Depreciation Characteristics
Depreciation has the following characteristics:
(1) Depreciation is charged in the case of fixed assets only, for example, Buildings, Plant and Machinery, Furniture, etc. It is not about depreciation in the case of current assets, such as shares, debtors, bills receivable, etc.
(2) Depreciation causes a perpetual, gradual, and continuing decline in the value of the asset.
(3) Depreciation occurs up to the last day of the estimated useful life of the asset
(4) Depreciation occurs due to use of the asset In certain cases, however, depreciation may occur even if the assets are not used, for example, leased property, patent rights, copyrights, etc.
(5) Depreciation is a charge against income for an accounting period.
(6) Depreciation does not depend on fluctuations in the market value of the asset
(7) The amount of depreciation for an accounting year cannot be determined with precision, it must be estimated. In certain cases, however, it can be determined exactly, for example, leased property, patent rights, copyrights, etc.
(8) The total depreciation of an asset cannot exceed its depreciable value (cost less scrap value).
Basic Depreciation Determination Factors
(1) original cost of the fixed asset, that is, purchase price plus freight and installation charges;
(2) estimated amount of expenses for repairs during the useful life;
(3) the estimated useful life of the asset after which it will be scrapped;
(4) estimated residual or scrap value;
(5) interest on investment: the amount invested in the purchase of the asset, if it had been invested in some other investment, what interest would have been earned;
(6) possibility of obsolescence.
Fixed installment method or original cost or straight line, reduction/declining balance method
Under this method, depreciation is not calculated on the cost of the asset. It is calculated on the book value. of asset The book value of the asset is obtained by deducting depreciation from its cost. The book value of the asset is gradually reduced due to the depreciation charge. Since the depreciation percentage rate is applied on the reduction of the asset balance. This method is called the balance reduction method or the declining installment method or the amortized value method.
Merits and demerits.
The declining balance method not only fairly equalizes depreciation expense with related income, but also distributes it fairly. the incidence of depreciation and repairs (ie higher depreciation but larger repairs in later years) on the profit and loss account over the useful lives of the assets. Eliminating most of the cost in the early years also minimizes the impact of obsolescence. It’s equally helpful to manage, as accelerated depreciation means lower earnings and taxable taxes, thus less cash outflow.
Accelerated depreciation methods
Sum of year digits (SYD). This depreciation method accelerates depreciation expense so that the amount recognized in earlier periods of an asset’s useful life is greater than those recognized in later periods. The SYD is found by estimating the useful life of an asset in years, then assigning consecutive numbers to each year and adding these numbers. for n years,
SYD = 1 + 2 + 3 + 4 + … +n
annuity method
The method recognizes the time value (interest) of money and, therefore, considers the real cost of using a long-lived asset equal to the real amount invested in it plus the interest lost on the acquisition of the asset. Under this method, so much depreciation is written off each year that after debiting the asset’s account with interest on the declining value, it will reduce the asset to zero at the end of its life. Therefore, the amount written off as depreciation is the same each year, but the interest will decrease each year.
The amount of annual depreciation that will be canceled by the Annuity method will be determined from the Annuity Tables
Depreciation Fund Method or Sinking Fund Method
Under this method, a fixed amount is charged as depreciation each year. It strives to provide the required lump sum of cash at retirement from a long-lived asset by setting aside and annually investing a lump sum in readily attainable securities. These securities accrue interest at a fixed rate and are reinvested together with successive fixed depreciation installments, allowing compound interest to accumulate. The sinking fund method, therefore, takes into account this probable interest income while setting annual depreciation and investing it, which, together with compound interest, accumulates to the depreciable cost of the asset at the end of its useful life. Obviously, the fixed annual depreciation fee is here less compared to the straight-line method. However, its magnitude depends on the useful life of the asset and the interest rate. The longer the span and the higher the rate, the lower the annual depreciation per rupee of depreciable cost.
Deficiencies of the depreciation fund method
The depreciation fund method assumes a constant rate of return on each periodic investment in identical securities. This is not true in this dynamic world where rates fluctuate from time to time. Any variation in the rate of return upsets the previous periodic allocation for depreciation and leads to its restatement. In addition, the amount realized on the sale of securities rarely matches their acquisition cost due to fluctuations that can be both erratic and considerable. Those can cause a big gap between the cash required and that supplied.
Insurance policy method
This method attempts to provide the required cash upon retirement of a specific asset in exchange for a periodic contribution (premium). Under this, a trader takes out a ‘Capital Redemption Insurance Policy’ from an insurance company which agrees to pay on a certain date a certain sum if the trader, paying a fixed number of premiums after regular intervals. The merchant treats the periodic payment as depreciation and charges it to the profit and loss account. In this case, the depreciation is charged at the end of the year, while the premium is paid at the beginning of the year. At maturity, the insurance company pays the policy money which is normally enough to replace the retired game. Normally, the amount received is greater than the total premium paid since the policy earns interest.
Evaluation method
Under the system, each year the asset is valued and the value is compared to the value at the beginning of the year. The drop is treated as depreciation. Suppose if the value of tools at the beginning of the year was Rs 8,000, then during the year tools worth Rs 6,000 were purchased and at the end of the year, according to the valuation, they amounted to Rs 11,000. The depreciation amount for the year will be: Rs 8,000 + Rs 6,000-11,000 = Rs 3,000. This method is useful for collecting depreciation on livestock and loose tools.
Exhaustion method
Natural resources include physical assets such as mineral deposits, oil and gas resources, and timber forests. These natural resources are depleted by exploitation. In some cases, the reduction in physical deposits is offset by the growth or development of additional deposits.
The cost of natural resources is the price paid for their acquisition plus the price paid for the development of said asset to bring it to a state suitable for production.
It is better not to calculate the periodic depletion in terms of the year. Rather, it is better to calculate the cost per unit and then multiply the unit cost by the units produced in that particular year.
Machine hour rate
Under this method, the total number of working hours of a machine is estimated during its entire effective useful life, and then the cost of the machine is divided by the expected number of hours of useful life, this gives the rate per hour. Annual depreciation is calculated by multiplying this rate by the number of hours the machine actually runs in a year.
mileage method
This method is used only for those assets whose useful life depends on the fact how many kilometers have been driven, for example, buses, cars, trucks and rolling stock, etc.
overall method
Under this method, the value of the assets, regardless of their nature, is added together and depreciation is charged at an average rate over value added.
Choosing a method
The depreciation methods mentioned above reveal that none is absolutely better or worse, as each method has its own advantages and disadvantages. The suitability of each method is relative and depends on several factors. The most important are the type of asset and the purpose of the depreciation.
The straight line method suits buildings and leases, etc. The installment reduction method is adapted to machinery, equipment, etc. and depletion method to waste assets such as mines. neighborhoods etc. However, the underlying purpose is the basic property determinants of a depreciation method. Important purpose composed of actual account reporting, tax benefits, comparative product cost, financial flexibility, replacement and expansion, etc. For example. The depreciation fund method provides for the amount set aside for depreciation to be invested outside the business in specified securities. Similarly, under the insurance policy method, the amount so set aside is turned over to the insurance company. If a company has working capital problems, the appropriateness of these methods is questionable.
Of the methods mentioned above, (1) fixed fee methods and (2) reduction fee methods are the most widely used.
Distinction between the Fixed Fee Method and the Reducing Fee Method
Fixed installation method
1. The rate and amount of depreciation remain the same each year.
2. The percent depreciation rate is calculated on the cost of the asset each year.
3. At the end of its life, the value of the asset is reduced to zero or scrap value.
4. The older the asset, the higher the cost of its repairs. But the amount of depreciation remains the same each year. Therefore, the total for depreciation and repairs increases each year. This reduces the annual profit gradually.
5. Comparatively easy and simple depreciation calculation.
Fee Reduction Method
1. The rate remains the same, but the amount of depreciation gradually decreases.
2. The percentage of the depreciation rate is calculated on the book value of the asset.
3. The value of the asset is never reduced to zero at the end of its life.
4. The amount of depreciation gradually decreases, while the cost of repairs increases.
Therefore, the total for depreciation and repairs stays about the same each year. Therefore, it causes little or no change in annual profit/loss.
5. Depreciation can be calculated without any difficulty, but it is not so easy and simple.