Allocation of depreciation

Factors affecting the periodic allocation of depreciation:

The depreciation value of an asset is allocated over the economic life of an asset on some rational basis. The depreciable value of the asset is the residual value of asset. It will be as under:

1) For new machine: Depreciable value – Acquisition cost less estimated scarp value if any.
2) For used machine: Depreciable value – Acquisition cost less (estimated scrap value plus accumulated depreciation up to given time)

The amount of the periodic depreciation is dependent on following factors: (1) Acquisition cost, (2) Estimated service life, (3) Estimated salvage value, (4) election of the depreciation method.

Acquisition cost: Acquisition cost refers the purchase price of an asset. In case of machine and equipment, the expenses incurred on their installation are also capitalized and thus become a part of the acquisition cost. The calculation of the depreciable value which is allocated over the estimated economic life of an asset is primarily based on the acquisition cost.

Estimated service life: The service life of an asset is the “total units of service” expected to be derived from the asset during its useful existence. The units of service are popularity measured in following two ways:

1) Time units – like years, months, days etc.
2) Output units – like physical unit, miles machine hours etc e.g. the service life of a motor car can be presented as 5 years or 1,00,000 kilometers.

The services life of an asset deteriorates due to two reasons: (1) Physical deteriorations, (2) Economic factors.

Physical deteriorations: The physical deterioration in the service life of an asset results from the following:

a) Wear and tear due to the operating use.
b) Action of the elements like rust, rot or decay and
c) Disaster like accidents, earthquake etc

The physical deterioration of an asset can be reduced by following a sound maintenance policy. The maintenance expenditure enhances the services life of an asset. It should be noted that as compared to the economic factors deteriorating the service life of an asset, it is relatively possible to estimate the physical deterioration with some degree of accuracy. Thus, estimation of the service life on the basis of the physical deterioration is relatively easy and certain.

Economics factors: Sometimes, even if the asset is in sound physical condition it is not economical to use it. The estimation of the asset deterioration caused by economic factors is relatively difficult. The following economic factors deteriorate the service life of an asset.

Obsolescence: The technological developments make it imperative to replace the asset even though it may be in excellent physical condition. For the maintenance of the competitive strength the asset is scrapped.

Inadequacy: Sometimes due to the growth of the business, the scale of operations is changed by terminating the service life of the existing assets.

While estimating the service life of an asset for the depreciation purposes, the physical as well as the economic factor should be considered carefully. For the tax purposes, the income tax authorities provide certain guidelines about the rates of depreciation on the basis of service life of different types of assets. According to Indian Income Tax Act, 1961 the classified rates of depreciation on certain assets are as under:

Estimated salvage value: The salvage value of an asset is the estimated amount that will be at the time of the disposal of the asset less the cost of its removal or disposal. Generally, for machines and equipment, the estimated salvage value is considered to be zero. Though the scrap machines have some commercial value, it is offset by the cost of its removal or disposal. Sometimes the later cost tends to be higher resulting into negative salvage value.