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Depreciation Methods and Principles

Jul 30, 2024,

Depreciation Methods and Principles

Lecture Overview

  • Lecture Name: Depreciation
  • Coverage: Approximately 5 marks in exams
  • Related to 11th-grade concepts but more complex in 12th grade

Definition of Depreciation

  • Reduction in the value of assets over time
  • Happens due to wear and tear, outdated technology, time passage

Reasons for Depreciation

  1. Wear and Tear: Physical usage decreases asset value (e.g., a used mobile phone).
  2. Obsolescence: Newer technology makes older technology outdated.
  3. Passage of Time: Time naturally reduces asset value.

Terms and Concepts

  • Tangible Assets: Depreciation (e.g., machinery).
  • Intangible Assets: Amortization (e.g., patents, goodwill).
  • Natural Resources: Depletion (e.g., coal mines, oil refineries).

Principles Governing Depreciation

  1. Matching Principle: Income should match expenses within the same period.
  2. Prudence Principle: Recognize losses as soon as they are foreseeable.
  3. Historical Cost Principle: Relates to the original cost of an asset.
    • Provisions for depreciation created to satisfy the historical cost principle.

Methods of Depreciation

  1. Straight Line Method (SLM)

    • Fixed amount of depreciation each year.
    • Depreciation = (Acquisition Cost - Scrap Value) / Useful Life
  2. Reducing Balance Method (RBM) / Diminishing Balance Method (DBM)

    • Higher depreciation in the earlier years, lesser in later years.
    • Depreciation calculated on the book value of the asset.
  3. Sum of the Digits Method (SOD)

    • Combination of SLM and RBM
    • Applicable in scenarios involving taxations

Cost of Acquisition

  • All expenses necessary to bring the asset to its usable state (e.g., purchase cost, import duty, transport costs).

Depreciation Accounts

  • Maintained to track depreciation for financial record-keeping.
  • Machine Account, Depreciation Account, and if applicable, Provision for Depreciation Account.

Calculation Example

  • If a machine is bought for тВ╣10,00,000 with a useful life of 5 years and no scrap value, it is depreciated as follows (SLM): тВ╣2,00,000 per year.

Asset Sale and Depreciation

  • When an asset is sold, its depreciation is calculated up to the sale date.
  • Any remaining book value vs. sale price reflects profit or loss.

Change in Depreciation Method

  • When switching from one method to another, recalculation is needed.
  • Recalculation ensures alignment with both current and new principles.

Special Depreciation Rules for Natural Resources

  • Depletion method used for mining and resource extraction industries.

Conclusion

  • Understanding depreciation methods is crucial for accurate financial reporting
  • Aligns with principles like matching, prudence, and historical cost
  • Helps in maintaining accurate records for valuation and tax purposes.