Methods of Providing Depreciation
Seven Important methods of providing depreciation
Straight Line Method
Under this method, a fixed percentage of original cost is written off the asset every year. Thus, if an asset costs Rs.20,000 and 10 percent depreciation were considered adequate, Rs.2,000 would be written off every year. The amount to be written off every year is arrived at as under:
= ( Cost – Estimated Scrap Value ) / Estimated Life
The period for which the asset is used in a particular year should also be taken into account. This method is simple in calculation and also in such a case, the charge to the Profit and Loss Account is uniform every year. This method is useful when the service rendered by the asset is uniform from year to year. It is desirable, when this method is in use, to estimate the amount to be spent by way of repairs during the whole life of the asset and provide for repairs each year at the average actual repairs.
Written Down Value Method
Under this method, the rate or percentage of depreciation is fixed, but it applies to the value at which the asset stands in the books in the beginning of the year. In other words, under this method, a fixed percentage is written off every year on the reduced balance of the asset. Thus, the percentage of depreciation is not applied to the original cost but only to the balance, which remains after charging depreciation in the beginning of a year. The percentage of depreciation remains fixed for all the years of the working life of an asset but the actual amount of depreciation written off every year goes on decreasing with the reduction in the value of the asset.
Insurance Policy Method or Capital Redemption Policy Method
Under this method the business takes a policy from an insurance company. The amount of the policy is such that it is sufficient to replace the asset when it is worn out. Cash, which is equal to the amount of depreciation, is paid by way of premium every year. The amount goes on accumulating with the insurance company at a certain rate of interest and is paid back to the insured at the maturity of the policy. The amount so made available by the insurance company is used for purchasing a new asset. This method to a great extent is similar to sinking fund method, but no doubt the procedure is a little different. In this method, instead of buying securities, the insurance policy is taken and premium is paid every year. Company, that receives premium, allows a small interest on compound basis.
This method is a more suitable device for ensuring the availability of cash to replace the asset. The advantage under this system is that the company need not worry whether the investments as under the Depreciation Fund Method, will be sold at best prices or not.
If an insurance policy is taken, it serves two purposes. Firstly, it insures the asset. Secondly, the insurance company will pay the stipulated amount to enable the company to replace assets. This method is more expensive as the insurance company has to keep its margin of profits. It is suitable for losses where the life of the asset is definitely known. It yields a very low rate of interest. It makes no adjustments for price-level changes.
Sum of the Digits Method
Under this method, amount of the depreciation to be written off each year is calculated by the following formula:
= Remaining Life of the Asset (including the Current Year) / Sum of all the Digits of the Life of the Asset in Years x Cost of the Asset
Suppose the life of an asset costing Rs.50,000 is 10 years. The sum of all the digits from 1 to 10 comes to 55 i.e., 10+9+8+7+6+5+4+3+2+I = 55. The depreciation to be provided in the first year will be:
= 10 / 55 x 50,000 or Rs.9,091
In the second year, it will be:
9 /55 x 50,000 or Rs.8,181
This method is similar to the Written Down Value Method described earlier.
This method is used only in case of small items like cattle (Livestock), or loose tools where it may be too much to maintain an account of each single item. The amount of depreciation to be written off is determined by comparing the value at the end of the year (valuation being done by some one having expert knowledge of the valuation of the asset) with the value in the beginning.
Suppose on 1st April 2,007 the value of loose tools was Rs.10,000 and during the year Rs.30,000 worth of tools were purchased. Now if at the end of the year, the loose tools are considered to be worth only Rs.25,000 the depreciation comes to Rs.15,000 i.e. Rs.10,000+ Rs.30,000 – Rs.25,000.
The depletion method is used in case of mines, quarries, etc., where an estimate of total quantity of output likely to be available should be available. Depreciation is calculated per ton of output.
For example, if a mine is purchased for Rs.20,00,000 and it is estimated that the total quantity of mineral in the mine is 5,00,000 ton, the depreciation per ton of output comes to = 20,00,000 / 5,00,000 = Rs. 4.
If the output in the first year is 30,000 then the depreciation will be30,000 x Rs.4 = Rs. 1,20,000, in the second year, the output may be 50,000 ton; the depreciation to be written off will be Rs.2,00,000 i.e., 50,000 x Rs.4.
Machine Hour Rate Method
This is more or less like the depreciation method. Instead of the usual method of estimating the life of a machine in years, it is estimated in hours. Then, an accurate record is kept recording the number of hours each machine is run and depreciation is calculated accordingly.
For example, the effective life of a machine may be 30,000 hours. If the cost of the machine is Rs.4,50,000, the hourly depreciation is
= 4,50,000 / 30,000 = Rs. 15.
The depreciation for a particular year during which the machine runs for 2,500 hours will be 2,500 x Rs.15 = Rs.37,500.