Characteristics of Depreciation, Basic Factors of measurement of Depreciation

Law Of Diminishing Marginal Product - Characteristics of Depreciation, Basic Factors of measurement of Depreciation

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Characteristics of Depreciation

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Law Of Diminishing Marginal Product

Depreciation has the following characteristics:

(1) Depreciation is expensed in case of fixed assets only, e.g., Building, Plant and Machinery, Furniture 'etc. There is no request of depreciation in case of current assets-such as Stock, Debtors, Bills Receivable etc.

(2) Depreciation causes perpetual, gradual and continuous fall in the value of asset

(3) Depreciation occurs till the last day of the estimated working life of asset

(4) Depreciation occurs on list of use of asset In sure cases, however, depreciation may occur even if the assets are not used, e.g., Leasehold Property, Patent right, Copyright etc.

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

(6) Depreciation does not depend on fluctuations in shop value of asset

(7) The whole of depreciation of an accounting year cannot be carefully precisely-it has to be estimated. In sure cases, however, it may be ascertained exactly, e.g., Leasehold Property, Patent Right, Copyright etc.

(8) Total depreciation of an asset cannot exceed its depreciable value (cost less scrap value).

Basic factors of measurement of depreciation

(1) former cost of fixed asset i.e., buy price plus freight and installation expenses;

(2) estimated whole of expenditure on repairs during the useful life;

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

(4) estimated residual or scrap value;

(5) interest on investment-the whole invested on buy of asset, if it had been invested in some other venture what interest would have been earned;

(6) possibility of obsolescence.

Fixed Installment or former Cost or right Line Method, reducing/Diminishing balance method

Under this formula depreciation is not calculated on cost of asset. It is computed on the book value. Of asset. The book value of the asset is obtained by deducting depreciation from its cost. The book value of asset slowly reduces on list of depreciation charge. Since the depreciation percent rate is applied on reducing balance of asset. This formula is called reducing balance or diminishing installment formula or written down value method.

Merits and demerits.

Declining balance formula not only equitably matches depreciation expenses against the associated income but also fairly spreads. The incidence of depreciation and repairs (viz higher depreciation but heavier repairs in later years.) on profit and loss list over the assets life span. Elimination of major measure of cost in early years also minimizes the impact of obsolescence. It is equally useful to administration as accelerated depreciation means smaller dutible profits and taxes hence lesser outflow of cash.

Accelerated Depreciation Methods

Sum-of-the year's digits (Syd). This formula of depreciation accelerates depreciation expenses so that the whole recognized in the earlier periods of an asset's useful life are greater than those recognized in the latter periods. The Syd is found by estimating an asset's useful life in years, then assigning consecutive numbers to each year, and totaling these numbers. For n years,
Syd = 1 + 2 + 3 + 4 + ... +n

Annuity Method

The formula recognizes the time value (Interest) of money and hence regards the real cost of using a long-lived asset equivalent to the actual whole invested thereon plus the interest lost on the acquisition of asset. Under this method, so much depreciation is written off each year as after debiting the asset list with interest upon the diminishing value, will sell out the asset to nil at the end of its life. Thus, the whole written off as depreciation is the same every year, but the interest will diminish each year.

The whole of yearly depreciation to be written off by Annuity formula will be ascertained from Annuity Tables

Depreciation Fund formula or Sinking Fund method

Under this method, a fixed whole is expensed as depreciation every year. It endeavors to furnish the required lump sum cash at the resignation of a long, lived asset by annually setting aside and investing a fixed sum in readily realizable securities. These securities earn interest at fixed rate and the same being reinvested along with successive fixed installments of depreciation, allowed to collect at aggregate interest. The sinking fund formula thus takes into list of this probable income from interest while fixing the yearly depreciation and investing the same which together with aggregate interest accumulated to the asset's depreciable cost by the end of its useful life. Obviously, the fixed installment of yearly depreciation is here smaller as compared to right line method. Its magnitude, however, rests on the asset's life span and interest rate. Longer the span and higher the rate, smaller is the yearly depreciation per rupee of depreciable cost.

Shortcomings of Depreciation Fund Method

Depreciation fund formula assumes constant rate of return on every periodic venture in same securities. This is hardly true in this dynamic world where rates do vary now and then. Any inequity in the rate of return upsets the earlier periodic budget for depreciation and entails refection thereof. Added the whole realized on the sale of security rarely agrees with its acquisition cost owing to made fluctuations which may be both erratic and considerable. Those may cause a wide gap in the middle of the required and supplied cash.

Insurance course Method

This formula endeavors the furnish of required cash at the resignation of a specified asset in return of periodic offering (premium). Under this a trader takes a 'Capital Redemption assurance Policy' from an assurance enterprise which undertakes to pay at a given date a sure sum if the trader, paying a fixed whole of premiums after regular intervals. The trader treats the periodic payment as depreciation and charges it to profit and loss account. In this case, depreciation is expensed at the end of the year, whereas, the superior is paid at the beginning of the year. At maturity, the assurance enterprise pays the course money which is normally enough to replace the retired set. Normally, whole received is more than total superior paid as the course yields interest.

Revaluation Method

Under the system, each year the asset is valued and the value is compared with that in the beginning of the year. The fall is treated as depreciation. 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, on valuation these amounted to Rs. 11,000. The whole of depreciation for the year will be : 8,000 + 6,000-11,000 = Rs. 3,000 . This formula is useful for charging depreciation on livestock and loose tools.

Depletion Method

Natural resources consist of bodily assets like mineral deposits, oil and gas resources and timber stands. These natural resources get exhausted by exploitation. In some cases, the discount in bodily deposits is offset by increase or development of Added deposits.

The cost of natural resources is the price paid for its acquisition plus price paid for development of such asset in order to bring it to a state favorable for production.

The periodic depletion is best not calculated in terms of year. Rather it is best to conjecture the cost per unit and then multiply the cost of unit to units produced in that singular year.

Machine Hour Rate

Under this method, the total whole of working hours of a engine during the whole of its efficient life is estimated, and then the cost of engine is divided by the staggering whole of hours of useful life, this gives the rate per hour. The yearly depreciation is calculatedly multiplying this rate by the whole of hours, the engine certainly runs in a year.

Mileage Method

This formula is used only for those assets whose useful life depends upon the fact that how many kilometers they have been driven e.g. Buses, cars, trucks and rolling stock etc.

Global Method

Under this method, the value of the assets, irrespective of their nature is added together and depreciation is expensed at an mean rate on aggregated value.

Choice of a Method

Aforesaid methods of depreciation quote that none is certainly best or worst as each formula has its own merits and demerits. Suitability of every formula is relative and depends upon varied factors. Most important of these are the type of the asset and purpose of depreciation.
Straight line formula suits to structure and lease etc.. Reducing installment formula fits to machinery equipment etc. And depletion formula for wasting assets like mines. Quarries etc. However, the basal purpose is the basic determinants of the propriety of a depreciation method. important purpose consist of of true reporting of accounts, tax benefits, comparative stock cost, financial flexibility, exchange and expansion etc. For example. Depreciation fund formula envisages that the whole set aside for depreciation is to be invested covering the enterprise in exact securities. Similarly under assurance course method, the whole so set aside is handed over to assurance company. If a enterprise is having working capital problems the advisability of these methods is questionable.

Of the above-mentioned methods (1) Fixed Installment and (2) Reducing Installment methods are most widely used.

Distinction in the middle of Fixed Installment formula and Reducing Installment Method

Fixed Installment Method

1. The rate and whole of depreciation remain the same each year.

2. Depreciation rate per cent is calculated on cost of asset each year.

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

4. The older the asset, the larger the cost of its repairs. But the whole of depreciation remains the same each year. Hence, the total of depreciation and repairs increases every year. This reduces yearly profit gradually.

5. Computation of depreciation comparatively easy and simple.

Reducing Installment Method

1. The rate remains the same, but the whole of depreciation diminishes gradually.

2. Depreciation rate percent is calculated on book value of asset.

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

4. The whole of depreciation decreases gradually, while the cost of repairs increases.
So the total of depreciation and repairs remains more or less the same each "year. Hence, it causes microscopic or no convert in yearly profit/loss.

5. Depreciation can be computed without any difficulty, but it is not so easy and simple.

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