Characteristics of Depreciation, Basic Factors of measurement of Depreciation

Law Of Diminishing Returns Definition - Characteristics of Depreciation, Basic Factors of measurement of Depreciation

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Characteristics of Depreciation

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Law Of Diminishing Returns Definition

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 demand 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 unavoidable 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 wage of an accounting period.

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

(7) The number of depreciation of an accounting year cannot be determined precisely-it has to be estimated. In unavoidable 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 estimation of depreciation

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

(2) estimated number 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 number invested on buy of asset, if it had been invested in some other investment what interest would have been earned;

(6) possibility of obsolescence.

Fixed Installment or traditional Cost or level Line Method, reducing/Diminishing equilibrium 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 gradually reduces on list of depreciation charge. Since the depreciation percent rate is applied on reducing equilibrium of asset. This formula is called reducing equilibrium or diminishing installment formula or written down value method.

Merits and demerits.

Declining equilibrium formula not only equitably matches depreciation expenses against the linked wage 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 supervision 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 number 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 number 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 cut the asset to nil at the end of its life. Thus, the number written off as depreciation is the same every year, but the interest will diminish each year.

The number of each year 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 number is expensed as depreciation every year. It endeavors to supply the required lump sum cash at the seclusion 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 acquire at compound interest. The sinking fund formula thus takes into list of this probable wage from interest while fixing the each year depreciation and investing the same which together with compound interest accumulated to the asset's depreciable cost by the end of its useful life. Obviously, the fixed installment of each year depreciation is here smaller as compared to level 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 each year depreciation per rupee of depreciable cost.

Shortcomings of Depreciation Fund Method

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

Insurance course Method

This formula endeavors the supply of required cash at the seclusion of a specified asset in return of periodic gift (premium). Under this a trader takes a 'Capital Redemption guarnatee Policy' from an guarnatee business which undertakes to pay at a given date a unavoidable sum if the trader, paying a fixed number of premiums after quarterly intervals. The trader treats the periodic cost as depreciation and charges it to profit and loss account. In this case, depreciation is expensed at the end of the year, whereas, the excellent is paid at the starting of the year. At maturity, the guarnatee business pays the course money which is usually sufficient to replace the retired set. Normally, number received is more than total excellent 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 starting of the year. The fall is treated as depreciation. Suppose if the value of the tools at the starting 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 number 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 include corporeal assets like mineral deposits, oil and gas resources and timber stands. These natural resources get exhausted by exploitation. In some cases, the allowance in corporeal 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 suitable for production.

The periodic depletion is better not calculated in terms of year. Rather it is better to surmise 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 number of working hours of a machine during the whole of its sufficient life is estimated, and then the cost of machine is divided by the improbable number of hours of useful life, this gives the rate per hour. The each year depreciation is calculatedly multiplying this rate by the number of hours, the machine 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 recap 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 various factors. Most foremost 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 tool 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. foremost purpose include of true reporting of accounts, tax benefits, comparative product cost, financial flexibility, replacement and expansion etc. For example. Depreciation fund formula envisages that the number set aside for depreciation is to be invested outside the business in specific securities. Similarly under guarnatee course method, the number so set aside is handed over to guarnatee company. If a business 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 between Fixed Installment formula and Reducing Installment Method

Fixed Installment Method

1. The rate and number 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 number of depreciation remains the same each year. Hence, the total of depreciation and repairs increases every year. This reduces each year profit gradually.

5. Computation of depreciation comparatively easy and simple.

Reducing Installment Method

1. The rate remains the same, but the number 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 number 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 tiny or no convert in each year profit/loss.

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

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