Depreciation Accounting – How to fix Depreciation Amount

FIXATION OF DEPRECIATION AMOUNT

Following are the three important factors which should be considered for determining the amount of depreciation to be charged to the Profit and Loss Account in respect of a particular asset.

1. Cost of the asset The cost of the asset includes the invoice price of the asset, less any trade discount pius all costs essential to bring the asset to a useahie condition. It should be noted that financial charges, such as interest on money borrowed for the purchase of the asset, should not be included in the cost of the asset.

2. Estimated scrap value. The term scrap value means the residual or the salvage value which is estimated to be realised on account of the sale of the asset at the end of its useful life. In determining the scrap value, the cost to be incurred in the disposal or removing of the asset should be deducted out of the total realisable value.

3. Estimated useful life. This is also termed as economic lift of the asset. This may be calculated in terms of years, months, hours, units of output of other operating measures such as kilometers in case of a taxi or a truck.

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Depreciation Accounting – Amortization

Amortization. The process of writing off intangible assets is termed as amortization. Some intangible assets like patents, copyrights, leaseholds have a limited useful life. Hence, their cost must be written off over such period.

The American Institute of Certified Public Accountants (AICPA) has put the difference between depreciation, depletion, and amortization in the following words.

“Depreciation can be distinguished from other terms with specialised meanings used by accountants to describe assets cost allocation procedures. Depreciation is concerned with charging the cost of man made fixed assets to operations (and not with determination of asset value for the balance sheet). Depletion refers to cost allocations for natural resources such as oil and mineral deposits. Amortization relates to cost allocation for intangible assets such as patent and leaseholds. Thc use of the term depreciation should alsobe avoided in connection with the valuation prOcedures for securities and investments”.

 

Depreciation Accounting – Change in the Method of Depreciation

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).

Depreciation Accounting – Sinking fund method

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.

Sum of years digits | Double declining balance method

Sum of years digits (or SYD) method. This method is on the paltern of Diminishing Balance Method. The amount of depreciation to be charged to the Profit and Loss Account under this method goes on decreasing every year. The depreciation is calculated

Double declining balance method. This method is similar to reducing or declining balance method explained above except that the rate of depreciation is charged at the rate which is twice the straight line rate. While computing this rate two things have bee,n kept in mind;

(a) No allowance is to be made for the scrap value of the asset.

(b) The total cost should not be reduced by charging the depreciation to an amount lower than the estimated scrap value of the asset.

The declining charge methods of depreciation are preferred over unifonn charge methods of depreciation on account of the following reasons:

(1) The total cost for use of the asset is evenly spreaded over the useflul life of the asset. Such cost of the use of the asset includes both depreciation and repairs. With the asset growing order.

Depreciation Accounting – Declining Charge Depreciation Methods

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.

 

Depreciation Accounting – Features of Depreciation

BASIC FEATURES OF DEPRECIATION 

1. The term depreciation is used only in respect of fixed assets. Of course, the current assets may also lose their value. Loss on account of fall in their value is taken caie of by valuing them for Balance Sheet purposes “at cost or market price whichever is less”.

2. Depreciation is a charge against profits. This means that true profit of the business cannot be ascertained withQut charging depreciation.

3. Depreciation is different from maintenance. Maintenance expenses are incurred for keeping the machine in a slate of efficiency. However, any degree of maintenance cannot assure that the asset will never reach a state of scrap. Of course, good maintenance delays this stage but it cannot absolutely prevent it.

4. All fixed assets, with certain possible exceptions e.g.,land, and antiques etc., suffer depreciation although the process i’nay be invisible or gradual.

 

Depreciation Accounting – Depletion method

Depletion 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.

Depreciation Accounting – Causes of Depreciation

CAUSES OF DEPRECIATION

The causes of depreciation are as follows:

1. Wear and tear. Assets get worn or torn out on account of constant use as is the case with plant and machinery, furniture and fixtures- used in a factory.

2. Exhaustion. An asset may get exhausted through working. This is the case with mineral mines, oil wells etc. On account of continuous extraction of minerals or oil, a stage comes when the mine or well gets completely exhausted and nothing is left.

3. Obsolescence. Some assets are discarded before they are worn out because of changed conditions. For example, an old machine which is still workable may have to be replaced by a new machine because of the latter being more efficient and economical. Such a loss on account of new inventions or changed fashions is termed as loss on account of obsolescence.

4. Etfiux of time. Certain assets get decreased in their value with the passage of time.  This is true in case of assets like leasehold properties, patents or copy rights.

5. Accidents. An asset may meet an accident and, therefore, it may get depreciated in its value. On the basis of the above causes, it can be said that depreciation is the decrease or depletion in the value of an asset due to wear and tear, lapse of time, obsolescence, exhaustion and accidents.

 

Depreciation Method – Machine hour rate method

Machine hour rate method. This is also known as Service Hours Method. This method lakes into account the running time of the asset for the purpose of calculating depreciation. The method is particularly suitable for charging depreciation on plant and machinery, air-crafts, etc. The amount of depreciation is calculated as follows:

Original Cost of the Asset — Scrap Value/ Life of the Asset in hours 

For example, if a machine (having a scrap value of Rs 1,000) is purchased for Rs 20,000 and it has an effective life of 10 years of 1,000 hours each, the amount of depreciation per hour will be computed

The method has the advantage of correlating the charge for depreciation, to the actual working time of the machine. However, this method can he used only in case of those assets whose life can be measured in terms of working time.

 

Objectives of Providing Depreciation

OBJECTIVES OF PROVIDING DEPRECIATION

The following are objectives of providing depreciation:

1. Ascertainment of true profits. When an asset is purchased, it is nothing more than a payment in advance for an expense. For example, if a building is purchased for Rs 10,000 for business, the effect of such a purchase will be saving in the cost of rent in the future. But, after a certain number of years, the building will become useless. The cost of the building is, therefore, nothing except paying rent in advance for a period of years. If the rent had been paid, it would have been charged as an expense for determination of the true profits, made by the business during a particular period. The amount paid for the purchase of building should, therefore, be charged over a period of time for which the asset would be serviceable.

2. Presentation of true financial position. The assets get depreciated in their value over a period of time on account of various factors, as explained before. In order to present a true slate of affairs of the business, the assets should be shown in the Balance Sheet, at their proper values.

3. Replacement of assets. Assets used in the business need replacement after the expiry of their service life. By pmviding depreciation a part of the profits of the business is kept in the business which can be used for purchase of new assets on the old fixed assets becoming useless.