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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 query 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 catalogue of use of asset In determined 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 earnings of an accounting period.
(6) Depreciation does not depend on fluctuations in store value of asset
(7) The whole of depreciation of an accounting year cannot be considered precisely-it has to be estimated. In determined 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 measurement of depreciation
(1) original cost of fixed asset i.e., buy price plus freight and facility expenses;
(2) estimated whole 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 whole invested on buy of asset, if it had been invested in some other venture 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 formula 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 slowly reduces on catalogue of depreciation charge. Since the depreciation percent rate is applied on reducing balance of asset. This formula is called reducing balance or diminishing installment formula or written down value method.
Merits and demerits.
Declining balance formula not only equitably matches depreciation expenses against the linked earnings but also fairly spreads. The incidence of depreciation and repairs (viz higher depreciation but heavier repairs in later years.) on profit and loss catalogue 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 supervision as accelerated depreciation means smaller chargeable profits and taxes hence lesser outflow of cash.
Accelerated Depreciation Methods
Sum-of-the year's digits (Syd). This formula of depreciation accelerates depreciation expenses so that the whole 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
Annuity Method
The formula recognizes the time value (Interest) of money and hence regards the real cost of using a long-lived asset equivalent to the actual whole 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 catalogue with interest upon the diminishing value, will sell out the asset to nil at the end of its life. Thus, the whole written off as depreciation is the same every year, but the interest will diminish each year.
The whole of each year depreciation to be written off by Annuity formula will be ascertained from Annuity Tables
Depreciation Fund formula or Sinking Fund method
Under this method, a fixed whole is charged as depreciation every year. It endeavors to provide the required lump sum cash at the resignation of a long, lived asset by annually setting aside and investing a fixed sum in easily realizable securities. These securities earn interest at fixed rate and the same being reinvested along with successive fixed installments of depreciation, allowed to derive at composition interest. The sinking fund formula thus takes into catalogue of this probable earnings from interest while fixing the each year depreciation and investing the same which together with composition interest accumulated to the asset's depreciable cost by the end of its useful life. Obviously, the fixed installment of each year 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 each year depreciation per rupee of depreciable cost.
Shortcomings of Depreciation Fund Method
Depreciation fund formula assumes constant rate of return on every periodic venture in selfsame 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. Additional the whole realized on the sale of safety rarely agrees with its acquisition cost owing to made fluctuations which may be both erratic and considerable. Those may cause a wide gap in the middle of the required and supplied cash.
Insurance course Method
This formula endeavors the provide of required cash at the resignation of a specified asset in return of periodic offering (premium). Under this a trader takes a 'Capital Redemption insurance Policy' from an insurance business which undertakes to pay at a given date a determined sum if the trader, paying a fixed whole of premiums after quarterly 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 superior is paid at the starting of the year. At maturity, the insurance business pays the course money which is ordinarily adequate to replace the retired set. Normally, whole received is more than total superior paid as the course yields interest.
Revaluation Method
Under the system, each year the asset is valued and the value is compared with that in the starting of the year. The fall is treated as depreciation. Suppose if the value of the tools at the starting 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 whole of depreciation for the year will be : 8,000 + 6,000-11,000 = Rs. 3,000 . This formula is useful for charging depreciation on livestock and loose tools.
Depletion Method
Natural resources comprise bodily assets like mineral deposits, oil and gas resources and timber stands. These natural resources get exhausted by exploitation. In some cases, the discount in bodily deposits is offset by growth or improvement of Additional deposits.
The cost of natural resources is the price paid for its acquisition plus price paid for improvement of such asset in order to bring it to a state suitable for production.
The periodic depletion is good not calculated in terms of year. Rather it is good to imagine 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 whole of working hours of a motor during the whole of its sufficient life is estimated, and then the cost of motor is divided by the predicted whole of hours of useful life, this gives the rate per hour. The each year depreciation is calculatedly multiplying this rate by the whole of hours, the motor truly runs in a year.
Mileage Method
This formula 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.
Global Method
Under this method, the value of the assets, irrespective of their nature is added together and depreciation is charged at an mean rate on aggregated value.
Choice of a Method
Aforesaid methods of depreciation present that none is truly best or worst as each formula has its own merits and demerits. Suitability of every formula is relative and depends upon assorted factors. Most prominent of these are the type of the asset and purpose of depreciation.
Straight line formula suits to structure and lease etc.. Reducing installment formula fits to machinery tool etc. And depletion formula for wasting assets like mines. Quarries etc. However, the basal purpose is the basic determinants of the propriety of a depreciation method. prominent purpose comprise of true reporting of accounts, tax benefits, comparative stock cost, financial flexibility, replacement and expansion etc. For example. Depreciation fund formula envisages that the whole set aside for depreciation is to be invested covering the business in definite securities. Similarly under insurance course method, the whole 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 in the middle of Fixed Installment formula and Reducing Installment Method
Fixed Installment Method
1. The rate and whole 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 whole of depreciation remains the same each year. Hence, the total of depreciation and repairs increases every year. This reduces each year profit gradually.
5. Computation of depreciation comparatively easy and simple.
Reducing Installment Method
1. The rate remains the same, but the whole 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 whole 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 puny or no change in each year profit/loss.
5. Depreciation can be computed without any difficulty, but it is not so easy and simple.
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