DEPRECIATION EXPENSE

Depreciation expense

What is depreciation?

Definition of depreciation:

Depreciation is the systematic allocation of a 
the depreciable amount of an asset over its useful life.

1. Depreciation is a process of allocation not of valuation.
2. Depreciation for the year is the portion of the total
    charge under such a system that is allocated to the year.
3. Depreciable assets are sort of long term prepaid 
   expense accounts.
4. Usually Land has an indefinite life so land is
    not depreciated.

What is the difference between Depreciation,
Amortization and Depletion?

1. AMORTIZATION is a process of allocating 
   the amortizable cost of intangible assets.
2. DEPLETION is a process of allocating the cost 
   of using (decreasing) resources,such as mineral deposits.

Rate of depreciation:

Mostly in all the standards depreciation is calculated at the rate of 
10%,which means the useful life of the Non current asset is 
10 years, however in other cases the rate or useful life of the 
A noncurrent asset is mentioned in the question.

Straight-line depreciation:

This method recognizes equal periodic depreciation charges over the
 the useful life of a noncurrent asset,thereby making depreciation a function 
solely of time without regard to asset productivity, efficiency or usage.

In straight-line depreciation method depreciation of every 
the year is the same if full-year policy is in place.

FORMULA FOR CALCULATING  STRAIGHT LINE DEPRECIATION:

DEPRECIATION CHARGE =(cost-residual value)/useful life

FOR THE YEAR

RATE OF DEPRECIATION=100/USEFUL LIFE

OR ALTERNATIVE COULD BE

Depreciation for the year=(cost - residual value)*rate of depreciation

Where residual value is not given, depreciable cost and cost are 
the same amounts

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FIFO METHOD

FIFO METHOD

Following two methods are generally used for measuring the historical
 cost of inventory

1. FIRST IN FIRST OUT (FIFO)
2. WEIGHTED AVERAGE COST(WAVG)

With FIRST IN FIRST OUT METHOD, it is considered that the inventory 
is consumed in the strict order in which it was manufactured or purchased. 
The first items that are received into inventory are the first items that go out.

The FIFO METHOD of inventory valuation is used within the PERIODIC
INVENTORY SYSTEM however it can also be used with PERPETUAL 
INVENTORY SYSTEM.

FOLLOWING RECORD MUST BE KEPT TO ESTABLISH THE 
COST OF INVENTORY USING FIFO:

• The date that units are issued from inventory and the number of units 
  issued.
• The date that units of inventory are received into inventory,the number 
  of units received and their purchase price(or manufacturing cost)

Since it is assumed that the first items received into inventory are the first 
units that are used, it follows that the value of inventory at any time should be 
the cost of the most recently-acquired units of inventory.

The choice of valuation method, FIFO, LIFO OR WEIGHTED 
AVERAGE THEREFORE AFFECTS THE REPORTED PROFITS 
FOR EACH PERIOD.

However, LIFO IS NOT ALLOWED AS A VALUATION METHOD, BUT IT 
CAN BE USED IN COST ACCOUNTING SYSTEMS, WHICH ARE NOT 
GOVERNED BY THE RULES OF ACCOUNTING STANDARDS

The different methods of inventory valuation will give significantly different
 values of closing inventory and cost of sales when the inflation is 
high however for the weighted average method it will be lower which will 
be explained in the upcoming blog.

Let’s have a look on the ADVANTAGES AND DISADVANTAGES OF 
FIFO METHOD:

ADVANTAGES OF FIFO METHOD

1. Easy to understand and can be explained to staff with ease
2. Represents Physical reality
3. Gives a value near to replacement cost

DISADVANTAGES OF FIFO METHOD

1. In a period of high inflation,inventory issue prices will lag behind 
   current market value.
2. Managers may find it difficult to compare costs and make decisions 
   when they are charged with different prices for the same materials.
3. Some managers might find it complex.

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