DEPRECIATION

AR 1
SY 2016-17
Pol D. Medina

Depreciation
the systematic allocation of the depreciable

amount of an asset over its useful life.

a process of allocation and not of valuation.
the portion of the cost or other amount
substituted for cost allocated or charged as
expense during an accounting period.
The objective of depreciation is to have each
period benefiting from the use of the asset bear
an equitable share of the asset cost.

Depreciation in the
financial statements

Depreciation is an expense.
It may be a part of the cost of goods

manufactured OR an operating expense.

The depreciation charge for each period shall
be recognized as expense unless it is included
in the carrying amount of another asset.
Except for nonexhaustible land, all property

shall be depreciated on a systematic basis

over the useful life of the asset irrespective of
the earnings of the entity.

Depreciation period
Depreciation of an asset begins when it is

available for use when the asset is in the

location and condition necessary for it to be
capable of operating in the manner intended
by management.
Depreciation ceases when the asset is
derecognized.
Depreciation does not cease when the asset
becomes idle temporarily.

Temporary idle activity does not preclude

depreciating the asset as future economic benefits

are consumed not only through usage but also
through wear and tear and obsolescence.
If the asset is "classified as held for sale",
depreciation shall be discontinued.

Kinds of depreciation
Physical depreciation

Related to the depreciable asset's wear and tear and

deterioration over a period.
Physical depreciation may be caused by:
a. Wear and tear due to frequent use
b. Passage of time due to nonuse
c. Action of the elements such as wind, sunshine, rain or
dust
d. Accidents
e. Disease
Physical depreciation results to the ultimate retirement of
the property or termination of the service of the asset.

Functional or economic depreciation

Arises from obsolescence or inadequacy of the asset to
perform efficiently.
Obsolescence may arise from the following:
a. When there is no future demand for the product which the
depreciable asset produces.
b. When a new depreciable asset becomes available and the
new asset can perform the same function for substantially less
cost.
Inadequacy arises when the asset is no longer useful to the
firm because of an increase in the volume of operations.

Depreciable amount
The cost of an asset or other amount

substituted for cost, less its residual value.

Each part of an item of property, plant and

equipment with a cost that is significant in

relation to the total cost of the item shall be
depreciated separately.

Residual value
the estimated amount that an entity would currently

obtain from disposal of an asset, after deducting the

estimated cost of disposal, if the asset were already
of the age and condition expected at the end of its
useful life.
the expected worth of the asset in present pesos at
the end of its useful life.
The residual value of an asset shall be reviewed at
least at each financial year-end and if expectation
differs from previous estimate, the change shall be
accounted for as a change in an accounting estimate.

The residual value of an asset may increase to an

amount equal to or greater than the asset's carrying

amount.
If it does, the asset's depreciation charge is zero
unless and until its residual value subsequently
decreases to an amount below the asset's carrying
amount.
Depreciation is recognized even if the fair value of the
asset exceeds its carrying amount as long as the
residual value does not exceed the carrying amount.
Repair and maintenance of an asset do not negate the
need to depreciate it.

Useful life
either the period over which an asset is expected

to be available for use by the entity, OR

the number of production or similar units expected
to be obtained from the asset by the entity.
The useful life of an asset is expressed as follows:
a. Time periods as in years
b. Units of output or production
c. Service hours or working hours

Factors considered in determining

the useful life of an asset:

Expected usage of the asset Usage is assessed

by reference to the asset's expected capacity or

physical output.
Expected physical wear and tear This depends
on the operational factors such as the number of
shifts the asset is used, the repair and
maintenance program, and the care and
maintenance of the asset while idle.

Technical or commercial obsolescence This

arises from changes or improvements in

production, or change in the market demand for
the product output of the asset.
Legal limits for the use of the asset, such as the
expiry date of the related lease.

The useful life of an asset is defined in terms

of the asset's expected utility to the entity.

The estimation of useful life of an item of
property, plant and equipment is a matter of
judgment based on the experience of the
entity with similar assets.

SERVICE LIFE
The period of time

an asset shall be
used by an entity
Equivalent of useful
life

PHYSICAL LIFE
Refers to how long

the asset shall last

Methods of depreciation

1. Equal or uniform charge methods

Straight line
Composite method
Group method

2. Variable charge or use-factor methods

Working hours or service hours
Output or production method

3. Decreasing charge or accelerated or

diminishing balance methods
Sum of years' digits method
Declining balance method
Double declining balance method
150% declining balance method

4. Other methods
Inventory or appraisal method
Retirement method
Replacement method

Straight line method

the annual depreciation charge is calculated by

allocating the depreciable amount equally over the

number of years of estimated useful life.
a constant charge over the useful life of the asset.
The formula for the computation of the annual
depreciation following the straight line method is as
follows:
Cost minus residual value
Annual depreciation =
Life in years

Cost minus residual value equals depreciable

amount.
Depreciable amount multiplied by the annual
straight line rate of depreciation also gives the
amount of annual depreciation.
The straight line rate is determined by
dividing 100% by the life of the asset in years.
This method is adopted when the principal

cause of depreciation is passage of time.

The straight line approach considers

depreciation as a function of time rather

than as a function of usage.
The carrying amount is the amount at
which an asset is recognized in the
statement of financial position after
deducting any accumulated depreciation
and accumulated impairment loss.

Composite and group method

Large entities find it more practical to

compute depreciation by treating many

individual assets as though they were a single
asset.
The two methods of depreciating various
individual assets as a single asset are
composite method and group method.

 Under the composite

method, assets that are

dissimilar in nature or
assets that have
different physical
characteristics and vary
widely in useful life, are
grouped and treated as a
single unit.

Under the group

method all assets that

are similar in nature and
in estimated useful life
are grouped and treated
as a single unit.

The accounting procedure and the

method of computation for
the composite and group method are THE
SAME.

The average life and the composite or group

rate are computed, and the assets in the

group are depreciated on that basis.

Accounting procedures
Composite & group method
Depreciation is reported in a single

accumulated depreciation account. The

accumulated depreciation account is not
related to any specific asset account.
The composite or group rate is multiplied by
the total cost of the assets in the group to get
the periodic depreciation.

When an asset in the group is retired, no gain or loss

is reported. The asset account is credited for the cost

of the asset retired and the accumulated
depreciation account is debited for the cost minus
salvage proceeds.
When the asset retired is replaced by a similar asset,
the replacement is recorded by debiting the asset
account and crediting cash or other appropriate
account.
The composite or group rate is multiplied by the
balance of the asset account to get the periodic
depreciation.

Composite method
The composite life is determined by dividing

the total depreciable amount by total annual

depreciation.
The composite rate is determined by

dividing the total annual depreciation by the

total cost.
The accumulated depreciation account is not

related to any specific asset account in the

group.

Group method

Rule :

Depreciation should be limited to the remaining

carrying amount of the asset reduced by
salvage proceeds, if any.

Variable charge methods

The variable methods assume that

depreciation is more a function of use rather

than passage of time.
The life of the asset is considered in terms of
the output it produces or the number of hours
it works.
Depreciation is related to the estimated
production capability of the asset and is
expressed in a rate per unit of output or per
hour of use.

Two variable methods

Working hours method
Output or production method

These methods are adopted if the principal

cause of depreciation is usage.

The use of these methods is based

on the following:
Assets depreciate more rapidly if they are

used full time or overtime.

There is a direct relationship between
utilization of assets and realization of revenue.
If assets are used more intensively in
production, greater revenue is expected.

The variable methods are found to be appropriate

for assets such as machineries.
The major objection to these methods is that the
units of output or service hours which serve as the
basis of depreciation are in many cases difficult to
estimate.

Working hours method

Output or production
method

Under this method, a

depreciation rate per hour is
computed by dividing the
depreciable amount by the
estimated life in terms of
service hours.

The output or production

method results in a charge
based on the expected use or
output.

The depreciation rate per

hour is then multiplied by the
actual hours worked in one
period to get the depreciation
for that period.

Under this method, a

depreciation rate per unit is
computed by dividing the
depreciable amount by the
estimated life in terms of units
of output.

Decreasing charge or accelerated methods

The decreasing charge or

accelerated methods provide higher

depreciation in the earlier years and
lower depreciation in the later years
of the life of the asset.
These methods result in a decreasing
depreciation charge over the useful
life.

Rationale
New assets are generally capable of producing more

revenue in the earlier years than in the later years.

The cost of using an asset includes not only depreciation
but also repairs on such assets.
Such repair cost should be allocated over the life of the
asset on a systematic and uniform basis.
It has been observed that repairs tend to increase with the
age of the asset, hence repairs are small in the earlier
years and large during the later years.
Thus, following the decreasing charge method, the overall
effect would be a uniform charge because the decreasing
amount of depreciation and the increasing repairs will
tend to equalize each other.

Decreasing charge
methods
Sum of years' digits
Declining balance
Double declining balance

Sum of years' digits

Provides for depreciation that is computed by

multiplying the depreciable amount by a series of

fractions whose numerator is the digit in the life of the
asset and whose denominator is the sum of the digits in
the life of the asset.
The fractions are developed by getting the sum of the
digits in the life of the asset.
Life + 1
SYD = Life ()
2

Sum of half years' digits

If the life of the asset is 2 1/2 years, the procedure is to multiply the

life by 2 in order to get the life of the asset in half years.

Thus, the life of the asset in half years would be 5 (2 1/2 years x 2).
The sum of half years' digits would then be 15, computed as follows:
5+ 1
5()
2
The depreciation may be computed as follows:

First year
Two fractions: 5/15 and 4/15 (each fraction pertaining to
half year or six months)
Second year Two fractions: (3 /15 and 2/15)
Third year

One fraction: 1/15

Declining balance method

a fixed or uniform rate is multiplied by the declining

carrying amount of the asset in order to arrive at the

annual depreciation.
Because of the use of a fixed rate, this method is also
known as fixed rate on diminishing carrying amount
method.
The following formula is derived to get the fixed rate:
Rate = 1 - n Residual value Cost
The "n" in the formula is the life of the asset.

The nature of the method is such that the

value of the asset cannot be reduced to

zero and that the formula cannot be used
unless there is a residual value.
A residual value must always be assigned
to the asset.
In the absence of any residual value, a
nominal amount of P1 should be assumed.

Double declining balance method

The common application of the declining

balance method is the "double declining

balance."
The procedure for the double declining balance
method is the same as the declining balance
method in that a fixed rate is multiplied by the
declining carrying amount of the asset to arrive
at the annual depreciation.
The double declining balance method is an
approximation of the declining balance method.
The difference between the two lies in the
determination of the rate to be used.

Under the declining balance method, the fixed

rate is determined following a mathematical

formula.
But under the double declining balance method,
the straight line rate is simply doubled to get
the fixed rate.
The term "double declining balance" came to its
name because the straight line rate is doubled.
Thus, this method is also known as "200%
declining balance method".

Inventory method
Consists of merely estimating the value of

the asset at the end of the period.

The difference between the balance of the
asset account and the value at the end of the
year is then recognized as depreciation for the
year.
In recording depreciation, no accumulated
depreciation account is maintained.

The depreciation is credited directly to the

asset account.
This depreciation approach is applied
generally to assets which are small and
relatively inexpensive such as hand tools
or utensils.
It is defended on practical grounds.

Retirement and replacement method

No depreciation is recorded until the asset is

retired.
The amount of depreciation is equal to the original
cost of the asset retired minus salvage proceeds.
Under the replacement method, no depreciation is
recorded until the asset is retired and replaced.
The amount of depreciation is equal to the
replacement cost of the asset retired, minus
salvage proceeds.
If the asset retired is not replaced, the original cost
of the asset retired but not replaced is recognized
as depreciation.

The retirement and replacement method may be

used in much the same situations as the inventory

method.
Such methods are suitable when a large number of
similar items are employed by the entity and the
items are constantly being retired and replaced.
These methods are frequently used by public
utility entities which have a large number of
virtually identical items that are being installed,
retired and replaced such as poles, lines, meters
and telephone receivers.

Change in useful life

Unexpected physical deterioration or

technological improvement may indicate that

the useful life of the asset is less than that
originally estimated.
Conversely, improved maintenance
procedures or revision of operating
procedures may prolong the life of the asset
beyond the original estimate.

The useful life of an item of PPE shall be

reviewed at least at each financial year-end

and if expectations are significantly different
from previous estimate, the change shall be
accounted for as a change in accounting
estimate.

Therefore, the depreciation charge for the

current and future periods shall be adjusted.

Past depreciation is not corrected.
The procedure is simply to allocate the
remaining carrying amount of the asset over
the remaining revised life in order to get the
subsequent annual depreciation.

Change in depreciation method

Depreciation method used shall reflect the

pattern in which the asset's economic

benefits are expected to be consumed by
the entity.
The depreciation method shall be
reviewed at least at each financial yearend and if there has been a significant
change in the expected pattern of
economic benefits embodied in the asset,
the method shall be changed to reflect the
new pattern.

When such a change in depreciation method

is necessary, the change shall be accounted

for as a change in accounting estimate, and
the depreciation charge for the current and
future periods shall be adjusted.