Methods of Depreciation

 

Different methods of calculating provision for depreciation are mainly Accounting customs which may be used by different concerns taking into consideration thier individual peculiarities.

   The following are the main methods of providing Depreciation:

Fixed instalment ( or fixed percentage on original cost or straight line) method:

Under this method a fixed percentage of the original value of the asset is written off every year so as to reduce the asset account to nil or to its scrap value at the end of the estimated life of the asset.

  To ascertain the annual charge under this method all that is necessary is to divide the original value of the asset ( minus it's residual value, if any ) by the number of years of its estimated life i.e., 

  The amount of depreciation charged during each period of the assets like is constant.

   If the charge of depreciation is plotted annually on a graph paper and the points joined together, then the gap will reveal a straight line, that is why it is also called as straight line method.

Merits of fixed instalment method:

(i) This method is simple to understand and easy to apply.

(ii) it can write down an asset to zero at the end of its working life, if so desired.

(iii) This method is very suitable for those Assets which have a fixed life e.g., furniture, fixtures, short leases and other Assets of a small intrinsic value.

Demerits of fixed instalment method:

(i) The charge for depreciation remains constant year after year.

   The expenses of repairs and maintenance are increasing as the asset grows older. The profit and loss account thus in the later years bears more than its share of valuation.

(ii) It becomes difficult to calculate the depreciation on additions made during a year.

(iii) Under this method the depreciation charge remains the same from year to year irrespective of the use of the asset.

 Thus it does not take into consideration the effective utilisation of the asset.

(iv)  This method tends to report an increasing rate of return on investment in the asset amount is taken.

  Inspite of these drawbacks, this method is mostly used by firms in U.S.A,  Canada, U.k, and some firms in india.

Diminishing Balance ( or Reducing Instalment or written down value) method:

  Under this method, depreciation is calculated a certain percentage each year on the Balance of the asset which is brought forward from the previous year.

   The amount of depreciation charged in each period is not fixed but it goes on decreasing  gradually as the beginning balance of the asset in each , year will reduce.

   The charges in initial periods are higher than those in the later periods. Overall charges, i.e amount of depreciation, repairs and maintenance taken together remains equal throughout the life of the asset.

•   This method is justified in the cases where (I) there is much uncertainty of revenue in later years and (ii) there is also increase in repairs and maintenance costs consequently decreasing efficiency and revenues in every succeeding period. It is usually adopted for plant and machinery.

Merits of Diminishing Balance method:

(i) It tends to give a fairly even charge of depreciation against revenue each year and is counter - balanced by the repairs being light and in the later years when repairs are heavy this is counter- balanced by the decreasing charge for depreciation.

(ii) Fresh calculations of depreciation are not necessarily as and when additions are made.

(iii) This method is recognised by the income tax authorities in india.

Demerits of Diminishing Balance method:

(i) The original cost of the asset is altogether lost sight of an subsequent years and the asset can never be reduced to zero.

(ii) This method does not take into consideration the asset as an investment and interst is not taken into consideration.

(iii) As compared to the first method, it is difficult to determine the suitable rate of depreciation.

Annuity method:

   Under this method, amount spent on the purchase of an asset is regarded as an investment which is assumed to earn interest at a certain rate. 

   Every year the asset account is debited with the amount of calculated on the debit balance of the asset Account at the beginning of the year.

     

    The depreciation will be different according to the rate of interest and According to the period over which the asset is to be written off.

   The  fixed amount of depreciation as well as the rate of interest is so adjusted that at the end of the working life of the asset it's book 📚 value is reduced to zero or to its break up value if any.

   If often happens that owing to a fraction of paise being neglected there often arises a slight difference at the end of the last year and it is , therefore, adjusted in the last instalment.

   This method is to a great extent scientific as it treats the purchase of an asset as an investment in the business itself and charge interest on the same.

Depreciation fund method: 

  Ready cash may not be available when the time of replacement comes because the amount of depreciation is retained in the business itself in the form of asset not separate from other assests  which cannot be readily sold.

   The method ( applied to long leases etc.) Implies that the amount written off as depreciation should be kept aside and invested in readily saleable securities.

 The securities accumulate and when the life of the asset expires, the securities are sold and with the sale proceeds a new Asset is purchased.

  Since the securities always earn interest, it is not necessary to provide for the full amount of depreciation.

  Something less will do. How much amount is to be invested every year so that a given sum is available at the end of a given period depends on the rate of interest which is easily calculated from sinking fund tables.