Characteristics of depreciation, basic factors for determining depreciation

Characteristics of depreciation

Depreciation has the following characteristics:

(1) Depreciation is only charged for fixed assets e.g. buildings, installations and machines, furniture etc. There is no depreciation on current assets such as stocks, accounts receivable, accounts receivable etc.

(2) Depreciation causes a perpetual, gradual and continuous decline in the value of assets

(3) Depreciation takes place up to the last day of the estimated useful life of assets

(4) Depreciation occurs due to the use of assets. However, in certain cases, depreciation may occur even if the assets are not used, e.g. Leasehold, Patent, Copyright etc.

(5) Depreciation is a charge against the income of an accounting period.

(6) Depreciation does not depend on fluctuations in the market value of assets

(7) The amount of depreciation of a financial year cannot be precisely determined, it must be estimated. However, in certain cases it can be determined precisely, for example Long Lease, Patent Law, Copyright, etc.

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

Basic factors for determining depreciation

(1) original cost of fixed assets, ie purchase price plus freight and installation costs;

(2) estimated amount of repair costs over the useful life;

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

(4) estimated salvage or scrap value;

(5) interest on investment – the amount invested when purchasing an asset, which interest would have been earned had it been invested in another investment;

(6) possibility of obsolescence.

Fixed term or original cost or straight line method, diminishing/decreasing balance method

This method does not depreciate the cost of the asset. It is calculated on the book value. of assets. The book value of the asset is obtained by subtracting the depreciation from the cost. The book value of assets gradually decreases due to depreciation costs. Since the depreciation rate is applied to reducing the balance of assets. this method is called diminishing balance or diminishing installment method or amortized value method.

Pros and cons.

Declining balance method not only equitably aligns depreciation expense with related income, but also spreads out fairly. the incidence of depreciation and repairs (ie higher depreciation but heavier repairs in later years.) in the income statement over the life of the asset. Eliminating much of the cost in the early years also minimizes the impact of obsolescence. It is equally useful for management, as accelerated depreciation means smaller taxable gains and taxes, and therefore less cash outflow.

Accelerated depreciation methods

Sum of the digits of the year (SYD). This method of depreciation accelerates the depreciation expense so that the amount recognized in the earlier periods of an asset’s useful life is greater than the amount recognized in the later periods. The SYD is found by estimating the useful life of an asset in years, then assigning sequential numbers to each year and adding those numbers. for one year,
SOUTH = 1 + 2 + 3 + 4 + … +n

annuity method

The method recognizes the time value (interest) of money and therefore considers the true cost of using long-lived assets to be equal to the actual amount invested on them plus the interest lost in acquiring the asset. Under this method, so much is depreciated each year that after debiting the asset account with interest on the diminishing value, the asset is reduced to zero at the end of its useful life. So, the amount written off as amortization is the same every year, but the interest will decrease every year.

The amount of annual depreciation to be amortized under the annuity method is determined using the annuity tables

Amortization Fund Method or Sinking Fund Method

With this method, a fixed amount is charged annually as depreciation. It aims to provide the required lump sum cash on retirement of a long-lived asset by setting aside a fixed annual amount and investing in readily realizable securities. These securities earn interest at a fixed rate of interest and are reinvested along with successive fixed amortization periods, which may be accumulated at compound interest. Thus, the sinking fund method takes this probable interest income into account while determining and investing annual amortization, which, along with compound interest, adds up to the depreciable cost of the asset at the end of its useful life. Naturally, the fixed depreciation period here is smaller compared to the straight-line method. However, its size depends on the life and interest rate of the asset. The longer the span and the higher the rate, the smaller the annual depreciation per rupee of depreciable expenses.

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Shortcomings of the amortization fund method

The amortization 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 fluctuate every now and then. Any variation in the rate of return disrupts and mirrors the previous periodic allocation for depreciation. Further, the amount realized on the sale of securities rarely matches the acquisition costs due to fluctuations incurred which can be both erratic and significant. These can cause a large gap between the money needed and the money delivered.

Insurance Policy Method

This method aims to provide the necessary cash at the retirement of a particular asset in exchange for a periodic contribution (premium). In this, a trader purchases “Capital Redemption Insurance” from an insurance company that commits to paying a certain amount on a certain date if the trader pays a set number of premiums at regular intervals. The merchant treats the periodic payment as a debit and charges it to the income statement. In this case, depreciation is made at the end of the year, while the premium is paid at the beginning of the year. On the due date, the insurance company pays the policy money that is normally sufficient to replace the retired set. Normally, the amount received is more than the total premium paid, as the policy accrues interest.

Revaluation method

Under the system, the asset is appraised every year and the value is compared to that at the beginning of the year. The decrease is treated as amortization. Suppose if the value of the tools at the beginning of the year was Rs. 8,000, during the year tools worth Rs. 6,000 were purchased and at the end of the year when appraised were Rs. 11,000. The depreciation amount for the year is: 8,000 + 6,000-11,000 = Rs. 3,000. This method is useful for accounting for depreciation on livestock and loose tools.

Exhaustion method

Natural resources include physical assets such as mineral deposits, oil and gas wells, and timber stands. These natural resources are depleted through 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 its acquisition plus the price paid for developing such an asset to bring it to a state suitable for production.

It is better not to calculate the periodic depletion in years. 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.

Hourly rate machine

This method estimates the total working hours of a machine over its entire effective life, and then divides the cost of the machine by the expected number of hours of useful life, which gives the hourly rate. The annual depreciation is calculated by multiplying this percentage by the number of hours the machine actually runs in a year.

Mileage method

This method is only used for assets whose useful life depends on the number of kilometers driven, e.g. buses, cars, trucks and rolling stock, etc.

Global method

In this method, the value of assets, regardless of their nature, is added together and depreciated at an average rate over the aggregated value.

Choice of a method

The aforementioned methods of depreciation show that none of them is absolutely best or worst, as each method has its own advantages and disadvantages. The suitability of each method is relative and depends on several factors. The most important of these are the type of asset and the purpose of the depreciation.
Straight line method suits buildings and lease etc. Reduced installment method suits machine equipment etc and depletion method for wasting assets like mines. quarries etc. However, the underlying purpose is the fundamental determinants of the suitability of a method of depreciation. Major purposes include truthful reporting of accounts, tax benefits, comparative product cost, financial flexibility, replacement and expansion etc. For example. The depreciation fund method means that the amount set aside for depreciation is invested outside the company in specific securities. Similarly, in the insurance policy method, the amount thus reserved is transferred to the insurance company. If a company has working capital problems, the desirability of these methods is questionable.

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Of the above methods, (1) Fixed Installment and (2) Reduced Installment Methods are the most commonly used.

Distinguish between fixed installment method and installment method

Fixed payment method

1. The depreciation percentage and depreciation amount remain the same every year.

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

3. At the end of its useful life, the value of the asset is reduced to zero or scrap value.

4. The older the asset, the higher the cost of repairs. But the depreciation amount remains the same every year. The total of depreciation and repairs therefore increases every year. As a result, the annual profit gradually decreases.

5. Calculation of depreciation relatively easy and simple.

Reduction of the payment method

1. The rate remains the same, but the depreciation amount gradually decreases.

2. The depreciation rate is calculated based on the book value of the asset.

3. The value of assets is never reduced to zero at the end of its useful life.

4. The depreciation amount gradually decreases, while the repair costs increase.
The total of depreciation and repairs therefore remains more or less the same every year. So it causes little or no change in annual profit/loss.

5. The depreciation can be calculated without any effort, but it is not so easy and simple.