DEPRECIATION

Dr. C.SRINIVAS
PROFESSOR
MECHANICAL DEPT
• Indirect Expenses
• These expenses are all the expenses,
except direct labour, direct material
and direct expenses, incurred in the
production of a product. It includes
repair of plant, power and water
charges, depreciation of building.
machines etc., taxes, insurances,
compensations, salaries of supervisors
administrative officers and sales agents
etc.
• Because there are several types of
expenses incurring on a product during a
year and it is difficult to have an account
of these expenses, therefore, to have a
systematic method of charging them,
these groups. expenses are categorized
into certain Classified statement of
different expanses. These are grouped in
following major categories: (i) Factory
expenses (iii) Sales expenses. (ii)
Administrative expenses
• As regards to on costs, some of them can
easily be known from various records:
Example of such on costs are, power charges,
insurance building rent, water charges, fuel
charges, etc. But some charges require good
knowledge and experience of the estimator.
These charges are discussed as under :
• (1) Depreciation (2) Obsolescence (3)
Interest on capital (4) Idleness (5) Repairs and
maintenance.
 1. DEPRECIATION
• Whenever any machine or equipment
performs useful work its wear and tear is
bound to occur. This can be minimized upto
some extent by proper care and maintenance
but can't be totally prevented. Its efficiency
also reduces with the lapse of time and at one
time it becomes uneconomical to be used
further and needs replacement by another
new one
• Therefore, we can say that, efficiency and
value of machine or asset constantly
reduces with the lapse of time during use,
which is known as "Depreciation". So
some money must be set aside yearly from
the profits, so that when the equipment
becomes uneconomical, it can be replaced
by the new one. Therefore, the initial cost
of machine plus installation charges +
repair charges-scrap value is charged
against overheads and is spread over the
machines useful life.
• For this purpose depreciation
account for the complete plant or
individual equipment is opened in
the Company's Books and known as
"Depreciation Fund" or "Sinking
Fund". This amount is deducted
yearly from the profits and kept
separate to have sufficient money for
replacement at the end of useful life.
• 2. OBSOLESCENCE Suppose a factory owner
purchases a machine for his production shop but
after some duration a better machine comes in the
market, whose production rate is very high and
much economical. Although the old machine is
efficient but becomes out of fashion and
uneconomical due to new better machine which
has come in the market. This is known as
'Obsolescence'. consideration of this factor is of
much importance and some money should also be
set aside from the profit for this cause. Hence
"Obsolescene" is the depreciation of existing
machinery or asset due to new and better
invention; design; equipment or process etc.
• It is very difficult problem for the estimator to provide for
the oncost on obsolescence, because no body can say
when a revolutionary change in the machine is coming in
the market. But it is a general practice to reduce the life
of a machine so as to account the effect of obsolescence.
Now the depreciation and obsolescence charges are
calculated on the reduced life.
• Suppose an estimator expects the life of machines as 20
years then the depreciation rate will be 100/20=5%. By
considering obsolescence also, its life may be taken as 15
years. Then the combined depreciation and obsoles-
cence charges will be 100/15=6.66% instead of 5%.
Therefore, the difference 6.66-5.00=1.66% will be
obsolescence charges
Types of Depreciation
 Types of Depreciation
• Depreciation can be classified as under:
• (a) Depreciation due to Wear and Tear.
when any machinery performs work, wear
and tear of certain components takes place,
although sufficient precautions are taken, i.e.
proper lubrication and cooling is done, which
minimize wear and tear but it cannot be totally
prevented. So the cost of replacement because of
this cause is the value of depreciation due to
wear and tear.
• (b) Depreciation due to "Physical decay". There
are certain items in a factory such as insulation
of material, furniture, electric cables, poles,
buildings, and vessels etc., which get decay,
because of climatic and atmospheric effect,
with the result the value of these articles goes
on reducing with the lapse of time. Although
every effort is made by the owner to keep them
in serviceable condition, even then because of
climatic and atmospheric effect, there will be
reduction in their costs. This reduction in cost is
depreciaton due to physical decay
• (c) "Accidental" Depreciation. Although, the
machine might have installed even few days back
and sufficient care is taken to prevent accident,
even then, accident may occur due to some wrong
operation, or some loose component or some
other cause, which may result in a heavy damage.
So the depreciation in machine caused due to this
reason is called accidental depre ciation.
• Now-a-days, to cover this most of the owners get
their equipment insured with the insurance
companies. For that, owners have to pay certain
premium yearly. The amount of premium depends
upon the estimated cost and life of equipment.
• (d) Depreciation due to "Deferred maintenance
and neglect". Every manufacturer supplies
certain instructions for the smooth and efficient
running of an equipment. For example, in the
case of a vehicle, a manufacturer gave the
following instructions: (i) Lubricating oil S.A.E. 30
should be used in engine. (ii) Oil should be
drained and new S.A.E. 30 oil should be refilled
after first 1000 km running and then every 5000
km. (iii) All the bolts and nuts should be re-
tightened after 5000 km running. (iv)
Decarbonising after 6000 km running and so on.
• Now if these instructions are not
properly followed because of neglect
the value of the vehicle may reduce
and depreciation in value because of
this, proper maintenance is not done
as recommended by manufacturer;
then is called depreciation due to
deferred maintenance and neglect.
• (e) Inadequacy. This is the form of functional
depreciation. Inadequacy means reduction in
efficiency of an asset. This may result first, even if
any equipment is servicing under proper
precautions and sufficient maintenance is provided,
there is fall in efficiency with the lapse of time.
• Secondly, suppose after 2-3 years of running the
demand of products manufactured by certain plant
is increased. But the plant cannot cope with the
increased demand. This needs additional money
either to replace with the bigger size machinery or
installation of the similar size more plants. This is,
what is called depreciation due to inadequacy.
• F. Depreciation by Obsolescence. Now-a-days
because of much scientific advancement,
there are large changes every day. If a new
machinery comes in the market, which is
much efficient because of new invention and
better design than the existing one
manufacturing same type of products and
product produced by the new equipment are
much cheaper and better than the existing
one, then the existing machinery has to be
replaced to withstand market competition.
 DEPRECIATION
What is depreciation?

• The word depreciation means a decrease in the value of any

physical asset with the passage of time.
• Depreciation means a decrease in the value of fixed assets
due to their use in business, the passage of time, or
obsolescence.
• The monetary value of an asset decreases over time due to use,
Types of assets
1. Current assets: Cash, customer balances, stock of material
and goods.
2. Fixed assets: Buildings, motor vehicles, furniture and
Assets are broadly divided into two categories-

 Fixed assets are also called long-term assets as

they provide benefits to the business for more
than one year.
 Most fixed assets lose their value over time as
these are put into use and as the years pass by.
 The fixed assets lose their usefulness due to the
arrival of new technologies and changes in
fashions etc.
 These are then generally required to be
replaced, as their useful life is over.
 Hence, the cost of a fixed asset is allocated
over its useful life.
 Each year’s allocation of the cost is charged
as depreciation expense for that year.
 Thus, depreciation is an expense charged
during a year for the reduction in the value of
fixed assets, arising due to:
• Normal wear and tear out of its use and
passage of time
• Obsolescence due to changes in
technology, fashion, taste, and other market
conditions
 Causes of
Depreciation
•Wear and tear
•Passage of time
•Depletion
•Obsolescence
•Accidents
•Permanent fall in price
Causes of Depreciation

• Wear and tear. Fixed assets are purchased for use in

business. Due to the constant use of fixed assets in
business for generating income, the value of such
assets is decreased. It is called ‘wear’ and ‘tear’. It is
the main cause of depreciation.

• Passage of time. Every asset has a certain economic

useful life. With the passage of time effective life of
the assets decreases. Certain assets like a lease, have
a certain legal life. With the passage of time, the value
of such assets goes down, even may not be actually
used in the business.
• Depletion. Depletion is a reduction of natural
resources. In the case of wasting assets, depletion is
also a cause of a fall in the value of assets like mines,
• Obsolescence. Due to the invention of new
technology, the assets based on old technology
may become obsolete and out of date.
• Accidents. Accidents may also cause a permanent
fall in the useful life as well as in the value of assets.
• Permanent fall in price. A permanent fall in the
market value of investments is recorded as
depreciation. Other assets are depreciated on the
basis of its useful life.
 CAUSES OF DEPRECIATION

The following are the causes for which depreciation is

provided in accounts.
i) Normal wear and tear
(a) Due to usage - Every asset has a life for which it can
run, produce, or give service. Thus, as we put the asset to
use its worth decreases. Like a decrease in the efficiency
and functioning of a bicycle due to its running and usage.
(b) Due to the passage of Time – As time goes by
elements of nature, wind, sun, rain, etc, cause physical
deterioration in the worth of an asset. Like a reduction in
the worth of a piece of furniture due to the passage of
time even when it is not used.
ii) Obsolescence
(a) Due to the development of improved
or superior equipment: Sometimes fixed
assets are required to be discarded before
they are actually worn out due to either of
the above reasons. The arrival of superior
equipment and machines etc. allows the
production of goods at lower cost. This
makes older equipment worthless as the
production of goods with their use will be
costlier and non-competitive. For example,
Steam engines became obsolete with the
arrival of diesel and electric locomotives.
(b) Due to changes in fashion, style,
taste, or market conditions :
Obsolescence may also result from a
decline in demand for certain goods and
services with a change in fashion, style,
taste, or market conditions. The goods and
services that are no longer in vogue lead to
a decrease in the value of the assets that
were engaged in their production – like
factories or machines meant for making old-
fashioned hats, shoes, furniture, etc. Loss in
the value of fixed assets for such reasons is
called obsolescence and is also charged as
Objectives of Providing Depreciation
• To ascertain the true and fair profits
• To show the asset at its proper value
• To make arrangements for funds for
the replacement of the fixed asset
• Ascertaining accurate cost of
production
• To comply with legal provisions
• To avail tax benefits
 OBJECTIVES
The following are the objectives of charging depreciation
of Assets:
i) To show the True Financial Position of the Business: As
Fixed Assets have some effective working life during which
it can be economically operated. Depreciation is the
gradual loss in the value of fixed assets. If depreciation is
not provided, profit and loss A/c will not disclose the true
profit made during the accounting period. At the same,
the Balance Sheet will not disclose the true Financial
position as Fixed assets appearing in the Balance Sheet
will be overvalued. If depreciation is ignored year after
year, ultimately when the asset is worn out, the proprietor
will not be in a position to continue the
business smoothly.
ii) To retain funds in the business for
replacement of the asset: Net profit is the
yield of the capital invested by the proprietor
and may be wholly withdrawn by him in the
form of cash. If depreciation is provided, this
figure of net profit will be reduced and the
amount withdrawn by the proprietor will also
be decreased. As such the cash equivalent to
the change for depreciation will be left over
by the business. This accumulated amount
will enable the proprietor to replace a new
asset.
 FACTORS AFFECTING THE
DEPRECIATION
The following are the factors that affect the
amount of depreciation of an asset.
i) Cost of Asset: Cost of asset is the
purchase price of the asset and includes all
such expenses that are incurred before it is
first put to use. For example expenses on
loading, carriage, installation, transportation,
and unloading of the asset up to the point of
its location, expenses on its erection and
assembly.
ii) Useful Life of the Asset: Useful life is
the expected number of years for which the
asset will remain in use.
iii) Scrap Value: Scrap value is the
residual value at which the asset could be
sold to a scrap dealer (Kabari) after its
useful life.
iv) Depreciable value of the asset:
Depreciable value is the cost of asset
minus the scrap value.
Factors affecting the amount of depreciation
•Assessment of depreciation and the amount
to be charged in respect thereof in an
accounting period are usually based on the
following three factors:
•Historical cost or other amount substituted
for the historical cost of the depreciable asset
when the asset has been revalued;
•Expected useful life of the depreciable asset;
and
•Estimated residual value of the depreciable
Factors determining depreciation
•Actual cost of asset
•Estimated scrap value
•Estimated working life of an asset
•Interest on investment
•Repairs
•Statutory provision
Methods of Depreciation
• There are different methods of providing depreciation.
• Each method has its own advantages and disadvantages.
• Different methods of providing depreciation are suitable for
different assets depending upon the nature and type of the
asset.
The methods of depreciation are:
1. Straight line method (Fixed installation method or
Original cost method)
2. Diminishing balance method (Declining balance method
or Reducing balance method or Written down value
method)
3. Sum of the years-digits method (Annuity method)
1. Straight line method (SLM)
In this method, the property is assumed to lose
value by a constant amount every year, and thus
a fixed amount of original cost is deducted every
year.
So that only scrap value is left at the end of the
useful period.
Under this method, the amount of depreciation is
uniform from year to year.
That is why this method is also called, the ‘Fixed Installation
Method’ or ‘ Original Cost Method’.
Out of the cost of the asset, its scrap value is deducted and it
is divided by the number of years of its estimated life.
The calculation of the rate of depreciation under the
straight-line method is as follows:
Let D = The annual depreciation,
C = Original cost or fixed cost of the asset.
S = Scrap value or salvage value of the asset,
n = Life of asset in years,
B = Book value of the asset after m years.

Annual Depreciation, D = = ;
Rate of depreciation = =
Merits of Straight-Line Method of Depreciation
1. Simplicity :
 Calculation of depreciation under this method is very simple
and therefore the method is widely popular.
 Once the amount of depreciation is calculated, the same
amount is written off as depreciation each year.
 Hence this method is simple and calculations are easier to
understand.
2. Asset is completely Written Off:
 Under this method, the book value of an asset is reduced to
net scrap value or zero value.
 In other words, in the books of accounts, the value of the
asset at the end of its useful life is equal to zero or its
residual value.
3. No window dressing.
• A fixed amount of depreciation is charged to the profit and
loss account every year. The effect of depreciation on profit is
equal and chances of manipulating profits are very low.
Demerits of the Straight-Line Method of Depreciation
• Unequal charge against income. The total charge
on account of using fixed assets comprises
depreciation plus repairing charges. Under SLM,
depreciation charged is fixed but repair charges go
on increasing year by year. Thus, the total charge
against income goes on increasing.
• Interest factor ignored. When a fixed asset is
purchased, the amount is invested permanently. If
the amount would have been invested outside the
firm, the interest would have been received on it.
Thus, the loss of interest is ignored, while
calculating depreciation.
• Undue pressure in later years. Under the fixed
installment method, the total charge against the
income goes on increasing year by year, while the
efficiency of an asset goes on decreasing. Thus, the
• Difficulty in Computation: When there are
various machines having different life spans, the
computation of depreciation becomes complicated
because the depreciation on each machine will have
to be calculated separately for each asset.
• Unsuitable for long-term assets. The assets
having long life requires several addition and
extensions from time to time. This method is not
suitable for them. It is also not suitable for assets
having heavy investment.
• No provision of funds for replacement. In this
method amount charged as depreciation is not
invested outside the business. It is retained in the
business and becomes a part of working capital.
When the asset becomes useless, the firm has to
face the problem of funds for the replacement of
the asset as it becomes difficult to withdraw an
2.Diminishing balance
method(Written down value
method)
 Under this method, depreciation is charged at a
fixed rate on the opening balance of the asset.
 This balance is reduced every year.
 Thus, the amount of depreciation also goes on
reducing year after year. While calculating the
depreciation in this method, the salvage value of
the asset is not taken into consideration.
 Thus, it is clear that under this method value of an
asset as well as the depreciation charged goes on
reducing every year.
 Due to this reason this method is also
called the “Reducing Instalment
Method.”
 The value of the asset left after
charging depreciation is called,
written down value. Due to this
reason, this method is called “Written
Down Value Method.”
 The rate of depreciation charged
under this method is higher than that
charged in the straight-line method.
Calculation of depreciation rate under diminishing
balance method:

=1- 100

Depreciation, reducing balance method :

Where s is the scrap value of the asset
C is the cost of the asset and
n is the useful life of the asset.
Advantages of Diminishing balance Method of Depreciation
Disadvantages of Diminishing balance Method of
Depreciation
The following are the disadvantages of this method.
Difficulty in determining the rate of
depreciation. It is very difficult to calculate a
rate of depreciation which will depreciate the
asset completely. Even if an asset becomes
obsolete and useless, the books shows some
balance.
Interest factor ignored. Like, the fixed
instalment method, interest factor is ignored in
diminishing balance method also.
No provision of funds for replacement.
Like the fixed instalment method, the amount
Asset cannot be completely written off.
Under diminishing balance, the value of
asset is not completely written off. The asset
account continues in the books, may be a
very small amount, even after the asset
becomes obsolete and useless.
No information about original cost and
accumulated depreciation. Under this
method the asset account shows the
reduced balance after charging depreciation.
Assets are grouped on the basis of rate of
depreciation and it becomes difficult to know
the original cost and accumulated
distinction between straight line method and diminishing balance method
 SUM-OF-THE-YEARS’-DIGITS
3.

METHOD
 This is another accelerated depreciation
method that was introduced by the US
Internal Revenue Code of 1954.
 Under this method, the costless salvage
value is charged to different years in the
ratio of capital blocked in the asset in the
year concerned to the total blockage over
its life.
 This method assumes that the depreciation
of the first year should be the highest as no
portion of the capital has been recovered till
then and the depreciation of the last year
should be the least of all years because a
Since depreciation is measured
according to the volume of
blocked investment, its
magnitude is expressed by means
of a fraction.
The denominator of the fraction,
which remains constant is the
total of the digits representing
the useful life of the asset.
The numerator, on the other
hand, measures the blockage of
Formula
Let,
Dt = Depreciation in period t
C = Cost of the asset
S = Estimated salvage value of the
asset
n = Estimated life of the asset in
years
t = The year of life of the asset (i.e. 1
is the first year, 2 is the second year,
and so on)

The formula for measuring depreciation for

a particular year is:
3. SUM-OF-THE-YEARS’-DIGITS METHOD
 This is another accelerated depreciation method that
was introduced by the US Internal Revenue Code of
1954.
 Under this method, the costless salvage value is
charged to different years in the ratio of capital
blocked in the asset in the year concerned to the
total blockage over its life.
 This method assumes that the depreciation of the
first year should be the highest as no portion of the
capital has been recovered till then and the
depreciation of the last year should be the least of
all years because a major portion of the invested
capital has been already recovered.
 Since depreciation is measured according to the
volume of blocked investment, its magnitude is
expressed by means of a fraction.
 The denominator of the fraction, which remains
Merits of sum-of-the-years’-digits method
The merits of the method are as follows:

1. In this method, the quantum of depreciation is greater in the earlier years

in comparison with the later years because the benefits received from the
use of the asset are greater in the early years than in the later years.
2. In the earlier year repairs are light but depreciation is heavy but in the
later year, as the asset gets older the repairs are heavy but depreciation is
light. So depreciation plus repairs will more or less constant every year
and the charge to Profit and Loss Account should be uniform.
3. If the asset is retired earlier than anticipated as result of unforeseen
obsolescence, the loss upon retirement will be less than if straight line
depreciation were used, because, asset are recovered at a higher rate in
the earlier years where as only a small fraction remains left for recovering
them in the later years.
4. For tax accounting purposes, these methods have a clear advantage over
the straight line method. The larger deductions in the early years mean
that at the very least tax payments are postponed for a considerable
period. On the other hand, this method gives a tax postponement with the
5. In this method nearly three-fourth of total depreciation is charged within half of
its life. That means three-fourth of blocked investment recovered within short
span.
6. This method is very simple to understand and simple to calculate.
7. This method is preferable for assets with services Uses of eight years or more.
Demerits of sum-of-the-years’-digits method

Although this method is considered to be a great immolation in the field of

depreciation accounting but it has some disadvantages which are given below:

8. This method also ignored the cost of capital on invested fund.

9. In the earlier year greater depreciation is charged at a result less profit is
available for declaring dividend in the earlier year. This may create serious
problem for organisation to attract new investor. As dividend is one of the
motivating factors for investment. Again more depreciation in the earlier year
may resultant the high cost of production in the competitive market.
 QUESTIONS FROM UNIT II
QUESTIONS FROM FINANCE MANAGEMENT
1. Discuss the objectives and functions of financial management.
2. (a). Differentiate between simple interest and compound interest
(b). Explain the need for a cash flow diagram.
3. Explain the cash flow diagram with a neat sketch.
QUESTIONS FROM ECONOMIC EVALUATION OF ALTERNATIVES
1. Explain the economic evaluation of the alternative with a neat diagram.
2. Differentiate between the present worth method and future worth method
3. (a). Compare and contrast the present worth method with a future worth method with
a suitable
examples.
(b). Compare and contrast the Annual equivalent method with the Rate of return
method
with suitable examples.
4. Opening a new centre requires some amount for a company. They expect that the
centre will generate net annual cash flows of 75,000 a year for 10 years. The rate of
interest is at 15%.
Calculate the present capital you need. Mar’ 22 EE415 HSEL03 R18
5. (a). Explain in detail about present and future worth methods with suitable examples.
(b). Explain the annual equivalent method with a suitable example.
6. Explain future worth method with example.
 Questions on Depreciation Questions from Unit 2
Contd…..
1. (a). Explain the different types of depreciation and the importance of depreciation amount in industry
practice.
(b). The asset has a useful life of 10 years and its cost is Rs. 10,000. The rate at which an asset is
depreciating is 10% per
annum. At the end of its life, what will be the scrap value of the asset?Dec’ 2021 EC415 R18 Sept’ 2023
ME325 HSEL03 R18
2. (a). Elucidate the different methods of calculating depreciation.
(b). An equipment costs Rs. 1,50,000. At the end of its economic life of five years, its salvage value is Rs.
5,00,000. Using
the Sum of the Years Digit Method of Depreciation, What will be its book value for the third year? March
2022 EC415 R18
3. A company purchased a factory machine for Rs. 51,000 on January 1, 2015. The machine is expected to
have a salvage value of Rs. 6,000 at the end of its 5-year useful life. During its useful life, the machine is
expected to be used for 5,000 hours. The machine was used as under: Prepare Schedule of
Depreciation based on straight-line method. Oct’ 22 ME325 HSEL03 R18
4. (a). Discuss in detail different types of depreciation.
(b). Explain the procedure involved in the calculation of depreciation by the
following methods (i) Straight line (ii) Declining balance
5. (a). Discuss in detail the concept of depreciation.
(b). An individual purchased an apartment building for use in a business for $3,00,000 in 2004. The
building was sold for
$3,50,000 in October 2012. Depreciation taken was $84,000. If there is no other section 1231 gain(loss)
during the year,
6. (a) What is Depreciation? Discuss the need for Depreciation.
(b). A firm purchased machinery at Rs. 50,000 on 1/1/93. On 1/7/93 it bought additional machinery of Rs.
10,000
and spent Rs.1,000 on its erection. The accounts are closed on 31st December every year. Assuming annual
depreciation is 10%. Calculate depreciation for 5 years under the reducing balance method. Mar’22 EE415
R18
7. Discuss in detail about methods of depreciation.
8. What is depreciation? Explain the straight-line method of depreciation.
9. A machine was purchased for Rs. 20,000. The estimated salvage value at the end of 15 years of the
estimated useful
life of the machine was Rs.8,000. Determine the depreciation fund accrued at the end of 4 years and 6
months of
its useful life. Dec’ 21 ME325 HSEL03 R18
10. (a). Explain the diminishing balance method of depreciation.
(b). A milling machine is purchased for Rs. 12000 and the expenses incurred on its installation are Rs. 500.

The assumed serviceable period and salvage value are 12 years and Rs.2000 respectively. By diminishing
balance
method, determine the fixed percentage by which the cost of the machine is reducing every year. Also,
calculate
the depreciation fund after one year. July 21 ME325 HSEL03 R18
11. Explain the causes of depreciation.
12. Explain the different types of depreciation and the importance of depreciation amount in industry practice.