Depreciation Study

8/6/2019 Depreciation Study

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The Institute of Technology and Management1

Assignment

On

A STUDY OF DEPRECIATION

A Report submitted in partial fulfillment of the requirements for the award of the degree

of

MASTER OF BUSINESS ADMINISTRATION

TO

The Institute of Technology and Management

(Affiliated to Southern New Hampshire University, USA)

BY

Subroto Banerjee Roll. No JHL2010XMBA2P004

Under the guidance of.

Prof. Ravi Kumar

DECEMBER 2010


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Contents

SLNo. Headings

PageNumber

1 About depreciation 3

2 Depreciation in Economics 3

3 Definitions of Depreciation 3

4 Why Depreciation 4

5 Accounting concepts related to Depreciation 4

6 Methods of calculating depreciation 5

6.1 Depreciation Methods based on passage of time 6

6.1.1. Straight-line method 6

6.1.2. Written down Value method/Declining-balance method (or Reducing balancemethod) 7

6.2. Activity based depreciation methods 8

6.2.1. Sum-of-years' digits method 8

6.2.2. Units-of-production depreciation method 8

6.2.3. Units of time depreciation 8

6.3. Group depreciation method 8

6.4. Composite depreciation method 8

7 Depreciation Under Income Tax Act and Companies Act. 9

8 Computation under the Companies Act 10

9 Major features of Indian Accounting Standard on Depreciation (AS6) 109.1. Depreciable Assetts to which AS6 applies 10

9.2. Assets to which AS6 does not Apply 10

9.3. Disclosure requirements of AS6 11

10 Comparing Depreciation Methods and conclusion. 11


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1. About Depreciation:

Depreciation is a term used in accounting, economics and finance with reference to the fact that assetswith finite usefulness lose value over time.

Let us consider an asset that we know will lose value as time passes: a computer. When we purchase acomputer we are aware that we will, in all likelihood, need to purchase another in (say) 5 years. Althoughwe tend to think of the cost being lumped at the beginning, it would be more appropriate to spread to costover its useful life. We can deduce that a computer bought for Rs. 25000 in fact costs Rs. 5000 per year,assuming it is worth nothing after year 5.

Depreciation further refers to two very different but related concepts:

1. Decline in value of assets, and

2. Allocation of the cost of assets to periods in which the assets are used.

The former affects values of businesses and entities. The latter affects net income. Generally the cost isallocated, as depreciation expense, among the periods in which the asset is expected to be used. Such

expense is recognized by businesses for financial reporting and tax purposes. Methods of computingdepreciation may vary by asset for the same business. Methods and l ives may be specified in accountingand/or tax rules in a country. Several standard methods of computing depreciation expense may be used,including fixed percentage, straight line, and declining balance methods. Depreciation expense generallybegins when the asset is placed in service. Example: a depreciation expense of 100 per year for 5 yearsmay be recognized for an asset costing 500.

2. Depreciation in Economics:

In economics, depreciation is the gradual and permanent decrease in the economic value of the capitalstock of a firm, nation or other entity, either through physical depreciation, obsolescence or changes inthe demand for the services of the capital in question. If capital stock is C0 at the beginning of a period,investment is I and depreciation D, the capital stock at the end of the period, C1, is C0 + I - D.

3. Definitions of Depreciation:

Depreciation is a measure of the wearing out, consumption or other loss of value of a depreciable assetarising from use, effluxion of time or obsolescence through technology and market changes. Depreciationis allocated so as to charge a fair proportion of the depreciable amount in each accounting period duringthe expected useful life of the asset. Depreciation includes amortisation of assets whose useful life is

predetermined (ICAI)


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The gradual reduction of an asset's value. It is an expense, but because it is non-cash, it is ofteneffectively a tax write-off; that is, a person or company usually may reduce his/her/its taxable income bythe amount of the depreciation on the asset. Because there are many different ways to accountdepreciation, it often bears only a rough resemblance to the asset's useful life. This may further benefitthe company as they may continue to use the asset tax-free after its value has technically depreciated tonothing. (Farlex Financial Dictionary)

4. Why Depreciation:

There are three reasons. Firstly, the use of any asset erodes its value due to wear and tear or due to thepassage of time, or due to obsolescence resulting from a change in technology. The cost of an assetshould be written down to reflect its correct value. Since assets like plant and machinery, buildings, andfurniture and fixtures are used to generate revenue, the reduction in their values represents a charge,which is debited to the profit and loss account to arrive at the correct profits of the year.

Secondly, depreciation is a non-cash expenditureit does not involve an outflow of cash from thebusiness, and therefore results in the accumulation of funds. But since it is debited to the profit and lossaccount like any other expense, it reduces the taxable profits and, therefore, the burden of tax. It acts asa source of internal financing for replacement of an asset at the end of its useful life.

Further providing for depreciation is now is mandatory as per law of almost all countries.

5. Accounting concepts related to Depreciation:

In accounting, it is treated as an expense recorded to allocate a tangible asset's cost over its useful life.As depreciation is a noncash expense, it increases free cash flow while decreasing reported earnings.Alternatively the same term is also used for a decrease in the value of a particular currency relative toother currencies.

In determining the profits (net income) from an activity, the receipts from the activity must be reduced byappropriate costs. One such cost is the cost of assets used but not currently consumed in the activity.[1]Such costs must be allocated to the period of use. The cost of an asset so allocated is the differencebetween the amount paid for the asset and the amount expected to be received upon its disposition.Depreciation is any method of allocating such net cost to those periods expected to benefit from use ofthe asset. The asset is referred to as a depreciable asset. Depreciation is a method of allocation, notvaluation.[2]

Any business or income producing activity[3] using tangible assets may incur costs related to thoseassets. Where the assets produce benefit in future periods, the costs must be deferred rather than treatedas a current expense. The business then records depreciation expense as an allocation of such costs for

financial reporting. The costs are allocated in a rational and systematic manner as depreciation expenseto each period in which the asset is used, beginning when the asset is placed in service. Generally thisinvolves four criteria:

cost of the asset,

expected salvage value of the asset,

estimated useful life of the asset, and


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a method of apportioning the cost over such life.[4]

Cost generally is the amount paid for the asset, including all costs related to acquisition.[5] In somecountries or for some purposes, salvage value may be ignored. The rules of some countries specify livesand methods to be used for particular types of assets. However, in most countries the life is based onbusiness experience, and the method may be chosen from one of several acceptable methods.

When a depreciable asset is sold, the business recognizes gain or loss based on net basis of the asset.This net basis is cost less depreciation.

Accounting rules also require that an impairment charge or expense be recognized if the value of assetsdeclines unexpectedly.[6] Such charges are usually nonrecurring, and may relate to any type of asset.

Depletion and amortization are similar concepts for mineral assets (including oil) and intangible assets,respectively.

Depreciation expense does not require current outlay of cash. However, the cost of acquiring depreciableassets may require such outlay. Thus, depreciation does not affect a statement of cash flows, but cost of

acquiring assets does.

Depreciation is generally recognized under historical cost systems of accounting. Some proposals for fairvalue accounting have no provision for systematic depreciation expense.

Depreciation expense is recorded in the income statement of a business. The impact of accumulateddepreciation expense is generally recorded in a separate account and disclosed in financial statementsunder most accounting principles. Generally, the net cost in excess of accumulted depreciation isdisclosed in the presentation of assets and liabilities (balance sheet) of a business.

6. Methods of calculating depreciation:

There are several methods for calculating depreciation, generally based on either the passage of time orthe level of activity (or use) of the asset.


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6.1. Depreciation Methods based on Passage of Time:

Straight-line depreciation

Straight-line depreciation is the simplest and most-often-used technique, in which the company estimatesthe salvage value of the asset at the end of the period during which it will be used to generate revenues(useful life) and will expense a portion of original cost in equal increments over that period. The salvagevalue is an estimate of the value of the asset at the time it will be sold or disposed of; it may be zero oreven negative. Salvage value is also known as scrap value or residual value.

6.1.1. Straight-line method

For example, a vehicle that depreciates over 5 years, is purchased at a cost of US$17,000, and will havea salvage value of US$2000, will depreciate at US$3,000 per year: ($17,000 $2,000)/ 5 years = $3,000annual straight-line depreciation expense. In other words, it is the depreciable cost of the asset divided bythe number of years of its useful life.

This table illustrates the straight-line method of depreciation. Book value at the beginning of the first yearof depreciation is the original cost of the asset. At any time book value equals original cost minusaccumulated depreciation.

Bookvalue at

beginningof theyear

Depreciationexpense

Accumulateddepreciation

Book valueat the end of

the year

$17,000(originalcost) $3,000 $3,000 $14,000

$14,000 $3,000 $6,000 $11,000

$11,000 $3,000 $9,000 $8,000

$8,000 $3,000 $12,000 $5,000

$5,000 $3,000 $15,000

$2,000(scrapvalue)

If the vehicle were to be sold and the sales price exceeded the depreciated value (net book value) thenthe excess would be considered a gain and subject to depreciation recapture. In addition, this gain abovethe depreciated value would be recognized as ordinary income by the tax office. If the sales price is ever


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less than the book value, the resulting capital loss is tax deductible. If the sale price were ever more thanthe original book value, then the gain above the original book value is recognized as a capital gain.

6.1.2. Written down Value method/Declining-balance method (or Reducing balance method)

Depreciation methods that provide for a higher depreciation charge in the first year of an asset's life andgradually decreasing charges in subsequent years are called accelerated depreciation methods. Thismay be a more realistic reflection of an asset's actual expected benefit from the use of the asset: manyassets are most useful when they are new. One popular accelerated method is the declining-balancemethod. Under this method the book value is multiplied by a fixed rate.

Annual depreciation = depreciation rate * book value at beginning of year

The most common rate used is double the straight-line rate. For this reason, this technique is referred toas the double-declining-balance method. To illustrate, suppose a business has an asset with $1,000original cost, $100 salvage value, and 5 years useful life. First, calculate straight-line depreciation rate.Since the asset has 5 years useful life, the straight-line depreciation rate equals (100% / 5) 20% per year.With double-declining-balance method, as the name suggests, double that rate, or 40% depreciation rate

is used. The table below illustrates the double-declining-balance method of depreciation.

Book value atbeginning of

yearDepreciation

rateDepreciation

expenseAccumulateddepreciation

Bookvalue atend ofyear

$1,000(originalcost) 40% $400 $400 $600

$600 40% $240 $640 $360

$360 40% $144 $784 $216

$216 40% $86.40 $870.40 $129.60

When using the double-declining-balance method, the salvage value is not considered in determining theannual depreciation, but the book value of the asset being depreciated is never brought below its salvagevalue, regardless of the method used. The process continues until the salvage value or the end of theasset's useful life, is reached. In the last year of depreciation a subtraction might be needed in order toprevent book value from falling below estimated Scrap Value.

Since double-declining-balance depreciation does not always depreciate an asset fully by its end of life,some methods also compute a straight-line depreciation each year, and apply the greater of the two. Thishas the effect of converting from declining-balance depreciation to straight-line depreciation at a midpointin the asset's life.

It is possible to find a rate that would allow for full depreciation by its end of life with the formula:

where N is the estimated life of the asset (for example, in years).


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6.2. Activity based depreciation methods:

Activity depreciation methods are not based on time, but on a level of activity. This could be miles drivenfor a vehicle, or a cycle count for a machine. When the asset is acquired, its life is estimated in terms ofthis level of activity. Assume the vehicle above is estimated to go 50,000 miles in its lifetime. The per-miledepreciation rate is calculated as: ($17,000 cost - $2,000 salvage) / 50,000 miles = $0.30 per mile. Eachyear, the depreciation expense is then calculated by multiplying the rate by the actual activity level.

6.2.1. Sum-of-years' digits method

Sum-of-years' digits is a depreciation method that results in a more accelerated write-off than straight line,but less than declining-balance method. Under this method annual depreciation is determined bymultiplying the Depreciable Cost by a schedule of fractions.

depreciable cost = original cost salvage value

book value = original cost accumulated depreciation6.2.2. Units-of-production depreciation method

Under the units-of-production method, useful life of the asset is expressed in terms of the total number ofunits expected to be produced:

Depreciation stops when book value is equal to the Scrap Value of the asset. In the end the sum ofaccumulated depreciation and scrap value equals to the original cost.

6.2.3. Units of time depreciation

Units of time depreciation is similar to units of production, and is used for depreciation equipment used inmine or natural resource exploration, or cases where the amount the asset is used is not linear year to

year.

6.3. Group depreciation method

Group depreciation method is used for depreciating multiple-asset accounts using straight-line-depreciation method. Assets must be similar in nature and have approximately the same useful lives.

6.4. Composite depreciation method

The composite method is applied to a collection of assets that are not similar, and have different servicelives. For example, computers and printers are not similar, but both are part of the office equipment.Depreciation on all assets is determined by using the straight-line-depreciation method.

Depreciation expense equals the composite depreciation rate times the balance in the asset account

When an asset is sold, debit cash for the amount received and credit the asset account for its originalcost. Debit the difference between the two to accumulated depreciation. Under the composite method nogain or loss is recognized on the sale of an asset. Theoretically, this makes sense because the gains andlosses from assets sold before and after the composite life will average themselves out.


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To calculate composite depreciation rate, divide depreciation per year by total historical cost. To calculatedepreciation expense, multiply the result by the same total historical cost. The result, not surprisingly, willequal to the total depreciation Per Year again.

7. Depreciation Under Income Tax Act and Companies Act:

Under Income Tax Act, Depreciation is allowed as a deduction while computing income under the headprofits and gains of business or profession and income from other sources. It is allowed on all fixedassets, save and except land. However, it is not allowed to a person earning salary income, even if heuses his car for commuting between his office and residence. Likewise, a person who owns houseproperty and lets it out cannot claim depreciation on the building while working out income from houseproperty. Income tax Act 1956 (India) recognizes only Written down value/Declining value method forcalculation of Depreciation.

Under the Income Tax Act. Depreciation is charged on the block of assets, and not on individual assets.The block represents the group of assets for which the same rate of depreciation applies. Under the

Income Tax Act, depreciation is computed using the written-down value method, except in case of anundertaking engaged in generating and distributing power.

While the actual cost of new asset is added to the block, the amount received on the sale of an asset(including scrap value) is reduced from it. Depreciation at the prescribed rates is computed on the written-down value of the block as on the last day of the financial yeartypically 31 March. This value is theaggregate cost of acquisition of the assets in a block as reduced by the depreciation charged in previousyears.

Condition for allowability

The following fundamental conditions need to be fulfilled to claim depreciation:

(1) The person claiming depreciation must be the owner or the co-owner of the asset;

(2) The asset must be(put to use) used in the business. If it is only partly used for business, depreciationwould be allowable on pro-rata basis;

(3) The asset must be used during the relevant financial year. If an asset is purchased and put to use forless than 180 days, that is, on or after the first day of October, only 50 per cent of the normal depreciationwill be allowed in that year. In the subsequent years however, the asset will be subject to depreciation atthe normal rates. So if an assessee buys a machine on 1 September 2009 but does not put it to usebefore 1 December 2009, he will be allowed depreciation at 7.5 per cent (instead of the normal 15 percent) for the financial year ended 31 March 2006. The crucial date is the date of putting the asset to use.

Suppose a Person purchased a Car on 31st March and put to use on same date even then he can claim50% of the depreciation of the full year i,e 7.5%(50% of 15%)

Download Depreciation rate for Income Tax Act and Companies ACT

Hire-purchase or lease?

In case an asset is purchased under a hire-purchase scheme, the depreciation is available to the hirer(the user of the asset). But if it is taken on lease, depreciation is allowed to the lessor (the financer).


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Hence, acquiring an asset on hire purchase is a better option than acquiring the same under lease, if theintention is to avail deduction for depreciation.

However, in a lease, although a lessee (the user) loses the benefit of depreciation, he can treat the leaserentals as an expense and reduce his taxable income accordingly. The decision to go in for lease or hirepurchase should depend on when the asset will be put to use, the rate of depreciation available on theasset and the cash flow position of the user, among others.

Claim of depreciation :optional /mandatory ?

Until 31 March 2001, a taxpayer could choose whether or not to claim depreciation. From 1 April 2001onwards, however, the claim of depreciation is no longer optional and the amount of depreciation will becompulsorily treated as deduction, irrespective of whether or not the claim has been made.

8. Computation under the Companies Act:

Depreciation is computed using either the straight-line method (where the amount of depreciation isuniform for all the years) or the written-down value method (where the amount of deprecation is highest in

the first year and goes on reducing year after year). The rates are as prescribed by companies Act.

9. Major features of Indian Accounting Standard on Depreciation (AS6):

Defenition as per AS6:

Depreciation is a measure of the wearing out, consumption or other loss of value of a depreciable assetarising from use, effluxion of time or obsolescence through technology and market changes. Depreciationis allocated so as to charge a fair proportion of the depreciable amount in each accounting period duringthe expected useful life of the asset. Depreciation includes amortisation of assets whose useful life is

predetermined

9.1. Depreciable Assetts to which AS6 applies:

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 toothers, or for administrative purposes and not for the purpose of sale in the ordinary course of business.

9.2. Assets to which AS6 does not Apply:

This Standard deals with depreciation accounting and applies to all depreciable assets, except thefollowing items to which special considerations apply:

1. Forests, plantations and similar regenerative natural resources;2. Wasting assets including expenditure on the exploration for and extraction of minerals, oils,

natural gas and similar non-regenerative resources3. Expenditure on research and development


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4. Goodwill and other intangible assets5. Live stock.

This standard also does not apply to land unless it has a limited useful life for the enterprise.

9.3. Disclosure requirements of AS6

1. The depreciation methods used, the total depreciation for the period for each class of assets, thegross amount of each class of depreciable assets and the related accumulated depreciation aredisclosed in the financial statements along with the disclosure of other accounting policies. Thedepreciation rates or the useful lives of the assets are disclosed only if they are different from theprincipal rates specified in the statute governing the enterprise.

2. In case the depreciable assets are revalued, the provision for depreciation is based on therevalued amount on the estimate of the remaining useful life of such assets. In case therevaluation has a material effect on the amount of depreciation, the same is disclosed separatelyin the year in which revaluation is carried out.

3. A change in the method of depreciation is treated as a change in an accounting policy and isdisclosed accordingly.

10. Comparing Depreciation Methods and conclusion:

For the sake of comparison an example is use to study, what the depreciation charges for the same$500,000 depreciable property would look like depending upon the method used (the chart is at thebottom of this page).

Depending upon which method is used by management, the bottom-line reported profits of a company

can vary greatly from year to year. The level of attention an investor must give on depreciation methoddepends upon the asset intensity of the business he or she is studying. The more asset-intensive anenterprise, the more attention depreciation should be given. In other words, one should understand thedepreciation philosophy behind every management team when one is examining businesses that requirehuge plants, factories, equipment, and capital expenditure investment. This is much less important whenanalyzing businesses that are not asset intensive, such as software companies, advertising agencies, orinsurance brokers.

If we have two asset intensive businesses, and they are using different depreciation methods, and / oruseful lives, we must adjust them so that they are on a comparable basis in order to get an accuratepicture of how they stack up against each other in terms of profit.

Some managements will report depreciation expense broken out as a separate line on the incomestatement, while others will be more clandestine about it, including it indirectly through SG&A expenses(for the deprecation costs of desks, for instance). Either way, one should be able to garner the informationeither through the income statement itself or going through the annual report.


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Conclusion:

As clear from the above table, in straight line method the profit will be higher in the initial years comparedto Declining balance method as the amount of depreciation is less. However with progressing years, theamount of depreciation in Straight line method will remain same while the depreciation amount underDeclining balance method will keep on decreasing hence the profit under Declining balance method inprogressive years will be higher.

From Investors/external stake holders point of view one has to discount for the method of depreciation

used to come to a sound judgment.

From Managements point of view the best method depends on the type of business, Objectives ofbusiness and the prevalent laws.

As per Indian Income Tax act 1956 only Declining balance method can be used for depreciating assets.While Indian Companies Act, allows both Declining balance and Straight line method of depreciation.

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