Depreciation Features
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 depreciation in the case of current assets, such as shares, debtors, invoices receivable, etc.
(2) Depreciation causes a perpetual, gradual, and continuous decline in the value of the asset
(3) Depreciation occurs until the last day of the estimated useful life of the asset
(4) Depreciation occurs because of the use of the asset. In certain cases, however, depreciation can 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 period cannot be determined with precision, it must be estimated. In certain cases, however, it can be determined exactly, for example, leased property, patent right, copyright, etc.
(8) The total depreciation of an asset cannot exceed its depreciable value (cost less scrap value).
Basic Depreciation Determining Factors
(1) original cost of the fixed asset, that is, purchase price plus freight and installation expenses;
(2) estimated amount of expenses in repairs during the useful life;
(3) the estimated useful life of the asset after which it will be discarded;
(4) estimated residual or scrap value;
(5) interest on the 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 Fee 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. 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 balance of the asset. This method is called the declining balance method or the declining installment method or the amortized value method.
Merits and demerits.
The declining balance method not only fairly matches depreciation expense to related income, it also distributes it fairly. the incidence of depreciation and repairs (ie higher depreciation but more extensive repairs in later years) in the profit and loss account over the useful life of the assets. Eliminating most of the cost in the early years also minimizes the impact of obsolescence. It’s just as helpful to manage, as accelerated depreciation means lower earnings and taxable taxes, hence less cash outflow.
Accelerated Depreciation Methods
Sum of Digits of the Year (SYD). This depreciation method accelerates depreciation expense so that the amount recognized in early periods of an asset’s useful life is greater than that 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 temporary 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 in 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 declining value, you’ll 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 the 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 cash upon retirement of a long-lived asset by reserving and investing a lump sum annually in readily realizable securities. These securities accrue interest at a fixed rate and they are reinvested together with successive fixed depreciation installments, allowing them to accumulate at compound interest. The sinking fund method, therefore, takes this probable interest income into account while setting annual depreciation and investing it, which, together with compound interest, accumulates at the depreciable cost of the asset at the end of its useful life. Obviously, the fixed annual depreciation fee is lower here compared to the straight-line method. However, its magnitude depends on the useful life of the asset and the interest rate. The longer the period 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 vary from time to time. Any variation in the rate of return upsets the previous periodic allocation for depreciation and entails its replacement. In addition, the amount realized on the sale of securities rarely matches their acquisition cost due to fluctuations that can be both erratic and significant. Those can cause a huge gap between cash required and cash supplied.
insurance policy method
This method attempts the cash supply required upon retirement of a specific asset in exchange for a periodic contribution (premium). Under this, a trader takes out a ‘Money Redemption Insurance Policy’ from an insurance company which promises 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, 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 out the policy money, which is usually enough to replace the retired game. Normally, the amount received is greater than the total premium paid since the policy earns interest.
Evaluation method
According to the system, each year the asset is valued and the value is compared with that of the beginning of the year. The drop is treated as depreciation. Suppose if the value of the 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 they were valued at Rs 11,000. The amount of depreciation for the year will be: 8,000 + 6,000-11,000 = 3,000 rupees. This method is useful for collecting depreciation on livestock and loose tools.
depletion 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 periodic depletion in terms of years. 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 over its entire effective life is estimated, and then the cost of the machine is divided by the expected number of hours of useful life, this gives the hourly rate. 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 they have been driven, for example, buses, cars, trucks and rolling stock, etc.
global method
Under this method, the value of the assets, regardless of their nature, is added up and depreciation is charged at an average rate over the added value.
Choosing a method
The aforementioned depreciation methods 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 depreciation.
The straight line method suits buildings and leases, etc. The installment reduction method accommodates machinery, equipment, etc. and depletion method to waste assets such as mines. neighborhoods etc. However, the underlying purpose is the basic determinants of ownership of a depreciation method. Important purpose composed of actual account reports, tax benefits, product comparative cost, financial flexibility, replacement and expansion, etc. For example. The depreciation fund method provides that the amount set aside for depreciation is invested outside of the business in specified securities. Similarly, under the insurance policy method, the amount thus set aside is given 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 Quota Method and the Reducing Quota 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. Calculation of depreciation comparatively easy and simple.
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 of 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 that easy and simple.