Characteristics of Depreciation
Depreciation has the following characteristics:
(1) Depreciation is charged in case of fixed assets only, e.g., Building, Plant and Machinery, Furniture ‘etc. There is no question of depreciation in case of current assets-such as Stock, Debtors, Bills Receivable etc.
(2) Depreciation causes perpetual, gradual and continuous fall in the value of asset
(3) Depreciation occurs till the last day of the estimated working life of asset
(4) Depreciation occurs on account of use of asset In certain cases, however, depreciation may occur even if the assets are not used, e.g., Leasehold Property, Patent right, Copyright etc.
(5) Depreciation is a charge against revenue of an accounting period.
(6) Depreciation does not depend on fluctuations in market value of asset
(7) The amount of depreciation of an accounting year cannot be determined precisely-it has to be estimated. In certain cases, however, it may be ascertained exactly, e.g., Leasehold Property, Patent Right, Copyright etc.
(8) Total depreciation of an asset cannot exceed its depreciable value (cost less scrap value).
Basic factors of determination of depreciation
(1) original cost of fixed asset i.e., purchase price plus freight and installation expenses;
(2) estimated amount of expenditure on repairs during the useful life;
(3) estimated useful life of asset after which it will be discarded;
(4) estimated residual or scrap value;
(5) interest on investment-the amount invested on purchase of asset, if it had been invested in some other investment what interest would have been earned;
(6) possibility of obsolescence.
Fixed Installment or Original Cost or Straight Line Method, reducing/Diminishing Balance method
Under this method depreciation is not calculated on cost of asset. It is computed on the book value. of asset. The book value of the asset is obtained by deducting depreciation from its cost. The book value of asset gradually reduces on account of depreciation charge. Since the depreciation percent rate is applied on reducing balance of asset. this method is called reducing balance or diminishing installment method or written down value method.
Merits and demerits.
Declining balance method not only equitably matches depreciation expenses against the related revenue but also fairly spreads. the incidence of depreciation and repairs (viz higher depreciation but heavier repairs in later years.) on profit and loss account over the assets life span. Elimination of major portion of cost in early years also minimizes the impact of obsolescence. It is equally useful to management as accelerated depreciation means smaller taxable profits and taxes hence lesser outflow of cash.
Accelerated Depreciation Methods
Sum-of-the year’s digits (SYD). This method of depreciation accelerates depreciation expenses so that the amount recognized in the earlier periods of an asset’s useful life are greater than those recognized in the latter periods. The SYD is found by estimating an asset’s useful life in years, then assigning consecutive numbers to each year, and totaling these numbers. For n years,
SYD = 1 + 2 + 3 + 4 + … +n
The method recognizes the time value (Interest) of money and hence regards the real cost of using a long-lived asset equivalent to the actual amount invested thereon plus the interest lost on the acquisition of asset. Under this method, so much depreciation is written off each year as after debiting the asset account with interest upon the diminishing value, will reduce the asset to nil at the end of its life. Thus, the amount written off as depreciation is the same every year, but the interest will diminish each year.
The amount of annual depreciation to be written off by Annuity method will be ascertained from Annuity Tables
Depreciation Fund method or Sinking Fund method
Under this method, a fixed amount is charged as depreciation every year. It endeavors to provide the required lump sum cash at the retirement of a long, lived asset by annually setting aside and investing a fixed sum in readily realizable securities. These securities earn interest at fixed rate and the same being reinvested along with successive fixed installments of depreciation, allowed to accumulate at compound interest. The sinking fund method thus takes into account of this probable income from interest while fixing the annual depreciation and investing the same which together with compound interest accumulated to the asset’s depreciable cost by the end of its useful life. Obviously, the fixed installment of annual depreciation is here smaller as compared to straight line method. Its magnitude, however, rests on the asset’s life span and interest rate. Longer the span and higher the rate, smaller is the annual depreciation per rupee of depreciable cost.
Shortcomings of Depreciation Fund Method
Depreciation fund method assumes constant rate of return on every periodic investment in identical securities. This is hardly true in this dynamic world where rates do vary now and then. Any variation in the rate of return upsets the earlier periodic allocation for depreciation and entails refection thereof. Further the amount realized on the sale of security rarely agrees with its acquisition cost owing to made fluctuations which may be both erratic and considerable. Those may cause a wide gap between the required and supplied cash.
Insurance Policy Method
This method endeavors the supply of required cash at the retirement of a specified asset in return of periodic contribution (premium). Under this a trader takes a ‘Capital Redemption Insurance Policy’ from an insurance company which undertakes to pay at a given date a certain sum if the trader, paying a fixed number of premiums after regular intervals. The trader treats the periodic payment as depreciation and charges it to profit and loss account. In this case, depreciation is charged at the end of the year, whereas, the premium is paid at the beginning of the year. At maturity, the insurance company pays the policy money which is normally sufficient to replace the retired set. Normally, amount received is more than total premium paid as the policy yields interest.
Under the system, each year the asset is valued and the value is compared with that in the beginning of the year. The fall is treated as depreciation. Suppose if the value of the tools at the beginning of the year was Rs. 8,000, during the year tools worth Rs. 6,000 were purchased and at the end of the year, on valuation these amounted to Rs. 11,000. The amount of depreciation for the year will be : 8,000 + 6,000-11,000 = Rs. 3,000 . This method is useful for charging depreciation on livestock and loose tools.
Natural resources include physical assets like mineral deposits, oil and gas resources and timber stands. These natural resources get exhausted by exploitation. In some cases, the reduction in physical deposits is offset by growth or development of additional deposits.
The cost of natural resources is the price paid for its acquisition plus price paid for development of such asset in order to bring it to a state suitable for production.
The periodic depletion is better not calculated in terms of year. Rather it is better to calculate the cost per unit and then multiply the cost of unit to units produced in that particular year.
Machine Hour Rate
Under this method, the total number of working hours of a machine during the whole of its effective life is estimated, and then the cost of machine is divided by the expected number of hours of useful life, this gives the rate per hour. The annual depreciation is calculatedly multiplying this rate by the number of hours, the machine actually runs in a year.
This method is used only for those assets whose useful life depends upon the fact that how many kilometers they have been driven e.g. buses, cars, trucks and rolling stock etc.
Under this method, the value of the assets, irrespective of their nature is added together and depreciation is charged at an average rate on aggregated value.
Choice of a Method
Aforesaid methods of depreciation reveal that none is absolutely best or worst as each method has its own merits and demerits. Suitability of every method is relative and depends upon various factors. Most important of these are the type of the asset and purpose of depreciation.
Straight line method suits to buildings and lease etc.. reducing installment method fits to machinery equipment etc. and depletion method for wasting assets like mines. quarries etc. However, the underlying purpose is the basic determinants of the propriety of a depreciation method. Important purpose comprise of true reporting of accounts, tax benefits, comparative product cost, financial flexibility, replacement and expansion etc. For example. depreciation fund method envisages that the amount set aside for depreciation is to be invested outside the business in specific securities. Similarly under insurance policy method, the amount so set aside is handed over to insurance company. If a business is having working capital problems the advisability of these methods is questionable.
Of the above-mentioned methods (1) Fixed Installment and (2) Reducing Installment methods are most widely used.
Distinction between Fixed Installment Method and Reducing Installment Method
Fixed Installment Method
1. The rate and amount of depreciation remain the same each year.
2. Depreciation rate per cent is calculated on cost of asset each year.
3. At the end of its life the value of asset is reduced to zero or scrap value.
4. The older the asset, the larger the cost of its repairs. But the amount of depreciation remains the same each year. Hence, the total of depreciation and repairs increases every year. This reduces annual profit gradually.
5. Computation of depreciation comparatively easy and simple.
Reducing Installment Method
1. The rate remains the same, but the amount of depreciation diminishes gradually.
2. Depreciation rate percent is calculated on book value of asset.
3. The value of asset is never reduced to zero at the end of its life.
4. The amount of depreciation decreases gradually, while the cost of repairs increases.
So the total of depreciation and repairs remains more or less the same each “year. Hence, it causes little or no change in annual profit/loss.
5. Depreciation can be computed without any difficulty, but it is not so easy and simple.