Depreciation characteristics

Depreciation has the following characteristics:

(1) Depreciation is charged only for fixed assets, for example buildings, plant and machinery, furniture, etc. There is no question of depreciation in the case of current assets, such as shares, debtors, invoices receivable, etc.

(2) Depreciation causes a perpetual, gradual and continuous fall in the value of the asset.

(3) Depreciation occurs until the last day of the asset’s estimated useful life.

(4) Depreciation occurs due to 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 the income of an accounting period.

(6) Depreciation does not depend on fluctuations in the asset’s market value.

(7) The amount of depreciation for an accounting year cannot be determined precisely, it must be estimated. In certain cases, however, it can be determined exactly, for example, rental property, patent right, copyright, etc.

(8) The total depreciation of an asset cannot exceed its depreciable value (cost less scrap value).

Basic factors for determining depreciation

(1) original cost of the fixed asset, that is, purchase price plus transportation and installation costs;

(2) estimated amount of expenses for repairs during the useful life;

(3) estimated useful life of the asset after which it will be discarded;

(4) estimated residual or scrap value;

(5) interest on investment: the amount invested in the purchase of an asset, if it had been invested in some other investment, what interest would have been earned;

(6) possibility of obsolescence.

Fixed installment payment or original cost or straight line method, balance reduction / decrease method

Under this method, depreciation is not calculated on the cost of the asset. It is calculated on the book value. of assets. The asset’s book value is obtained by deducting depreciation from its cost. The asset’s carrying amount is gradually reduced due to the depreciation charge. Since the percentage rate of depreciation is applied to the reduction of the asset balance. This method is called the method of reducing the balance or payment of declining installments or method of annotated value.

Merits and demerits.

The declining balance method not only equitably compares depreciation expense to related income, it also differs fairly. the impact of depreciation and repairs (ie higher depreciation but heavier repairs in later years) on the income statement over the useful life of the assets. Eliminating most of the cost in the early years also minimizes the impact of obsolescence. It’s equally useful for management, as accelerated depreciation means lower profit and taxable taxes, and therefore less cash outflow.

Accelerated depreciation methods

Sum of digits of the year (SYD). This depreciation method accelerates depreciation expenses so that the amount recognized in previous periods of an asset’s useful life is greater than those recognized in recent 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 actual amount invested in it plus the interest lost on acquiring the asset. With this method, as much depreciation is canceled each year that after debiting the asset account with interest on the decreasing value, the asset will be reduced to zero at the end of its useful 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 to be written off using the annuity method will be determined from the annuity tables.

Depreciation fund method or sinking fund method

With this method, a fixed amount is charged as depreciation each year. Strives to provide the lump sum of cash required upon retirement of a long-lived asset, setting aside and investing a lump sum in easily realizable securities annually. These securities accrue interest at a fixed rate and they are reinvested together with successive fixed depreciation installments, which are accumulated at compound interest. The sinking fund method takes into account this probable interest income, setting the annual depreciation and investing the same as together with the compound interest accumulated at the depreciable cost of the asset at the end of its useful life. Obviously, the fixed rate of annual depreciation is lower here compared to the straight-line method. However, its magnitude depends on the useful life and the interest rate of the asset. 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 hardly true in this dynamic world where rates vary from time to time. Any change in the rate of return upsets the previous periodic depreciation allocation and leads to its correction. In addition, the amount obtained from the sale of the security rarely matches its acquisition cost due to fluctuations made, which can be both erratic and considerable. Those can cause a huge gap between required and supplied cash.

Insurance policy method

This method seeks the required cash supply at the time of retirement of a specific asset in exchange for a periodic contribution (premium). By virtue of this, a merchant takes out a ‘Capital Reimbursement Insurance Policy’ from an insurance company that agrees to pay a certain sum on a specified date if the merchant pays a fixed number of premiums after regular intervals. The trader 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 the policy money that is normally enough to replace the retired group. Typically, the amount received is more than the total premium paid, since the policy earns interest.

Revaluation 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 that if the value of tools at the beginning of the year were Rs 8,000, then tools worth Rs 6,000 were purchased during the year, and at the end of the year, at the valuation, they 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 collecting depreciation on livestock and loose tools.

Depletion method

Natural resources include physical assets such as mineral deposits, oil and gas resources, and wood stands. These natural resources are depleted with 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 in order 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 cost of the unit by the units produced in that particular year.

Machine hour rate

With this method, the total number of working hours of a machine over its entire useful life is estimated, 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 of how many kilometers have been traveled, for example, buses, cars, trucks and rolling stock, etc.

Global method

Under this method, the value of assets, regardless of their nature, is added together and depreciation is charged at an average rate on the value added.

Choosing a method

The aforementioned depreciation methods reveal that neither is absolutely better or worse, as each method has its own merits and demerits. 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 is suitable for buildings and leases, etc., which reduces the adjustments of the installment payment method for machinery equipment, etc. and depletion method to waste assets such as mines. quarries, etc. However, the underlying purpose is the basic determinants of the appropriateness of a depreciation method. The important purpose included actual account reporting, tax benefits, product comparative cost, financial flexibility, replacement and expansion, etc. For instance. The depreciation fund method provides that the amount set aside for depreciation is invested outside of the business in specified securities. Similarly, in the insurance policy method, the amount set aside is given to the insurance company. If a company has working capital problems, the appropriateness of these methods is questionable.

Of the aforementioned methods (1) Payment in fixed installments and (2) Payment in reduced installments are the most used.

Distinction between the fixed payment method and the reduced payment method

Fixed payment method

1. The rate and amount of depreciation remain the same each year.

2. The percentage depreciation rate is calculated on the cost of the asset each year.

3. At the end of its life, the asset’s value 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 every year. Therefore, the total of depreciation and repairs increases every year. This reduces the annual profit gradually.

5. Comparatively easy and simple calculation of depreciation.

Reduction of the payment method in installments

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 asset’s value 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 remains more or less 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.


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