DEPRECIATION

 Defined as the systematic allocation of the depreciable amount of an asset over the useful
life.
 It is a matter of cost allocation in recognition of the exhaustion of the useful life of an item
of PPE.

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 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.

Depreciation Period
Depreciation of an asset begins when it is available for use, meaning, 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. Derecognized asset means it
has been already sold or if the asset is going to be an inventory. Therefore, depreciation does not
cease when the asset becomes idle.

KINDS OF DEPRECIATION
1. 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 a wind, sunshine, rain or dust;
d. Casually or accident such as fire, flood, earthquake and other natural disaster;
e. Disease or decay - This physical cause is applicable to animals and wooden buildings.

2. Functional or economic depreciation

Arises from inadequacy, supersession and obsolescence.

Inadequacy arises when the asset is no longer useful to the entity because of an increase in the
volume of operations. For example, adequate buildings acquired at the inception of business may
become inadequate or limited in their future service potential when unexpected business growth
or expansion requires larger facilities for efficient operation.

Supersession arises when a new asset becomes available and new asset can perform the same
function more efficiently and economically or for substantially less cost.

Obsolescence is the catchall for economic or functional depreciation.

FACTORS OF DEPRECIATION
In order to properly compute the amount of depreciation, three factors are necessary, namely:
1. Depreciable amount - or depreciable cost is the cost of an asset or other amount substituted
for cost less the residual value.
Each part of an item of PPE with a cost that is significant in relation to the total cost of the
item shall be depreciated separately.

2. Residual value - It is the estimated net amount currently obtainable if the asset is at the end
of the 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

3. Useful life - It is 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.

FACTORS IN DETERMINING USEFUL LIFE

a. Expected usage of the asset - Usage is assessed by reference to the asset’s expected capacity
or physical output.
b. 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.
c. 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.
d. Legal limits for the use of the asset, such as the expiry date of the related lease.

Service life is the period of time an asset shall be used by an entity. The service life is the
equivalent of useful life. Physical life refers to how long the asset shall last.

DEPRECIATION METHOD
It shall reflect the pattern in which the future economic benefits from the assets are expected
to be consumed by the entity. It shall be reviewed at least at every year-end. The method shall
be changed if there is a significant change in the expected pattern of the future economic
benefits. Such change in depreciation method shall be accounted for as change in accounting
estimate.

METHODS OF DEPRECIATION
1. Equal or uniform charge methods
a) Straight line
b) Composite method
c) Group method
2. Variable charge or use-factor or activity methods
a) Working hours or service hours
b) Output or production method
3. Decreasing charge or accelerated or diminishing balance methods
a) Sum of years’ digits
b) Declining balance method
c) Double declining balance
4. Other methods
a) Inventory or appraisal
b) Retirement method
c) 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. In other words, it is 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 =
Useful life in years
Straight Line Rate
Depreciable amount multiplied by the 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. For example, if the useful life of the asset is 5 years, the annual straight line rate is 20%,
computed by dividing 100% by 5 years.

COMPOSITE AND GROUP METHOD

Large entities own various individual depreciable assets. For these entities, making detailed
depreciation computation for each individual asset referred to as unit depreciation is time
consuming and costly. Therefore, 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 asset 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 essentially the same. In other words, the average useful life and
the composite or group rate are computed, and the assets in the group are depreciated on that basis.

Accounting Procedures
a) Depreciation is reported in a single accumulated depreciation account. Thus, accumulated
depreciation account is not related to any specific asset account.
b) The composite or group rate is multiplied by the total cost of the assets in the group to get
the periodic depreciation.
c) 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.
d) 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.
Subsequently, the composite or group rate is multiplied by the balance of the asset account to get
the periodic depreciation.

COMPOSITE METHOD
The following computation is necessary in determining the composite life and composite rate:
(b)
(a) (a / b)
Residual Useful
Asset Cost Depreciable Annual
Value life
amount depreciation
In years
Building 650 000 50 000 600 000 15 40 000
Machinery 220 000 20 000 200 000 8 25 000
Equipment 130 000 30 000 100 000 4 25 000
1,000,000 100,000 900,000 90,000

The composite life is determined by dividing the total depreciable amount by total annual
depreciation. Thus, ₱900,000 divided by ₱90,000 equals 10 years. The composite rate is
determined by dividing the total annual depreciation by the total cost. Thus, ₱90,000 divided by
₱1,000,000 equals 9% composite rate.
All of the assets in the group are acquired at the beginning of current year. The annual depreciation
for the current year is recorded as follows:
 Depreciation Expense 90,000
Accumulated Depreciation 90,000

The accumulated depreciation account is not related to any specific asset account in the group.

VARIABLE CHARGE OR ACTIVITY METHODS

Assume that depreciation is more a function of use rather than passage of time. The useful life of
the asset is considered in terms of the output it produces or the number of hours it works. Thus,
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

a. Working hours method
b. Output or production method

Rationale for variable depreciation

The variable methods are adopted if the principal cause of depreciation is usage. The use of these
methods is based on the following:
a. Assets depreciate more rapidly if they are used full time or overtime.
b. 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 may
be difficult to estimate.

ILLUSTRATION
Machinery, at cost 600 000
Residual value none
Estimated useful life:
Years 5 years
Service hours 60,000
Output 150,000

Actual Operations Service hours Output

First year 14 000 34 000
Second year 13 000 32 000
Third year 10 000 25 000
Fourth year 11 000 29 000
Fifth year 12 000 30 000

WORKING HOURS METHOD

Under this method, a depreciation rate per hour is computed by dividing the depreciable amount
by the estimated useful life in terms of service hours. Thus, the rate per hour is ₱10, computed by
dividing ₱600 000 by 60,000 hours. The depreciation rate per hour is then multiplied by the actual
hours worked in one period to get the depreciation for that period.
 Accumulated Carrying
Year Particular Depreciation
depreciation amount
600 000
1 14 000 x 10 140 000 140 000 460 000
2 13 000 x 10 130 000 270 000 330 000
3 10 000 x 10 100 000 370 000 230 000
4 11 000 x 10 110 000 480 000 120 000
5 12 000 x 10 120 000 600 000 -

OUTPUT OR PRODUCTION METHOD

Results in a charge based on the expected use or output. Under this method, a depreciation rate per
unit is computed by dividing the depreciable amount by the estimated useful life in terms of units
of output. Thus, the rate per unit is ₱4, computed by dividing ₱600,000 by 150 000 units. The
depreciation rate per unit in then multiplied by the yearly output to get the annual depreciation.
Year Particular Depreciation Accumulated Carrying
depreciation amount
600 000
1 34 000 x 4 136 000 136 000 464 000
2 32 000 x 4 128 000 264 000 336 000
3 25 000 x 4 100 000 364 000 236 000
4 29 000 x 4 116 000 480 000 120 000
5 30 000 x 4 120 000 600 000 -

DECREASING CHARGE OR ACCELERATED METHODS

 Provide higher depreciation in the earlier years and lower depreciation in the later years of
the useful life of asset.
 Result in a decreasing depreciation charge over the useful life.

RATIONALE FOR ACCELERATED DEPRECIATION

The accelerated depreciation is on the philosophy that new assets are generally capable of
producing more revenue in the earlier years than in the later years. Another argument for the use
of decreasing charge method is that the cost of using an asset includes not only depreciation but
also repairs on such assets.

Three Decreasing Charge Methods

a. 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 useful life
of the asset and whose denominator is the sum of the digits in the useful life of the asset
 The fractions are developed by getting the sum of the digits in the useful life of asset.
 For example, the useful life is 4 years, the sum of years' digit us 1+2+3+4 or 10.
 If the useful life of an asset is too big, use the formula :
o SYD = Life [(Life +1)/2]
 For example, the useful life is 25 years
o SYD = 25[(25+1)/2] = 325
ILLUSTRATION - Sum of years' digits
Machinery ₱430,000
Residual Value 30,000
Estimated Useful Life 4 years

Depreciation Table -Sum of Years' Digits

Accumulated Carrying
Year Particular Depreciation
Depreciation Amount
430,000
1 4/10 × 400000 160,000 160,000 270,000
2 3/10 × 400000 120,000 280,000 150,000
3 2/10 × 400000 80,000 360,000 70,000
4 1/10 × 400000 40,000 400,000 30000

b. Declining balance
 Under this method, a fixed or uniform rate is multiplied by the declining carrying
amount of the asset in order to arrive at the annual depreciation.
 Also known as fixed rate on diminishing carrying amount method

FORMULA for fixed rate

𝒏
Rate = 1 - √𝒓𝒆𝒔𝒊𝒅𝒖𝒂𝒍 𝒗𝒂𝒍𝒖𝒆 ÷ 𝒄𝒐𝒔𝒕

ILLUSTRATION
Cost of asset ₱500,000
Residual Value 50,000
Estimated Useful Life 5 years
Computation of fixed rate
𝟓
Rate = 1 - √𝟓𝟎, 𝟎𝟎𝟎 ÷ 𝟓𝟎𝟎, 𝟎𝟎𝟎

𝟓
= 1 -√𝟎. 𝟏𝟎
= 0.369

Accumulated Carrying
Year Particular Depreciation
Depreciation Amount
500,000
1 36.9% × 500,000 184,500 184,500 315,500
2 36.9% × 315,500 116,420 300,920 199,080
3 36.9% × 199,080 73,461 374,381 125,619
4 36.9% × 125,619 46,353 420,734 79,266
5 79,266-50,000 29,626 450,000 50,000

c. Double Declining balance

 The common application of the declining balance method is the double declining
balance.
  The procedure is the same as declining method.
 This method is an approximation of the declining balance method.

The difference between the two:

a. Under the declining balance method, fixed rate is determined following a mathematical
formula
b. Under the double declining balance method, the straight line rate is simply doubled to
get the fixed rate.

ILLUSTRATION
Cost of asset ₱500,000
Date of acquisition January 1, 2020
Residual Value 50,000
Estimated Useful Life 5 years
Straight line rate (100% / 5) 20%
Double declining rate 40%

Accumulated Carrying
Year Particular Depreciation
Depreciation Amount
2020 40% × 500,000 200,000 200,000 300,000
2021 40% × 300,000 120,000 320,000 180,000
2022 40%× 180,000 72,000 392,000 108,000
2023 40%×108,000 43,200 435,200 64,800
2024 64,800-50,000 14,800 450,000 50,000

150% DECLINING BALANCE

 In application and procedure, this method is the same as the double declining method.
 Under this method, the fixed rate is 150% of the straight line rate.

INVENTORY METHOD
 It 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.

ILLUSTRATION - Inventory Method

An entity uses the inventory method to account for numerous small tools. The following
transactions concerning small tools occurred during the current year:

Tools account, January 1 ₱100,000

Acquisition, at cost 90,000
Sale of used tools, at residual value 2,000
Inventory of tools on Dec. 31, at cost 125,000

Journal Entries
1. To record the acquisition:
Tools 90,000
Cash 90,000
2. To record the sale of used tools at residual value
Cash 2,000
Tools 2,000

3. To record the depreciation of tools

Depreciation Expense 63,000
Tools 63,000

RETIREMENT AND REPLACEMENT METHOD

 Under the retirement 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.

ILLUSTRATION
The following data relate to the tools account for the current year:
Balance - Jan. 1, 1,000 units at 50 per unit ₱50,000
Acquisition- 2,500 units at 70 per units 175,000
Retirement of tools 1,200 units
Proceeds from retirement of tools 5,000

Retirement Method
1. To record the acquisition:
Tools 175,000
Cash 175,000

2. To record the retirement:

Cash 5,000
Depreciation 59,000
Tools 64,000*
* Cost of tools retired (FIFO):
(1,000 units × 50) + (200 units × 70)

Replacement Method
1. To record the acquisition of tools in excess of the retirement (2,500-1,200 equals 1,300):
Tools 91,000
Cash 91,000

2. To record the replacement of tools retired:

Depreciation 79,000*
Cash 79,000
*Replacement cost of tools retired - Proceeds from retirement
84,000 – 5,000 = 79,000
CHANGE IN USEFUL LIFE
 The useful life of an item of property, plant and equipment 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.

ILLUSTRATION
A depreciable asset costing ₱500,000 is originally estimated to have a useful life of 5 years. At the
beginning of the third year, the original useful life is revised to 8 years. Thus, the asset has a
remaining useful life of 6 years.
 Past depreciation is not corrected.
 The procedure is simply to allocate the remaining carrying amount of the asset over the
remaining revised useful life in order to get the subsequent annual depreciation.

Annual depreciation beginning third year:

₱500,000 / 5 = ₱100,000
₱500,000 – 200,000 = ₱300,000
₱300,000 / 6 = ₱50,000

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 year-end 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 un 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.

ILLUSTRATION
An entity decided to change from SYD to the straight line method of depreciation on January 1,
2020. The asset is acquired on January 1, 2018 at a cost of ₱1,000,000 and has an estimated useful
life of 4 years.

Accumulated Carrying
Year Particular Depreciation
Depreciation Amount
1,000,000
2018 4/10 × 1,000,000 400,000 400,000 600,000
2019 3/10 × 1,000,000 300,000 700,000 300,000

Allocate the remaining carrying amount of ₱300,000 over the remaining useful life of 2 years using
the new depreciation method which is the straight line. ₱300,000 / 2 = ₱150,000
References:
Valix, et. al. (2020) Intermediate Accounting Volume. 1, 2020 Revised Edition, GIC Enterprises
Co., Inc. Manila
Asuncion, et. al. (2018). Applied Auditing Book 1 of 2, Baguio City: Real Excellence Publishing

Assessments:
1. The equipment of ALMA Company has the following data:
Cost ₱1,100,000
Residual value 100,000
Useful life 4 years
Date acquired January 1, 2020
20,000 units
10,000 hours

Required: Compute for the depreciation for 2020 and 2021 under the following methods:
a. Straight line method
b. Working hours method (ALMA Company used 3,000 and 3,500 working hours for 2020 and
2021 respectively)
c. Units of output method (ALMA Company manufactured 2,000 and 2,500 units for 2020 and
2021 respectively)
d. Sum of the year’s digit
e. Double declining method
f. 150% declining balance method

2. On January 1, 2016, ALMA Company purchased a machine for ₱2,200,000. The machine has
an 8-year useful life, has a residual value of ₱200,000 and is being depreciated by straight line
method.
Case 1: Assume that on January 1, 2020, the company determines that the remaining useful life is
only 2 years.
Case 2: Assume that on January 1, 2020, the company determines that the residual value at the
end of useful life is only ₱50,000.
Case 3: Assume that on January 1, 2020, the company changes its method of depreciation from
straight line method to sum of the years digits method.

Required: Compute for the following under the cases above:

a. Depreciation expense in 2020
b. Carrying amount, December 31, 2020