Concept of Depreciation
Every business owns some fixed assets. Fixed assets are those assets of permanent or long-term nature purchased to increase the production or productivity of a business. These are not for sale during the ordinary course of business. However, these can be disposed of off when they are not needed by the business. Assets like building, machinery, furniture, vehicle etc. come under the category of fixed assets.
With the regular use of such fixed assets, their value gets reduced. Such reduction in the value of fixed assets is known as depreciation. Depreciation can also be regarded as a gradual and permanent decrease in the value of assets from any cause. In other words, depreciation can be said as a reduction in the quality or value of an asset. Similarly, depreciation can be said as that part of the cost of fixed assets thatare gone and not recoverable. It is treated as loss in the Profit and Loss Account and reduced from the related asset in the Balance Sheet.
Key Causes of Depreciation
- Physical wear and tear due to continuous use of the asset
- Exposure to sun, wind etc. and other natural forces
- Change in technology, taste, preference etc. of the customers
- Expiration of legal rights over assets like patent or lease
- Depletion due to continuous extraction such as in the case of mines
- Accidents ruining the physical status of the asset
Factors Determining Depreciation
For computing depreciation for accounting purposes, different factors are to be considered. Such factors determining depreciation has been explained below:
- Historical Cost: It represents total cash outlay to purchase, install, transport, commission etc. along with the improvement or additional cost. It includes all the costs incurred during the complete procedure of acquiring the asset. Higher the historical cost, higher will be the depreciation amount and vice-versa.
- Expected Useful Life: It is the expected life of the asset. It could be in the form of a number of years or units produced from the use of the purchased asset. The longer the life, the lower will be the depreciation and vice-versa.
- Estimated Residual Value: This is the remaining value of the asset at the end of its useful life. This is also called scrap value or salvage value or terminating value. Normally, the higher the residual value, the lower will be the depreciation ad vice-versa.
- Chance of Obsolescence: The amount of depreciation of assets depends on the chance of obsolescence. Such obscene could cause due to change in technology, change in manufacturing trends, change in fashion etc. More obsolescence means more depreciation and vice-versa.
- Legal Provisions: The value of depreciation is dependent on legal provisions too. It must comply with existing laws regarding adjustment, calculation and treatment of depreciation.
Methods of Depreciation
There are different methods in use so as to calculate and charge depreciation of fixed assets. The use of the method depends upon nature, need, choice and legal provision of the business. Such methods of depreciation have been explained below:
- Straight Line Method
- Diminishing Balance Method
- Sum of Year Digit (SYD) Method
- Annuity Method
- Machine Hour Method
- Production Unit Method
- Sinking Fund Method
- Insurance Policy Method
A. Straight Line Method
It is the simplest method of charging depreciation. Due to its simplicity, it is the most widely used method of charging depreciation. Under this method, depreciation is calculated based on the purchase price, useful life and residual value of the asset. This method assumes a uniform amount of depreciation every year. This method is also called Fixed Installment Method or the Original Cost Method. Under this method, the amount of depreciation is calculated as below:
Annual Depreciation =
Where,
Additional Costs = Transportation, installation, commission etc. on purchase
| Advantages | Disadvantages |
| It is easy to understand and simple to implement Equality in depreciation charged as the same amount is chargeable annually Accepted as a standard method by different accounting bodies, agencies and authorities Clarity of book value of an asset to draw necessary conclusions | Complexity at the time when the added asset has a different life than the existing one No provision to consider interest factor in investment made on assets Unreal assumption of uniform use during estimated life of the asset |
B. Diminishing Balance Method
This is another method of depreciation in which the amount of depreciation charged every year is different. More depreciation is charged in the first year which goes on decreasing gradually till the last year of the useful life of the asset. This has a more realistic assumption of not uniform use in every year of the useful life of the asset. In this method, the amount of depreciation reduces along with the reduction in the value of assets every year. This is also called the Reducing Balance Method or Declining Balance Method or Written Down Value Method. Under this method, depreciation is calculated as below:
Depreciation for first year = Total Purchase Cost × Depreciation Rate
Depreciation for subsequent years = Beginning Value of Asset × Depreciation Rate
| Advantages | Disadvantages |
| Easy calculation using a beginning value for every year instead of tracking original cost Balance effect on P/L Account as depreciation goes on decreasing and repair goes on increasing every year Logical to charge depreciation under this method as the value of the asset goes on decreasing with the subsequent yearsCorrect method on matching higher depreciation and revenue generated in the first year and going down subsequently | The value of an asset cannot be reduced to zero Ignores interest factor on the investment made on assets Useful only for assets having a long useful life |
C. Sum of Year Digit (SYD) Method
This is a method of depreciation in which the amount of depreciation charged decreases every year. This is also based on an assumption of no uniformity of use every year during the useful life of the asset. This is a very old-fashioned method. Hence, it is not adopted by any business in recent times. Under this method, depreciation is charged based on depreciation base and a fraction of year (highest to lowest order) divided by the sum of digits of the years. This can be understood as below:
Sum of Year Digit (SYD) = Add all the years in the useful life of the asset
Annual Depreciation = (Purchase Cost – Scrap Value) ×
D. Annuity Method
This is a distinct method of depreciation. This method says the amount invested to purchase an asset could earn interest if just deposited in a bank. Similarly, if the asset is taken in rent, the lender also wants the same interest as well. Hence, interest is also the cost that has to be considered while accounting for depreciation. This is also one of the least used methods in accounting practice to record depreciation. Under this method, the annual depreciation amount is calculated as below:
Annual Depreciation = (Purchase Cost – Scrap Value) × Annuity Factor
Where,
Annuity Factor = Present value interest factor for the given interest rate for given years of life
E. Machine Hour Rate Method
This is a method of depreciation in which the total life of the machine is estimated in hours, not in years. In this method, machine hour operated during each year is estimated and used to depreciate the machine. This is mostly suitable for those machines whose life and efficiency depend on hours of operation. Under this method, the amount of depreciation is calculated as below:
Depreciation for the year = (Purchase Cost – Scrap Value) ×
F. Production Unit Method
This is another method of depreciation that uses production units to calculate and charge depreciation. In this method, the production units throughout the life of the machine are estimated. Annual depreciation is charged based on units produced in a year and total estimated production units with respect to the depreciation base of the machine. Under this method:
Annual Depreciation = (Purchase Cost – Scrap Value) ×
G. Sinking Fund Method
Every asset being depreciated has to be replaced after the end of its useful life. To facilitate this, the sinking fund method evolved. In this method, a sinking fund is set where money accumulates with the view of replacing existing assets at the time of need. Every amount equal to depreciation is invested at a certain rate of interest which continues till the end of life of an existing asset. Such amount is accumulated in a fund which is equal to the cost of an existing asset. This fund is used to replace the existing asset at the end of its life. Under this method, the amount of depreciation is calculated as below:
Annual Depreciation = Depreciation Base × Sinking Fund Factor
Where,
Sinking Fund Factor = Factor at the given interest rate for a given period
H. Insurance Policy Method
This is also a method aimed at accumulating replacement funds at the end of the useful life of an existing asset. Under this, an insurance policy equal to the value of cost price of an existing asset is purchased. The policy has a maturity period equal to useful life existing asset. Every year premium is paid. After its maturity, the maturity value is received and used for replacing an existing asset.
