Depreciation
Meaning and Definition
The
term depreciation refers to fall in the value or utility of fixed assets which
are used in operations over the definite period of years. In other words,
depreciation is the process of spreading the cost of fixed assets over the
number of years during which benefit of the asset is received. The fall in
value or utility of fixed assets due to so many causes like wear and tear,
decay, effusion of time or obsolescence, replacement, breakdown, fall in market
value etc.
According
to the Institute of Chartered Accountant of India, "Depreciation is the
measure of the wearing out, consumption or other loss of value of a depreciable
asset arising from use, effluxion of time or obsolescence through technology
and market changes.
Purpose of
Charging Depreciation
The following
are the purpose of charging depreciation of fixed assets:
(1) To ascertain
in the true profit of the business.
(2) To show the
true presentation of financial position.
(3) To provide
fund for replacement of assets.
(4)
To show the assets at its reasonable value in the balance sheet.
Factors
Affecting the Amount of Depreciation
The following
factors are to be considered while charging the amount of depreciation :
(1) The original
cost of the asset.
(2) The useful
life of the asset.
(3) Estimated
scrap or residual value of the asset at the end of its life.
(4)
Selecting an appropriate method of depreciation.
Methods of
Charging Depreciation
The following
are the various methods applied for measuring allocation of depreciation cost:
(1) Straight
Line Method
(2) Diminishing
Balance Method
(3) Annuity
Method
(4) Sinking Fund
Method
(5) Sum of the Digits Method
(6)
Machine Hour Rate Method
(1) Straight
Line Method
This
method is also termed as Constant Charge Method. Under this method,
depreciation is charged for every year will be the constant amount throughout
the life of the asset. Accordingly depreciation is calculated by deducting the
scrap value from the original cost of an asset and the balance is divided by
the number of years estimated as the life of the asset.
The
following formula for calculating the periodic depreciation charge is :
Depreciation =
(Original Cost of Asset - Scrap Value)/Estimated Life of Asset
(or)
=(C-S)/N
Where
D = Depreciation
Rate
N C = Original
Cost of Asset
S = Salvage or
Scrap Value
N
= Estimated Useful Life
From the
following infonnation you are required to calculate depreciation rate :
Solution:
Cost of the
Machine Rs.30,ooO
Erection Charges
Rs.3,ooo
Estimated useful
life IO years
Estimated Scarp
Value Rs. 3000
Calculation of
depreciation rate for every year :
Depreciation =
(Original Cost of Asset - Scrap Value)/Estimated Life of an Asset
= (Rs.
33,000 - Rs. 3,000)/10
= Rs.3000
Thus,
the amount of depreciation would be Rs. 3,000 for every year.
Merits
(1) Simple and
easy to calculate.
(2) Original cost of asset reduced up to Scrap
Value at the end of estimated life.
(3) Estimated
useful life of the asset can be estimated under this method.
Demerits
(1) It does not
consider intensity of use of assets.
(2) It ignores
any additions or opportunity cost while calculating depreciations.
(3) It ignores
effective utilization of fixed assets, it becomes difficult to calculate
correct depreciation rate.
(4) Under the
assumption of constant charges of maintenance of assets it is impossible to
calculate true depreciation.
2) Diminishing
Balance Method
This method is also known as Fixed
Percentage On Declining Base Method (or) Reducing Instalment Method. Under this
method depreciation is charged at fixed rate on the reducing balance (i.e.,
Cost less depreciation) every year. Accordingly the amount of depreciation
gradually reducing every year.
The
depreciation charge in the initial period is high depreciation charge in the
initial period is high and negligible amount in the later period of the asset.
The following formula used for computing depreciation rate under Written-Down
Value Method
Merits
(1)
This method is accepted by Income Tax
Authorities.
(2)
Impact of obsolescence will be reduced
at minimum level.
(3)
Fresh calculation is not required when
additions are made.
(4)
Under this method the depreciation
amount is gradually decreasing and it will affect the smoothing out of periodic
profit.
Demerits
(1) Residual
Value of the asset cannot be correctly estimated.
(2) It ignores
interest on investment on opportunity cost which will lead to difficulty while
detennining the rate of depreciation.
(3) It is
difficult to ascertain the true profit because revenue contribution of the
asset are not constant.
(4) The original
cost of the asset cannot be brought down to zero.
3) Annuity Method
This
method is most suitable for a firm where capital is invested in the least hold
properties. Under this method, while calculating the amount of depreciation, a
fixed amount of depreciation is charged for every year of the estimated useful
life of the asset in such a way that at a fixed rate of interest is calculated
on the same amount had been invested in some other form of capital investment.
In
other
words, depreciation is charged for every year refers to interest losing or
reduction in the original cost of the fixed assets. Under the annuity method
where the loss of interest is due to the investment made in the form of an
asset is considered while calculating the depreciation.
4) Sinking
Fund Method
Like
the Annuity Method, the amount of depreciation is charged with the help of
Sinking Fund Table. Under this method an amoilnt equal to the amount written
off as depreciation is invested in outside securities in order to facilitate to
replace the asset at the expiry useful life of the asset. In other words, the amount
of depreciation charged is debited to depreciation account and an equal amount
is credited to Sinking Fund Account. At the estimated expiry useful life of the
asset, the amount of depreciation each year is invested in easily realizable
securities which can be readily available for the replacement of the asset.
5) Sum of Years Digits (SYD) Method
This method also
termed as SYD Method. The Sum of years Digits Method is designed on the basis of
Written-Down Value Method. Under this method the amount of depreciation to be
charged to the Profit and Loss Account goes on decreasing every year throughout
the life of the asset. The formula for calculating the amount of depreciation
is as follows :
Remaining
Life of the Asset
(Including
current year)
Rate
of Depreciation = ------------ x Original Cost of the Asset
Sum
of all the digits of the life
of
the assets in years
6) Machine
Hour Rate Method
This
method is similar to the Depletion Method but instead of taking estimated
available quantities in advance, the working life of the machine is estimated
in terms of hours. The hourly rate of depreciation is determined by dividing
the cost of the machine minus scrap value of the machine by the estimated total
number of hours
utilized every year.
Machine
Hour Rate = (Cost of the Machine) / Estimated Total Hours of Life
QUESTIONS
1.
What do you understand by Depreciation?
2.
What are the purpose of charging depreciation?
3.
Explain briefly the various methods of charging depreciation.
4.
Write short notes on :
(a)
Straight Line Method. (d) Insurance Policy Method.
(b)
Written - Down Value Method. (e) Depletion Method.
(c)
Annuity Method. (0 Revaluation Method.
5.
What do you understand by Sinking Fund Method? Explain it briefly.
6.
Discuss the merits and demerits of Straight Line Method.
7.
What do you understand by Machine Hour Rate method of depreciation?
8.
What are the factors affecting the amount of depreciation?
