The formulae for depreciation and book value are
as follows:
=
= =
The formulae for depreciation and book value in
terms of Pare as follows:
While availing income-tax exception for
the depreciation amount paid in each
year, the rate K is limited to at the most
2/n. If this rate is used, then the
corresponding approach is called the
double declining balance method of
depreciation.
The calculations pertaining to
and for different values of tare
summarized in Table .2
using the following formulae:

Table .2: and according to Declining


Balance Method of Depreciation.
End of year (n) Depreciation (Dt) Book value (Bt)
0 100,000,00
1 20,000,00 80,000,00
2 16,000,00 64,000,00
3 12,800,00 51,200,00
4 10,240,00 40,960,00
5 8,192,00 32,768,00
6 6,553,60 26,214,40
7 5,242,88 20,971,52
8 4,194,30 16,777,22

If we are interested in computing Dt and


Bt for a specific period t, the respective formulae can
be used.
Example .3:
Consider Example .1 and calculate the
depreciation and the book value for
period 5 using the declining balance
method of depreciation by assuming 0.2
for K.
Solution:
P= Rs. 1,00,000
F= Rs. 20,000
n= 8 years
K= 0.2
Sum-of-the-Years-Digits Method of Depreciation:
In this method of depreciation also, it is
assumed that the book value of the asset
decreases at a decreasing rate.
If the asset has a life of eight years, first the sum
of the years is computed as:
Sum of the years = 1 + 2 + 3 + 4 + 5 + 6 + 7 + 8
= 36 = n(n+ 1)/2
The rate of depreciation charge for the first year is
assumed as the highest and then it decreases.
The rates of depreciation for the years 1–8,
respectively are as follows:
8/36, 7/36, 6/36, 5/36, 4/36, 3/36, 2/36, and 1/36.
For any year, the depreciation is calculated by
multiplying the corresponding rate of depreciation
with (P– F).
The formulae for and for a specific
year t are as follows:
Example. 4:
Consider Example .1 and demonstrate the
calculations of the sum-of-the-years-digits method
of depreciation.
Solution:
P= Rs. 1,00,000 F= Rs. 20,000 n= 8 years
Sum = n(n+ 1)/2 = 8 x 9/2 = 36
The rates for years 1–8, are respectively 8/36, 7/36,
6/36, 5/36, 4/36, 3/36, 2/36 and 1/36.
The calculations of and
for different values of tare summarized in
Table .3 using the following formulae:

Table .3: and under Sum-of-the-


years-digits Method of Depreciation
End of year (n) Depreciation (Dt) Book value (Bt)

0 100,000,00

1 17,777,77 82,222,23

2 15,555,55 66,666,68

3 13,333,33 53,333,35

4 11,111,11 42,222,24

5 8,888,88 33,333,36

6 6,666,66 26,666,70

7 4,444,44 22,222,26

8 2,222,22 20,000,04

If we are interested in calculating Dt and Bt for a specific


t, then the usage of the formulae would be better.
Example .5 Consider Example .1 and find the
depreciation and book value for the 5th year using the
sum-of-the-years-digits method of depreciation.
Solution:
P= Rs. 1,00,000 F= Rs. 20,000 n= 8 years

= 80,000 ×(3/8) × (4/9) + 20,000 = Rs. 33,333.33


Service Output Method of Depreciation:
In some situations, it may not be realistic to
compute depreciation based on time
period. In such cases, the depreciation is
computed based on service rendered
by an asset. Let:
P= first cost of the asset
F= salvage value of the asset
X= maximum capacity of service of the asset
during its lifetime.
x= quantity of service rendered in a period.
Then, the depreciation is defined per unit of
service rendered:
Depreciation/unit of service = (P– F)/X
Depreciation for x units of service in a period =
Example.6:
The first coat of a road laying machine is Rs.
80,00,000. Its salvage value after five years
is Rs. 50,000. The length of road that can be
laid by the machine during its lifetime is
75,000 km. In its third year of operation, the
length of road laid is 2,000 km. Find the
depreciation of the equipment for that year.
Solution:
P= Rs. 80,00,000 F= Rs. 50,000 X= 75,000 km
x= 2,000 km
Depreciation for x units of service in a period =
Depreciation for year 3 =

= Rs. 2,12,000
Questions
1. Define the following:
(a) Depreciation.
(b) Book value.
2. Distinguish between declining balance
method of depreciation and double
declining balance method of depreciation.
3. The Alpha Drug Company has just purchased a
capsulating machine for Rs. 20,00,000. The plant
engineer estimates that the machine has a useful life
of five years and a salvage value of Rs. 25,000 at the
end of its useful life. Compute the depreciation
schedule for the machine by each of the following
depreciation methods:
(a) Straight line method of depreciation.
(b) Sum-of-the-years digits method of depreciation.
(c) Double declining balance method of depreciation.
4. An automobile company has purchased a wheel
alignment device for Rs. 10,00,000. The device can
be used for 15 years. The salvage value at the end of
the life of the device is 10% of the purchase value.
Find the following using the double declining
balance method of depreciation:
(a) Depreciation at the end of the seventh year.
(b) Depreciation at the end of the twelfth year.
(c) Book value at the end of the eighth year.
5. A company has purchased a Xerox machine for Rs.
2,00,000. The salvage value of the machine at the end
of its useful life would be insignificant. The maximum
number of copies that can be taken during its lifetime is
1,00,00,000. During the fourth year of its operation, the
number of copies taken is 9,00,000. Find the
depreciation for the fourth year of operation of the
Xerox machine using the service output method of
depreciation.
Thank You

You might also like