Lets look at what we did in the last class

We started with ACCOUNTING FOR DEPRECIATION

with Learning ObjectivesFixed Assets?Depreciation?Depreciation, Depletion, Amortization, and Impairment?Methods of Depreciation?Accounting for Depreciation Accounting Standards for DepreciationPresentation and Disclosures?

We tried to understand Fixed Assets Fixed Assets are long-term assets and usually, they have a life more than one year.

Fixed Assets are assets from which benefits are to accrue in future or it provides a stream of future benefits.

Fixed asset is an asset held with the intention of being used for the purpose of producing or providing goods or services and is not held for sale in the normal course of business.

We appreciated difference between Capital Expenditure vs Revenue Expenses

Cost of a fixed Assets includesAll those expenses necessary to incur to bring the asset into operation or to have its commercial operation.

The CUT-OFF point is the day of operation; before that all expenses related to an asset have to be capitalized; and after that all expenses have to be treated as Revenue Expenses related to the assets.

Accounting for Fixed Assets Purchase and Other ExpensesWe also learnt how to make entries for the purchase of fixed assets and other related expenses.

Where are they shown in the books of accounts?

Depreciation Please note that all fixed assets are subject to Depreciation except freehold land.

We tried to understand DepreciationDepreciation involves: allocating the cost of tangible assets to expense in a systematic and rational manner to periods expected to benefit from use of its depreciable assets.

We also tried to learn Why Depreciation? Fixed Assets are subject to depreciation and thus, depreciation needs to be provided so as to Ensure allocation of original cost of a fixed asset over its useful life;Ascertaining the true cost of operations; and Providing current valuation of fixed assets in the Balance Sheet.

Please disconnect in your mind Physical Depreciation and Accounting Depreciation.

Depreciation is not a SOURCE OF FUND.Two things are to be remembered about Depreciation

Now, lets move with Todays Agenda

To begin with, lets understand completely the nature of DepreciationAll fixed assets except land lose their capacity to provide services with passage of time. This loss of productive capacity is recognized as Depreciation Expense which is taken to Profit and Loss Account.#1

To begin with, lets understand completely the nature of DepreciationThe term Depreciation is used broadly in the following 2 senses:ECONOMIC DEPRECIATION: It is economic loss due to both physical deterioration and technological obsolescence. It may bePHYSICAL DEPRECIATIONFUNCTIONAL DEPRECIATION ACCOUNTING DEPRECIATION: It is a systematic allocation of cost basis over a period of time. It may beBOOK DEPRECIATIONTAX DEPRECIATION#2

Asset DepreciationDepreciationEconomic Depreciationthe gradual decrease inutility in an asset with use and timeAccounting depreciationThe systematic allocationof an assets value inportions over itsdepreciable lifeoftenused in engineeringeconomic analysisPhysicalDepreciationFunctionalDepreciationBook depreciationTaxDepreciation

Our next step isHow to determine the amount of depreciation each year so that it can be expensed to Profit and Loss Account?

What are the factors determining the depreciation expenses?

Depreciation Expense FactorsInitial CostResidual Value-Factor #1Factor #2Factor #3Factor#4: Method of determining the amount of Depreciation

Factors to Consider in Asset Depreciation Depreciable life (How long?)

Salvage value (Disposal value)

Cost basis (Depreciation basis)

Method of depreciation (How?)

Factor #1: Initial Cost Initial Cost is the cost of acquisition and including costs incurred to make the asset operational.

This cost is also called the HISTORICAL COST.

Factor #2: Residual Value or Salvage Value or Disposable Value Residual Value is the estimated amount that will be received at the time the asset will be sold or removed from the services.

It is managements best estimate of what an asset will be worth at the time of its disposable.

It is to be estimated at the time of determining the amount of depreciation.

Depreciable Amount or CostInitial cost minus resale value is called the Depreciable amount and it is this amount that has to be allocated as depreciation over the estimated life of an asset.

Depreciable Amount of a depreciable asset is its historical cost, or other amount substituted for historical cost in the financial statements, less the estimated residual value.

This amount is also known as DEPRECIATION BASE.

Factor #3: Estimated Life or Useful Life The assets estimated life is a measure of the service potential that the current user may expect from the asset.Many times, an asset physical life is taken as estimated life.Useful life is either (i) the period over which a depreciable asset is expected to be used by the enterprise; or (ii) the number of production or similar units expected to be obtained from the use of the asset by the enterprise.Useful life of an asset should be determined based on Expected use of the assetExpected physical wear and tearExpected commercial or technical obsolescenceLegal or other limits on the use of the asset.

Factor #4: Methods of Depreciation The following four depreciation methods are acceptable for Financial Accounting purposes:1. Straight-Line2. Units-of-Production3. Declining-Balance4. Sum-of-Years-DigitsStraight-line is far more widely used than other methods. Declining-balance and sum-of-years-digits are known as Accelerated Depreciation Methods.

Straight Line Method (SLM)The Straight-Line-Method provides for the same amount of depreciation expense for each year of useful life.

Straight-Line Method Cost estimated residual valueEstimated life= Annual depreciation

ExampleOriginal Cost....... Rs.24,000Estimated Life in years..5 yearsEstimated Residual Value...Rs.2,000

Straight-Line Method Rs. 24,000 Rs. 2,0005 years= Rs. 4,400 annual depreciation

Straight-Line Rate Rs.24,000 Rs.2,0005 years = Rs.4,400Rs.4,400 Rs.24,000= 18.3%

SLM Depreciation Amount and Book Value

Straight-Line MethodThe straight-line method is widely used by firms because it is simple and it provides a reasonable transfer of cost to periodic expenses if the asset is used about the same from period to period.

Units-of-Production MethodCost estimated residual valueEstimated life in units, hours, etc.= Depreciation per unit, hour, etc.

ExampleOriginal Cost....... Rs.24,000Estimated Life in hours.. 10,000Estimated Residual Value...Rs.2,000

Rs.24,000 Rs.2,000 10,000 hours= Depreciation per unit, hour, etc.= Rs.2.20 per hourUnits-of-Production Method

The units-of-production method is more appropriate than the straight-line method when the amount of use of a fixed asset varies from year to year.Units-of-Production Method

Declining-Balance MethodFormula to calculate the Depreciation Rate

DBM Depreciation Amount and Book Value

Physical Depreciation Physical Depreciation occurs from wear and tear while in use and from the action of the weather and environmental conditions.

Functional DepreciationFunctional Depreciation occurs when a fixed asset is longer able to provide services at the level for which it was intended, e.g., personal computer; that is to say, when an asset life is mentioned in terms of its usage, then we have a concept of Functional Depreciation.

Book Depreciation Book Depreciation is provided as per the prevailing accounting standards and the necessary law of land.

Tax Depreciation Tax Depreciation is provided as per the prevailing taxation laws.