Depreciation and Amortisation

Figure 1: Depreciation is the systematic allocation of the depreciable amount of an asset over its useful life.

Learning Outcomes

• Understand the meaning and nature of depreciation.
• Understand how to determine the amount of depreciation from the total value of Property, Plant and Equipment and its useful life.
• Understand various methods of depreciation and learn advantages and disadvantages of such methods.
• Understand how to calculate the amount of profit or loss resulting from the sale/disposal of Property, Plant and Equipment.
• Familiarize with the accounting treatment for change in the method of depreciation from Straight Line Method to Reducing Balance method.
• Familiarize with the accounting treatment for change in estimated useful life and residual value of property, plant and equipment.
• Understand the meaning and nature of intangible assets and its amortisation.

1. Introduction

1.1 Concept of Depreciation

• Tangible Assets are assets that have a physical substance i.e., they can be seen and touched, held for use in the production or supply of goods or services, for rental to others, or for administrative purposes.
• Property, plant and equipment are tangible items that:
  • (a) are held for use in the production or supply of goods or services, for rental to others, or for administrative purposes; and
  • (b) are expected to be used during more than a period of twelve months.

KNOWLEDGE NUGGET

• Depreciation: Systematic allocation of depreciable amount of an asset over its useful life
• Depreciable Amount: Cost of asset less its residual value
• Useful Life: Period over which asset is expected to be available for use
• Schedule II: Companies Act, 2013 prescribes useful life of assets

• Value of such assets decreases with passage of time mainly due to following reasons:
  • 1. Wear and tear due to its use in business
  • 2. Efflux of time (even when it is not being used)
  • 3. Obsolescence due to technological or other changes
  • 4. Decrease in market value
  • 5. Depletion mainly in case of mines and other natural reserves

As per Schedule II under the Companies Act, 2013, Depreciation is the systematic allocation of the depreciable amount of an asset over its useful life.

THREE IMPORTANT FACTORS FOR COMPUTING DEPRECIATION

• 1. Estimated useful life of the asset
• 2. Cost of the asset
• 3. Residual value of the asset at the end of its estimated useful life

1.2 Depreciation on components of an asset

• Accounting Standards as well as the Companies Act, 2013 requires depreciation to be charged on a component basis.
• 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 should be depreciated separately.
• Example: Aircraft — airframe, engines and interiors have different individual useful lives.

1.3 Objectives for Providing Depreciation

• (1) Correct income measurement: Depreciation should be charged for proper estimation of periodic profit or loss.
• (2) True position statement: Value of Property, Plant & Equipment should be adjusted for depreciation to depict actual financial position.
• (3) Funds for replacement: Generation of adequate funds for replacement of the asset at the end of its useful life.
• (4) Ascertainment of true cost of production: For ascertaining the cost of production, it is necessary to charge depreciation as an item of cost of production.

DEPRECIATION — KEY POINTS

• Depreciation is a non-cash expense — does not result in any cash outflow
• Depreciation by itself does not create funds — it merely draws attention to the fact that a certain amount should be retained for replacement
• Depreciation reduces distributable profits

2. Factors in the Measurement of Depreciation

• 1. Cost of asset including expenses for installation, commissioning, trial run etc.
• 2. Estimated useful life of the asset (both in terms of time & also utility/units).
• 3. Estimated scrap value (if any) at the end of useful life of the asset.

Cost of Property, Plant and Equipment comprises:

• (a) its purchase price, including non-refundable import duties and purchase taxes, after deducting trade discounts and rebates.
• (b) any cost directly attributable to bring the asset to the location and condition necessary for it to be capable of operating in a manner intended by the enterprise.
• (c) the initial estimate of the costs of dismantling, removing, the item and restoring the site on which an asset is located.

EXAMPLES OF DIRECTLY ATTRIBUTABLE COSTS

• Cost of employee benefits arising directly from acquisition or construction
• Cost of site preparation
• Initial delivery and handling costs
• Installation and assembly costs
• Cost of testing whether the asset is functioning properly
• Professional fees (e.g., engineers hired for installation)

EXPENSES NOT PART OF COST OF ASSET

• Costs of opening new facility (e.g., inauguration costs)
• Cost of introducing new product or service (e.g., advertisement)
• Cost of conducting business in a new location (including staff training)
• Administration and other general overhead costs
• Cost incurred while item is capable of operating but not yet put to use
• Cost of relocation of an asset

3. Methods for Providing Depreciation

INCOME TAX RULES

The Income Tax Rules prescribe the Diminishing Balance Method except in the case of assets of an undertaking engaged in generation and distribution of power.

3.1 Straight Line Method

• According to this method, an equal amount is written off every year during the working life of an asset so as to reduce the cost of the asset to nil or its residual value at the end of its useful life.
• Also known as Fixed Instalment Method.

FORMULAE — STRAIGHT LINE METHOD

Straight Line Depreciation = (Cost of Asset — Scrap Value) / Useful Life

Straight Line Depreciation Rate = (Straight Line Depreciation / Cost of Asset) × 100

3.2 Reducing or Diminishing Balance Method or Written Down Value (WDV) Method

• Under this system, a fixed percentage of the diminishing value of the asset is written off each year so as to reduce the asset to its residual value at the end of its life.
• Commonly used for plant, fixtures, etc.
• Annual charge for depreciation decreases from year to year.

FORMULA — REDUCING BALANCE METHOD

Rate of Depreciation = 1 — n √(Residual Value / Cost of Assets) × 100

where, n = useful life

Accounting Entries under Straight Line and Reducing Balance Methods

First Alternative

• A Provision for Depreciation or Accumulated Depreciation account is opened to accumulate the balance of depreciation.

ACCOUNTING ENTRIES

• Depreciation Account Dr.
• To Provision for Depreciation Account or Accumulated Depreciation
• Profit and Loss Account Dr.
• To Depreciation Account

Second Alternative

• Amount of Depreciation is credited to the Asset Account every year.

ACCOUNTING ENTRIES

• Depreciation Account Dr.
• To Asset Account
• Profit and Loss Account Dr.
• To Depreciation Account

3.3 Sum of Years of Digits Method

• Annual depreciation is calculated by multiplying the original cost of the asset less its estimated scrap value by the fraction:

FRACTION FOR SUM OF YEARS DIGITS METHOD

(Remaining life of the asset) / (Total of all digits of the life of the asset)

Total of all digits = n(n+1)/2

3.4 Machine Hour Method

• Depreciation is calculated on the basis of hours that the concerned machine worked.
• Variation of the Straight Line Method.

3.5 Production Units Method

• Depreciation is determined by comparing the annual production with the estimated total production.

FORMULA — PRODUCTION UNITS METHOD

Depreciable Amount × (Production during the period / Estimated total production)

3.6 Depletion Method

• Used in case of mines, quarries etc. containing only a certain quantity of product.
• Depreciation rate is calculated by dividing the cost of the asset by the estimated quantity of product likely to be available to be extracted.

FORMULA — DEPLETION METHOD

Annual Depreciation = Quantity Extracted × (Cost of Asset / Estimated Total Quantity)

4. Profit or Loss on the Sale/Disposal of Property, Plant and Equipment

• Whenever any depreciable asset is sold during the year, depreciation is charged on it for the period it has been used in the sale year.
• The written down value after charging such depreciation is used for calculating the profit or loss on the sale of that asset.
• Resulting profit or loss is ultimately transferred to profit and loss account.

EXAMPLE — CALCULATION OF PROFIT/LOSS ON SALE

Book value as on 1st Jan, 2022: ₹50,00,000

Depreciation @10% for 6 months (1st Jan to 30th June): ₹2,50,000

Written down value as on 1st July, 2022: ₹47,50,000

Less: Sale proceeds: ₹32,00,000

Loss on sale of the asset: ₹15,50,000

5. Change in the Method of Depreciation

• The depreciation method applied to an asset should be reviewed at least at each financial year-end.
• Change in depreciation method is treated as change in accounting estimate as per Accounting Standards.
• Its effect needs to be quantified and disclosed separately.

EXAMPLE — CHANGE IN METHOD

• Cost of Machine: ₹10,50,000
• Residual Value: ₹50,000
• Useful life: 10 years
• Depreciation charged for first 2 years on SLM: ₹2,00,000
• WDV at end of 2nd year: ₹8,50,000
• New method: WDV @ 25%
• Depreciation for 3rd year: ₹2,12,500 (25% of ₹8,50,000)

6. Revision of the Estimated Useful Life of Property, Plant and Equipment

• The residual value and the useful life of an asset should be reviewed at least at each financial year-end.
• Changes should be accounted for as a change in an accounting estimate.
• The written down value or the balance depreciable amount should be charged over the revised remaining estimated useful life of the asset.

EXAMPLE — REVISION IN USEFUL LIFE

• Machine costing ₹6,00,000
• Depreciated on SLM for 3 years assuming 10 years life, Nil residual value
• Depreciation per year: ₹60,000
• Book value at end of 3rd year: ₹4,20,000
• Revised remaining useful life: 5 years
• Depreciation from 4th year onwards: ₹4,20,000 / 5 = ₹84,000 per annum

7. Revaluation of Property, Plant and Equipment

• An asset whose fair value could be reliably measured could be carried at the revalued amount.
• Revaluations must be made at adequate intervals (say yearly).
• In case an item of PPE is revalued, whole class of such PPE to which such asset belongs should be revalued.

REVALUATION — RULES

• Increase in value: Credited to Revaluation Surplus
• Decrease in value: Recognized in Profit and Loss Account (or debited to Revaluation Surplus if reversal of previous increase)
• Revaluation Surplus may be transferred directly to retained earnings when asset is derecognized
• Transfer from Revaluation Surplus to Retained Earnings cannot be made through Profit or Loss

Note: Revaluation of Property, Plant and Equipment is an accounting policy choice, and not mandatory under the accounting standards or the Companies Act, 2013.

8. Intangible Assets

• An intangible asset is an identifiable non-monetary asset, without physical substance, held for use in the production or supply of goods or services, for rental to others, or for administrative purposes.

EXAMPLES OF INTANGIBLE ASSETS

• Streaming rights of movies/TV shows/web series
• Broadcasting rights of events (Cricket World Cup, IPL, etc.)
• Landing rights / time slots at airports
• Patents, Trademarks, Copyrights
• Distribution rights for motion pictures
• Long-term customer contracts
• Customer data (contact numbers, email IDs, spending data)
• Goodwill (purchased)
• Computer Software

Recognition of Intangible Assets

• (i) The intangible asset is identifiable.
• (ii) The enterprise can exercise control over such intangible asset.
• (iii) It is probable that the future economic benefits attributable to the asset will flow to the enterprise.
• (iv) The cost of the intangible asset can be measured reliably.

COST OF INTANGIBLE ASSET

• Purchase price
• Import duties and taxes (non-recoverable)
• Any directly attributable expenditure on making the asset ready for its intended use
• Trade discounts and rebates are deducted

DIFFERENCE BETWEEN TANGIBLE AND INTANGIBLE ASSETS

Tangible Assets	Intangible Assets
Have physical substance	DO NOT have physical substance
Finite life based on expected usage	Finite life based on contractual terms; can have indefinite life
Depreciated over useful life	Amortised over useful life
Examples: Property, Machinery, Vehicles	Examples: Software, Streaming rights, Patents, Trademarks

9. Amortisation

• Amortisation is the systematic allocation of the depreciable amount of an intangible asset over its useful life.
• It is presumed that the useful life of an intangible asset will not exceed ten years from the date when the asset is available for use unless evidence exists to the contrary.
• The amortisation method used should reflect the pattern in which the asset's economic benefits are consumed.
• If that pattern cannot be determined reliably, the straight-line method should be used.

EXAMPLE — AMORTISATION

• Patent registered on 1st July, 2021 at cost of ₹28,00,000 plus ₹2,00,000 legal fees
• Total cost: ₹30,00,000
• Useful life: 10 years
• Annual amortisation: ₹3,00,000
• Amortisation for 2021 (6 months): ₹1,50,000
• Amortisation for 2022: ₹3,00,000

Summary

• Depreciation is the systematic allocation of the depreciable amount of an asset over its useful life.
• Objectives for providing depreciation:
  • Correct income measurement
  • True financial position statement
  • Funds for replacement
  • Ascertainment of true cost of production
• Factors in the measurement of depreciation:
  • Cost of asset
  • Estimated useful life of the asset
  • Estimated scrap value
• Methods for providing depreciation:
  • Straight line method
  • Reducing balance method
  • Sum of years of digits method
  • Machine hour method
  • Production units' method
  • Depletion method
• The resulting profit or loss on sale of the tangible asset is ultimately transferred to profit and loss account.
• Change in depreciation method is treated as change in accounting estimate.
• Intangible Asset is an identifiable non-monetary asset, without physical substance.
• Amortisation is the systematic allocation of the depreciable amount of an intangible asset over its useful life.

Test Your Knowledge

True and False

• 1. Increase in market value of a fixed asset is one of the reasons for depreciation being charged. False
• 2. Depreciation is a cash expenditure like other normal expenses. False
• 3. Cost of property, plant and equipment includes purchase price, refundable taxes & import duties after deducting any discount or rebate. False
• 4. Cost of fixed asset should also include cost of opening a new facility such as inauguration costs. False
• 5. Depreciation is charged with a constant amount under straight line method and charged with a constant percentage under diminishing balance method. True
• 6. In case an item of Property, Plant & Equipment is revalued, whole class of assets to which that asset being revalued belongs should be revalued. True
• 7. In case the carrying amount of an asset is decreased due to revaluation, such decrease should always be recognized in the Profit and Loss account. False
• 8. Akash purchased a machine for ₹12,00,000. Estimated useful life is 10 years and scrap value is ₹1,00,000. Depreciation for the first year using sum of the years digit method shall be ₹2,00,000. True
• 9. Depreciation cannot be provided in case of loss, in a financial year. False
• 10. Providing for depreciation also helps in providing for accumulation of funds to facilitate the replacement at the end of its useful life. True
• 11. If the equipment account has a balance of ₹12,50,000 and the accumulated depreciation account has a balance of ₹4,00,000, the written down value of same shall be ₹16,50,000. False
• 12. Sum of the years digit method is an example of accelerated method of charging depreciation. True
• 13. Over the life of an asset subject to depreciation, the accelerated method will result in less Depreciation Expense in early years and more depreciation in later years of its life. False
• 14. While depreciating land cost, Straight line method shall give more depreciation than the written down value. False
• 15. Provision for depreciation account is debited at the time of recording the depreciation on an asset. False
• 16. If adequate maintenance expenditure is incurred with relation to running repairs of an asset, we need not charge any depreciation. False
• 17. When a property, plant or equipment is sold then provision for depreciation account is debited, asset account is credited and any gain or loss is recorded to profit and loss account. True
• 18. While calculating the depreciation as per diminishing balance method, the salvage value of the asset at the end of its life is reduced from its cost. False
• 19. Any change in the estimated useful life of an asset should be accounted for as a change in an accounting estimate in accordance with Accounting Standards. True
• 20. An intangible asset is a non identifiable, non monetary asset. False

Multiple Choice Questions

1. Original cost = ₹12,60,000; Salvage value = Nil; Useful life = 6 years. Depreciation for the first year under sum of years digits method will be	(a) ₹3,60,000 (b) ₹1,20,000 (c) ₹1,80,000
2. Obsolescence of a depreciable asset may be caused by:	(a) Technological changes (b) Improvement in production method (c) Both (a) and (b)
3. The number of production of similar units expected to be obtained from the use of an asset by an enterprise is called as	(a) Unit life (b) Useful life (c) Production life
4. If a concern proposes to discontinue its business from March 2018 and decides to dispose of all its plants within a period of 4 months, the Balance Sheet as on March 31, 2018 should indicate the plants at their	(a) Historical cost (b) Net realizable value (c) Cost less depreciation
5. In the case of downward revaluation of a plant which is for the first time revalued, the account to be debited is	(a) Plant account (b) Revaluation Reserve (c) Profit & Loss account
6. The portion of the acquisition cost of the tangible asset, yet to be allocated is known as	(a) Written down value (b) Accumulated value (c) Realisable value
7. The main objective of providing depreciation is to	(a) Create secret reserve (b) Reduce the book value of assets (c) Allocate cost of the assets
8. Original cost of a machine was ₹25,20,000 salvage value was ₹1,20,000, useful life was 6 years. Annual depreciation under Straight Line Method	(a) ₹4,20,000 (b) ₹4,00,000 (c) ₹3,00,000
9. The cost of a machine is ₹20,00,000. Two years later the book value is ₹10,00,000. The Straight-line percentage depreciation is	(a) 50% (b) 33-1/3% (c) 25%
10. A machinery with original cost of ₹10,00,000 and Nil Salvage value acquired on 1st April 2019 with 4 years useful life was depreciated using Straight Line Method. It was decided to sell the machinery on 1st October 2022 for ₹1,20,000. What shall be the gain or (loss) on the sale of Machinery?	(a) Loss of ₹1,30,000 (b) Gain of ₹1,20,000 (c) Loss of ₹5,000
11. Which of the following assets does not depreciate?	(a) Machinery and equipment (b) Patents (c) Land
12. A company purchased a machinery on April 01, 2017, for ₹15,00,000. It is estimated that the machinery will have a useful life of 5 years after which it will have no salvage value. The depreciation charged during the year 2021-22 was	(a) ₹5,00,000 (b) ₹4,00,000 (c) ₹3,00,000
13. If the equipment account has a balance of ₹22,50,000 and the accumulated depreciation account has a balance of ₹14,00,000, the book value of the equipment is	(a) ₹36,50,000 (b) ₹8,50,000 (c) ₹22,50,000
14. A plant with original cost of ₹50,00,000 was revalued after 2 years resulting in credit to Revaluation Surplus account of ₹4,00,000. Towards the year end of 2019-20, due to COVID-19 the plan value had gone down by ₹5,00,000 and accordingly management decided to revalue the same. What shall be the impact of this downwards revaluation on the Profit & Loss Account?	(a) Debit of ₹5,00,000 (b) Debit of ₹1,00,000 (c) Credit of ₹5,00,000
15. In respect of intangible assets, there is a presumption that the useful life of an intangible asset will not exceed	(a) 2 years (b) 3 years (c) 10 years
16. A company developed a technology to enhance the battery life of mobile phones. The cost of development have been capitalized as an intangible asset at ₹5,00,000. The company estimates the life of the technology developed to be 3 years. The company has forecasted that 50% of sales will be in year 1, 35% in year 2 and 15% in year 3. What should be the amortisation charge in third year?	(a) ₹2,50,000 (b) ₹75,000 (c) ₹1,75,000
17. An intangible asset is an asset	(a) with no physical existence (b) generated internally by the business (c) cannot be sold

High-Yield Interactive Quiz — Depreciation and Amortisation

Q1. Depreciation is the systematic allocation of the depreciable amount of an asset over its:

Correct Answer: B. As per Schedule II under the Companies Act, 2013, Depreciation is the systematic allocation of the depreciable amount of an asset over its useful life.

Q2. Which method of depreciation results in a constant amount being charged every year?

Correct Answer: B. Under Straight Line Method, an equal amount is written off every year during the working life of an asset.

Q3. Which of the following is NOT a factor in the measurement of depreciation?

Correct Answer: D. The three factors for computing depreciation are: Cost of asset, Estimated useful life, and Estimated scrap value. Market value is not a factor for depreciation calculation.

Q4. The Income Tax Rules prescribe which method of depreciation?

Correct Answer: B. The Income Tax Rules prescribe the Diminishing Balance Method except in the case of assets of an undertaking engaged in generation and distribution of power.

Q5. Which method is used in case of mines, quarries, etc.?

Correct Answer: C. Depletion method is used in case of mines, quarries, etc. containing only a certain quantity of product.

Q6. An intangible asset is:

Correct Answer: B. An intangible asset is an identifiable non-monetary asset, without physical substance, held for use in the production or supply of goods or services.

Q7. The presumed useful life of an intangible asset does not exceed:

Correct Answer: C. It is presumed that the useful life of an intangible asset will not exceed ten years from the date when the asset is available for use unless evidence exists to the contrary.

Q8. In case of revaluation, increase in the carrying amount of an asset should be credited to:

Correct Answer: B. In case the carrying amount of an asset increases due to revaluation, such increase should be credited to Revaluation Surplus and accumulated in equity.

Q9. A machine costing ₹12,60,000 with Nil salvage value and useful life of 6 years. Depreciation for the first year under sum of years digits method is:

Correct Answer: B. Sum of years digits = 6+5+4+3+2+1 = 21. Depreciation for first year = 6/21 × ₹12,60,000 = ₹3,60,000.

Q10. The depreciation charge for an asset should begin when:

Correct Answer: C. Depreciation of an asset begins when it is available for use, i.e., when it is in the location and condition necessary for it to be capable of operating in the manner intended by management.

Q11. Which of the following is NOT a directly attributable cost for determining the cost of Property, Plant and Equipment?

Correct Answer: C. Cost of introducing new product or service (e.g., advertisement) should NOT become part of cost of asset.

Q12. In case of change in depreciation method, the change is treated as:

Correct Answer: B. Change in depreciation method is treated as change in accounting estimate as per Accounting Standards. Its effect needs to be quantified and disclosed separately.