Depreciation (or sinking) fund method. One of the objectives of providing for depreciation (as explained earlier) is to provide for replacement of the assetat the end of its useful life. In case of the three methods discussed earlier, the amount of depreciation charged from the Profit & Loss Account continues to remain in the business. However, this amount may get invested in the course or running the business is some other assets. It may, therefore, not be possible for the business to have sufficient liquid resources to purchase a new asset at the time when it needs funds for replacement. Depreciation Fund Method takes care of such a contingency. According to this method, the amount charged by way of depreciation is invested in certain securities carrying a particular rate of interest. The amount received on account of interest from these securities is also invested from time to time together with the annual amount charged by way of depreciation. At the end of the useful life of the asset, when replacement is required, the securities are sold away and money realised on account the sale of the securities is used for purchase of a hew asset. The method has the advantage of providing a separate sum for replacement of the asset. However, the methodhas a disadvantage. It puts an increasing burden on the profit and loss of each year on account of a fixed charge for depreciation but increasing charge for repairs.
Change in the Method of Depreciation
Sometimes a change in the method of depreciation may be required. For example, a firm may change the method of depreciation from Fixed Instalment Method to Reducing Balance Method or vice versa. In such a case, there can be two different situations:
(i) Change in the method of depreciation may be desired from the current year onwards. In such a case, depreciation will be charged according to the new method from the current year (See Illustrations 13.9 and 13.12).
(ii) Change in the method of depreciation may be desired from a back date. This will require necessary adjustments to be made in the current year for any extra or less depreciation charged in earlier years. Jn such a case, the best course would be to compute the amount of depreciation which has already been charged according to the old method and the amount of depreciation that is to be charged according to the new method. The difference if any should be credited (or debited) to the Asset Account in the current year and should be shown as a separate charge (or income) in the Profit and Loss Account of the current year of the firm. (See Illustrations 13.10 and 13.11).
Declining Charge Depreciation Methods
In case of these methods the amount charged for depreciation declines over the asset’s expected life. These methods are suitable in those ease where (a) the receipts are expected to decline as the asset gets older and it is believed that the allocation of depreciation should be related to the pattern of asset’s expected receipts.
Following methods fall in this category.
(a) Diminishing balance method. According to this method, depreciation is charged on the book value of the asset each year. Thus, the amount of depreciation goes on decreasing every year. For example, if the cost of an asset is Rs 20,000, and the rate of depreciation is 10%, the amount of depriciation to be charged in the first year will be a sum of Ps 2,000. In the second year, depreciation will be charged at 10% on the hook value of the asset, i.e., Rs 18,000 (i.e., Rs 20,000— Ps 2,000) and so on.
Merits. (i) The method puts an equal burden for use of the asset on each subsequent year. The amount of depreciation goes on decreasing for each subsequent year while the charge for repairs goes on increasing for each subsequent year. Thus, increase in the cost of repairs for each subsequent year is compensated by decrease in the amount of depreciation for each subsequent year.
(ii) The method is simple to understand and easy to follow.
Demerits. (i) The value of the asset cannot be brought down to zero under this method.
(ii) The detennination of a suitable rate of depreciation is also difficult under this method as compared to the Fixed Instalment Method.
This is also known as productive output method. this method the charge for depreciation in respect of the use of an based on the following factors:
According to asset will be
(i) Total amount paid.
(ii) Total estimated quantities of the output available.
(iii) The actual quantity taken out during the accounting year.
The method is suitable in case of mines, queries, etc., where it is possible to make an estimate of the total output likely to he available. Depreciation is calculated per unit of output The amount of depreciation to be charged in a particular year is computed by multiplying the units of output with the rate of depreciation per unit of output. For example, if a mine is purchased for Rs 20,000 and it is estimated that the total quantity of mineral in the mine in 40,000 tonnes, the rate of depreciation per tonne would amount to 50 paise per tonne (Rs 20,000/4Q000 tonnes). In ease output in a year amounts to 10,000 tonnes, the amount of depreciation to be charged to the Profit and Loss Account would Rs 5,000 (i.e., 10,000 tonnes x Re 0.50).
The method has the advantage of correlating the amount of depreciation with the productive use of the asset. However, it requires making of a reasonably correct estimate of the output likely to be there. In the absenèe of correct estimate, the amount charged by way of depreciation will not be correct.
Uniform Charge Methods
In case of these methods depreciation is charged on uniform basis year after year. Such methods are considered appropriate only for such assets which are uniformly productive. Following three methods fall in this category.
Fixed instalment method. This is also termed as Straight Line Method (SLM).
According to this method, depreciation is charged evenly every year throughout the effective life of the asset The amount of depreciation is calculated as follows.
Depreciation = Original Cost of the Fixed Asset — Estimated Scrap Value/ Life of tie Asset in Number of Accounting Periods
Depreciation to be charged each year can also be expresscd as a percentage of cost.
Merits. (I) The method is simple to understand and easy to apply.
(ii) The value of the asset can be reduced to zero (or its scrap value) under this method. [Read more…]