DEPRECIATION and ITS TYPES




Q. Define Depreciation and Discuss types of Depreciation methods.




Ans. : DEPRECIATION:      The reduction in value of a tangible fixed asset due to normal
usage, wear and tear, new technology or unfavorable market conditions is called
Depreciation. Assets, such as 
plants and machinery, buildings,
vehicles,
 etc., which are expected to last more than one year,
but not for infinity, are subject to this reduction. It is allocation of
the cost of a fixed asset in each accounting period during its expected
time of use.
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Types of Depreciation
  • Straight
    Line Method
  • Diminishing
    Value Method
  • Annuity
    Method
  • Machine
    hour rate Method
  • Revaluation
    Method
  • Sum-of-the-years’
    Digit Method




Straight Line Method
Also known as Original cost method, Fixed installment method and Fixed
percentage method.
The simplest, most used and popular method of charging
depreciation is straight line method. An equal amount is allocated for each
accounting period. The rate of depreciation is the reciprocal of the estimated
useful life of an asset, so, for example, the useful life of an asset is 5
years, the depreciation charged will be 1/5 = 20%.
 
 
According to Straight Line Method,
Depreciation Amount = (Cost of asset − Salvage Value) / Useful life
of
 asset in years
Example – Straight Line Method
Asset cost = 1,000,000
Depreciation Rate = 20%
1st year = 20/100*1,000,000
=>2,00,000
2nd year = 20/100*1,00,000
=>2,00,000
Advantages of Diminishing Value
Method are
:
  1. Simple
    and easy to understand.
  2. The
    book value of an asset can be reduced to Zero.
  3. A fair evaluation of an asset each year in the
    balance sheet.

Diminishing Value Method
Also known as Written down value method,
Reducing installment method and Fixed percentage on diminishing balance.
According to the diminishing value method, depreciation is
charged on 
reducing balance on a fixed rate. Depreciation, in this case, is charged over the
useful life of an asset over its written down value. The percentage, at which
depreciation is charged, remains fixed, however, the amount of depreciation
goes on diminishing year after year.
Formula of Diminishing Value Method:


Where:
D = Depreciation Amount
n = Useful life of asset in years
r = residual value of asset
c = Cost of asset
Example – Diminishing Value Method
Asset cost = 1,000,000
Depreciation rate = 20% (DVM)
1st year = 20/100*1,000,000
=>2,00,000
2nd year = 20/100*(1,000,000-2,00,000)



=>1,60,000
Advantages of Diminishing Value Method are:
  1. More
    practical and easy to apply.
  2. Decreasing
    charge for depreciation cancels out increasing charges for repairs.
  3. This
    method is applicable for income tax purposes.

  Unit-of-Production
Depreciation

T This method provides for depreciation by means of a fixed rate per
unit of production. Under this method, one must first determine the cost per
one production unit and then multiply that cost per unit with the total number
of units the company produced within an accounting period to determine its
depreciation expense.

Depreciation Expense =  
  Total Acquisition Cost – Salvage Value /
Estimated Total Units


5.   
Estimated total units =
the total units this machine can produce over its lifetime

Depreciation expense =
depreciation per unit * number of units produced during
an accounting period


Sum-of-Year Method

The sum-of-year depreciation method produces a variable depreciation expense. At the end of the useful life of the asset, its accumulated depreciation is equal to the accumulated depreciation under the straight-line depreciation.

Depreciation In Year i

=
((n-i+1) / n!) * (total acquisition cost – salvage value)
Example: For $2 million,
Company ABC purchased a machine that will have an estimated useful life of five
years. The company also estimates that in five years, the company will be able
to sell it for $200,000 for scrap parts.
n! = 1+2+3+4+5 = 15
n = 5

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Double-Declining-Balance
Method


The DDB method simply doubles the straight-line depreciation amount that is
taken in the first year, and then that same percentage is applied to the
un-depreciated amount in subsequent years.

DDB In year i = (2 /
n) * (total acquisition cost – accumulated depreciation)
n = number of years
Example
For $2 million, Company ABC purchased a machine that will have an estimated
useful life of five years. The company also estimates that in five years the
company will be able to sell it for $200,000 for scrap parts.

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The
double-declining-balance method produces a very aggressive depreciation
schedule. The asset cannot be depreciated beyond its salvage value.


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