Depreciation Methods

 

Depreciation Methods

1996 Qn. Enumerate the methods of calculating Depreciation. Discuss the merits and limitations of these methods  - 20 marks

Ans:

1.       Straight Line Method / Fixed Installment Method

 

·         Fixed Percentage throughout the life of Asset

·         Fixed Amount throughout the Life of Asset

·         Easy to calculate

Calculation:

·          Depreciation  = Cost of Asset –Scrap value (estimated) / Estimated Life

·         Example:  Building cost – 10 lacs,  Life – 50 years , Scrap value at the end of life – 2 lacs

·         Depreciation per year = 10,00,000 – 2,00,000 / 50  = Rs. 16000

Merits:

·         Calculation of Depreciation is Simple and easy to understand

·         Depreciation burden on Profit and Loss Account equally throughout the life of the Asset 

·         Asset can be completely written off.

·         Suitable for the Assets having fixed working life.

Limitations:

·         Actual use of the asset is not considered.

·         Ignores the Interest factor.  That means not take into the account, the loss of interest on the amount invested in the Asset.

·         With the passage of time, the cost of maintenance of an asset goes up.  So initially the maintenance and depreciation together is less and goes up year after year.  So, the burden on the Profit and Loss account is uneven.

·          Difficult to assess the life of the Asset and Scrap value at the end of the life.  So, only estimated life and estimated scrap may not correct.

2.       Written Down Value (WDV) Method / Diminishing Balances Method:

·         Rate of percentage is fixed.

·         But, the Asset value is decreased year by year due to charging the Depreciation (duly deducting from the Asset value)

·         Though the percentage is fixed, but the Depreciation is calculated on the written down value of the Asset.

·         Useful for Assets like Buildings & Machinery, where the Repairs are required more due to passage of the time.

 

Example:

 

Cost of the Building is Rs. 10 Lacs.  Estimated Life of Asset is 50 years. 

 

Depreciation for the 1^st year =  Rs. 10,00,000 / 50  = Rs. 20,000

 

Depreciation for the 2^nd year = Rs. 9,80,000 / 50 = Rs. 19,600  ( Rs. 9,80,000 = Rs. 10,00,000 – Rs.20,000)

 

Depreciation for 3^rd year = Rs. 9,60,400 /50 = 19,208 (Rs. 9,60,400 = Rs. 9,80,000 – Rs.19,600)

 

It is goes on till 50^th year.

 

Merits:

 

·         Equally charged to Profit & Loss Account.  Because initially Depreciation is high and repairs are low. When Asset becomes older, Depreciation is low and the repairs are high.  So equally burdened throughout the life of the Asset.

·         Very logical because in the earlier years, the Asset is more productive and yields the better results compared to the later years.   So Depreciation too initially more and gradually reducing along with the passage of the time.

Limitations:

 

·         Assets cannot be completely written off.  But the balance lying at the end of life is negligible and can be charged to Profit and Loss Account of the last year.

·         Like Straight Line method, this method too ignores the Interest factor.

·         Actual usage of Asset is ignored.

 

3.       Annuity Method

 

·         Takes into the account the interest lost on the acquisition of the Asset (which is ignored in the previous two methods)

·         Interest is calculated on the book value of Asset and the same is debited to Asset Account and credited to Interest Account.

·         The Depreciation is based on the Interest rate and the life of the Asset and will be calculated with the help of Annuity Tables.

 

Example:  A lease is purchased on 1.1.2020 for 5 years at a cost of Rs. One Lac.  It is proposed to depreciate the Lease by Annuity method charging 12 %, one must write off a sum of Rs. 0.277410 for every Re One. 

Calculation of Depreciation for 1^st year =  Rs. 1,00,000 x 0.277410 = Rs. 27741

Calculation of Interest for 1^st year = Rs. 1,00,000 x 12 % = Rs. 12000

At the end of First year, Rs. 1,00,000 – Rs. 27,741 + Rs.12,000 = Rs. 84259

Calculation of Depreciation for 2^nd year = Rs. 27,741 (no change.  It is fixed throughout the life of the Asset)

Calculation of Interest for 2^nd year = Rs. 84,259 x 12 % = 10,111

At the end of 2^nd year = Rs.84,259 – Rs. 27,741 + 10,111 = 66,629

So, it is goes on till the completion of the Fifth year.

 

Merits:

·         This Method is scientific, because the depreciation is ascertained from the Annuity Tables duly taking the Interest foregone.

·         Provides recovery of invested Capital along with the Interest.   This is lack of the earlier two methods.

·         Suitable to such Assets which requires heavy investments initially.

Limitations:

·         Calculation of Depreciation becomes very difficult when additions are made to the Assets.

·         Calculation of Interest rate is arbitrary.

·         Not suitable for the Assets whose value is small.

·         Depreciation (which is fixed) and Interest (which is calculated on the diminishing value of Asset) are not uniform.

 

4.       Depreciation Fund Method:

 

·         This method is more realistic compared to previous methods. Because it provides the ready cash to the Company to replace the Asset at the end of life of Asset without any difficulty.

·         The amount written off as Depreciation should be kept aside and invested in readily saleable securities, preferably Govt Securities. With the accumulated securities, the company is able to replace the Asset at the end of life of the Asset.

·         Here, the Depreciation is not credited to the Asset Account.  Instead it is credited to Depreciation Fund Account

·         Journal entries are as follows

 

A.      Depreciation A/c  Dr    100

       To Depreciation Fund A/c   100

B.      Depreciation Fund Investments A/c   Dr 100

To Bank A/c                                                                        100

C.      Interest on Depreciation Fund Investments A/c Dr   10

To Depreciation Fund Investments A/c          10

·         Depreciation Fund Investments A/c shown on Assets Side

·         Depreciation Fund A/c shown on Liabilities side

·         The Asset continues to be shown at its original cost in the Balance sheet during its life period.

 

5.       Insurance Policy Method:

 

·         Instead of amount invested in Securities under Depreciation Fund method, a Insurance premium paid to cover the value of the Asset.

·         The Asset continues to be shown at its original cost in the Balance Sheet during its life period

·         The journal entries are

 

A.      Depreciation Insurance policy A/c  Dr 100

To Bank A/c                                                        100

B.      Profit & Loss A/c Dr   100

To Depreciation Reserve A/c 100

 

6.        Sum of Digits Method

Example:  Machine purchased at a cost of Rs. 10000.  Life is 5 years.

Formulae of Depreciation = Remaining life of the Asset / Sum of the digits of the life in years x cost of Asset

= 5/(1+2+3+4+5) x 10000

= 5/15 x 10000 

= 3333

 

Second Year Depreciation calculation

 = 4/(1+2+3+4)  x (10000-3333)

= 4/10 x 6667

= 2667

7.       Revaluation Method:

 

·         Very easy method. No formulas, no calculation specially.

·         Useful for small items like cattle, loose tools.  It’s not useful to maintain an account for single item.

·         At the end of year, the asset value is revalued and the difference between Opening Value and Revalue is charged as Depreciation in the Profit and Loss account.

·         Example:  Loose tools opening balance on 1.4.2019 is Rs. 10000.  On 31.03.2020, the same asset is revalued at Rs. 7500.  The difference Rs. 2500 was charged as Depreciation to Profit and Loss Account for the year ending 31.3.2020.

·         Merits and Limitations are not much. Just this method is useful for small assets like cattle, loose tools etc.

 

8.       Depletion Method:

 

·         Used for Quarries, Mines etc

·         Depreciation is calculated as per actual tonne of output

·         Example:

A Mine is purchased for Rs. 1,00,000.  Estimated Total quantity is 100 Tonnes.

Estimated Depreciation per Tonne = 100000/100 = Rs.1000

In 2019-20, the output is 5 Tonnes, the Depreciation = 5 x 1000 = Rs. 5000.9

9.       Machine Hour Rate Method:  (2004 -5 marks)

 

·         It is similar to Depletion method.

·         Depreciation is calculated based on the Number of machine hours used in that particular year.

Example:

An Machine is purchased at the cost of Rs. 1,00,000 /-.  Estimated Machine hours during its life is 10000.

Hence Depreciation per hour = 100000/10000 = Rs. 10

In 2019-20, the Total machine hours used are 400, the Depreciation charged to the Profit & Loss Account in that year = 400 x Rs.10 = Rs.4000

10.   Repair Provision Method:

 

·         The theme of this method is, the estimated repairs during the life of the Asset also considers at the time of calculation of the Depreciation and charged Actual Repairs to the Repairs provision instead of Profit & Loss Account.

 

·         Example:

 

A Machine purchased at the cost of Rs. 1,00,000 /-.  Estimated life is 10 years. Estimated Scrap value is Rs. 10,000/-.  Estimated Repairs 5000

 

 Depreciation& Repairs provision per year = Asset Value –Scrap Value + Estimated Repairs /No of years (life)

 

Depreciation& Repairs provision = 100000 – 10000 + 5000 / 10

 

Depreciation& Repairs Provision = 95000/10 = 9500  (Depreciation = 9000 & Repairs =500)

 

The Journal entry should be

 

Depreciation A/c Dr 9500

        To Machinery A/c  9000

        To Repairs Provision A/c  500

 

When Actual Repairs incurred

Repairs Provision A/c   Dr 300

              To Bank A/c                     300

       

·         The Actual Repairs, if any, not charged to Profit & Loss Account, but to Repairs Provison A/c

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