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STUDYMATERIAL - Depreciation – methods
MEANING:
Depreciation may be defined as the
permanent decrease in the value of an asset through wear and tear in the use or
the passage of time.
Depreciation is an expense or
loss involved in using machinery, motor vehicles, tools and other fixed assets
in the process of production and has to be provided for; this is done by
estimating the amount to be written off the value of particular aset each year and setting this
amount against the profits for that year.
Institute of chartered accountants of India
Depreciation is allocated so as to charge
a fair proportion of the depreciable amount in each accounting period during the expected useful life of the
asset.
Deprciation includes amortisation of
assets whose useful life is predetermined.”
CAUSES OF DEPRECIATION :
1.
Physical deterioration:
It
is caused mainly from wear and tear when the asset is in use and from erosion,
rust, rot and decay from being exposed to wind, rain, sun and other elements of
nature.
2.
Economic Factors:
These
may be said to be those that cause the asset to be put out of use even though
it is in good physical condition.
3. Time factors:
There are
certain assets with a fixed period of legal life such as lease, patents, and
copyrights.
3.
Depletion:
Some assets are of a wastig character perhaps
due to the extaction of raw materials from them. These materials are then ither
used by the firm to make something else or are sold in their raw state to other
firms.
NEED FOR PROVIDING DEPRECIATION:
1.To know
the true profits.
2. To show true financial position.
3. To make
provision for replacement of assets.
METHODS OF
DEPRECIATION:
1.
Straight line or fixed instalment method:
Under this
method a fixed percentage of the original value of the asset is written off
every year so as to reduce the asset account to nil or to its scrap value at te
end of the estimated life of the asset.
Merits:
i)
It is simple to understand and easy to apply.
ii)
It can write down down an asset to zero at the end of
its working life, if desired.
iii)
It is very suitable for those assets which have a
fixed life
Demerits:
i)
It becomes difficult to calculate te depreciaton on
additions made during the year.
ii)
The depreciation charge remains the same fom year to
year irespective of the use of the asset.
iii)
It tends to report an increasig rate of return on
investment in the asset amount due to the fact that the balnce of the asset
amount taken.
2.Diminishing balance or written down value method:
Under this
method depreciation is calculated at a certain percentage each year on the
balance of the asset which is brought forward from the previous year. The
amount of depreciation charged in each period is not fixed but it goes on
decreasing gradually as the beginning balance of the asset in each year will
reduce.
Merits:
1. It tends to
give a fairly even charge of depreciation against revenue each year.
2. Fresh
calculation of depreciation are not necessary as and when additions are made.
3. This method
is recognised by the income tax authorities in India
Demerits: 1.
The original cost of the asset is altogether lost
sight of in subsequent years and the asset can never be reduced to zero
2.
This method does not take into consideration the asset
as an investment and interest is not taken into consideration.
3.
As compared to the first method, it is difficult to
determine the suitable rate of depreciation.
DIFFERENCE
BETWEEN STAIGHT LINE AND WRITTEN DOWN METHODS:
Points of
distinction
1.
Change in depreciation amount.
2.Balance in Asset’s A/C
3.Overall charge
4. Profits.
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Straight
Line Method
1.Throught
the life of the asset, the amount of depreciation remains to be equal.
2.Asset’s
A/C at the expiry of the expected life becomes nil.
3.The
overall charge i.e., depreciation and repairs taken together go on increasing
from year to year . In other words the amount of depreciation and repairs is
relatively less during the earlier years
of the life of the asset than later years because repairs go on
increasing with use of asset.
4.Profits
under this method are more during the earlier years of the life of te asset.
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Written
down value
1.Amount
of depreciation is morte during earlier years of the life of asset than later
years and therefore amount is never equal.
2.The
account never becoms nil.
3.Overall
charge remains same for every year throught the life of the asset. Since
depreciation goes on decreasing and amount of repairs goes on increasing.
4.Profits
are less during earlier years than the later years.
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Sums of the
digits method:
This is a
variant of the reducing instalment or diminishing balance metod.
Annuity
method:
Under this
method amount spent on the purchase of an asset is regarded as an investment which
is assumed to earn interest at a certain rate. Every year the asset account is
debited with the amount of intrest and credited with the amount of
depreciation. This interest is calculated on the debit balance of the asset
acount at the beginning of the year.
Depreciation
fund method:
Under all
the methods discussed uptil now, ready cash may not be available when the time
of replacement comes because the amount of depreciation is retained in the
business itself in the form of assets not separate from other assets which
cannot be readily sold.
The Method (applied to long lease etc)
implies that the amount written off as depreciation should be kept aside and
invested in readily saleable securities.The securities accumulated and when the
life of the asset express, the securities are sold and with the sale proceeds a
new asset is purchased.
DIFFERENCE
BETWEEN SINKING FUND AND ANNUITY METHOD:
Points of
distinction.
1.
Investment in outside securities.
2.
Interest.
3.Receipt of interest.
4. Calculation of depreciation
5.Charge to
P/LA/C.
6.Change in interest.
7. Value of asset for reporting purpose.
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Sinking fund
1.Depreciation
charged is invested in outside securities at the end of first year.
2.First
interest is earned during second year & the first entry for investment of
inteest is made at the end of second year.
3.Actual
interest is received.
4.Amount
to be depreciated is calculated with the help of sinking fund table.
5.Depreciation
charged is cost minus interest .
6.The
amount of interest increass year after
year.
7.The
value in the Asset Account remains same year after year and depreciation is
charged to reverse account.
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Annuity method
1.Depreciation
charged is not invested in outside securities.
2.Interest
is earned from the first day of te first year, Hence entry is made at the end
of first year.
3.No
interest is received only adjustment entries are made.
4.Calcualted
with the help of Annuity table.
5.Depreciation
charged is cost plus interest.
6.It
decreases year after year.
7.The
depreciation is charged to the asset account every year so the value of asset
decreases.
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Insurance
policy method:
This method
is similar to the depreciation fund method but instead of making investment
arrangements are made with an insurance company which will receive premiums
annually amd pay at
the end of
fixed period te required amount.
Points of
distinctin
1.Use of
depreciation amount.
2.Risk.
3.
Utilisation of amount received.
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Sinking fund
1.Depreciation
amount is used to purchase securities at the end of the year.
2.There
may be risk of loss when the securities are realised.
3.New
asset is purchased after selling the securities and adjustment the amount so
received to buy new asset.
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Insurance Policy
1.It is
used to pay premiums to the insurance
2.A fixed
amount is received so there is no risk of loss.
3.Even if
the asset is destroyed during the yer, we can realize full amount from
insurance
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Revaluation
Method:
Under this method, the asset is revalued at
the end of the accounting year and this compared with the value of the asset at
the beginning of the year.The difference is treated as depreciation.
Depletion
Method:
This method is mostky used in case of mines,
quarriers etc. from which a certain quantity of output is expected to be
obtained. The value of mine depends only upon quantity of minerals that can be
obtained. When the whole quantity is taken, the mine loses its value. The rate
of depreciation is worked out only so much per tonne.
It is obtained by
simply dividing the cost of the mine by the total quantity of the minerals
expected to be available.
Machine
Hour rate method;
This method
is useful in case of machines. The life of the machine is fixed in terms of
hours. Hourly rate of depreciation is worked out by dividing the cost f the
machine by the total number of hours for which the machine is expected to be used.
Depreciation to be written off
in a year will be ascertained by multiplying the hourly rate of depreciation by
the number of hours that the machine actually runs in the year.
FIXED INSTALMENT METHOD:
1. A
company whose accounting year is the calender year, purchased on 1st
April 1990, machinery costing Rs.30000. It purchased another machine on 1st
october 1990, costing Rs 20000 and on 1st july 1991, costing Rs
10000. On 1st Jan 1992, one- third of the machinery which was installed
on 1st April 1990 became obsolete and was sold for Rs 3000. Show how
the machinery account would appear in the books of the company. The machinery
was depreciated by the fixed instalment
method @10%p.a.
ANNUITY METHOD:
2.Afive
lease worth Rs. 30000 is to be depreciated by Annuity system, the unwritten
balance of the asset bearing interest at 5%. The annual amount to be written
off as shown by the Annuity table is Rs.6,929.24.
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