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# Depreciation and its types

Depreciation and its types

Depreciation and its types

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### Depreciation and its types

1. 1. By W.Infant Emiliya Assisatant Professor
2. 2. Depreciation Methods  Straight Line Depreciation Method  Diminishing Balance Method  Annuity Method  Sinking Fund Method  Insurance Policy Method
3. 3. Straight Line Depreciation Method  This is the most commonly used method to calculate depreciation. It is also known as fixed instalment method. Under this method, an equal amount is charged for depreciation of every fixed asset in each of the accounting periods.This uniform amount is charged until the asset gets reduced to nil or its salvage value at the end of its estimated useful life.  So, this method derives its name from a straight line graph. This graph is deduced after plotting an equal amount of depreciation for each accounting period over the useful life of the asset.  Thus, the amount of depreciation is calculated by simply dividing the difference of original cost or book value of the fixed asset and the salvage value by useful life of the asset.
4. 4. The advantages of straight-line depreciation :  Straight-line depreciation is easy to calculate and consistently applied.  It has wide application to many fixed assets, especially when their obsolescence is simply due to passage of time.  Straight-line amortization schedules are simple and reduce the amount of required record- keeping.
5. 5. Disadvantage of straight-line depreciation  Some assets are more correctly depreciated based on output, input or usage.  It requires the use of MACRS recovery periods to be acceptable for U.S. tax purposes, prompting the need for additional calculations.  Some assets experience accelerated obsolescence in their early years, such as computers and vehicles.  Estimates for useful life and salvage value can be subjective and inconsistent among different companies.
6. 6. Straight Line Depreciation Formula  The formula for annual depreciation under straight line method is as follows:  Annual Depreciation Expense = (Cost of an asset – SalvageValue)/Useful life of an asset  Where,  Cost of the asset is purchase price or historical cost  Salvage value is value of the asset remaining after its useful life  Useful life of the asset is the number of years for which an asset is expected to be used by the business
7. 7. Diminishing Balance Method  This method is also known as reducing balance method, written down value method or declining balance method.A fixed percentage of depreciation is charged in each accounting period to the net balance of the fixed asset under this method.This net balance is nothing but the value of asset that remains after deducting accumulated depreciation.  Thus, it means that depreciation rate is charged on the reducing balance of the asset.This asset is the one reflected in the books of accounts at the beginning of an accounting period.So, the book value of the asset is written down so as to to reduce it to its residual value.  Now, as the book value of the asset reduces every year so does the amount of depreciation. Accordingly, higher amount of depreciation is charged during the early years of the asset as compared to the later stages.  Thus, the method is based on the assumption that more amount of depreciation should be charged in early years of the asset.This is on account of low repair cost being incurred in such years.As an asset forays into later stages of its useful life, the cost of repairs and maintenance of such an asset increase. Hence, less amount of depreciation needs to be provided during such years.
8. 8. Some of the merits of diminishing balance method are as follows −  Recognised by income tax authorities.  Minimises impact of obsolescence.  Depreciation amount decreases year by year.  Suitable for assets where scrap value equals to zero. Some of the demerits of diminishing balance method are as follows −  Asset value can be zero.  Interest is not considered.  Calculation of profit/loss is complicated.  Emphasis on historical cost.
9. 9. Diminishing Balance Method Formula Depreciation Expense = (Book value of asset at beginning of the year x Rate of Depreciation)/100
10. 10. Annuity Method  The annuity method of depreciation is a process used to calculate depreciation on an asset by calculating its rate of return—just as if it were an investment. It is commonly used with assets that have a large purchase price, long life, and a fixed (or at least constant) rate of return.  This annuity method of depreciation requires the determination of the internal rate of return (IRR) on the cash inflows and outflows of the asset.The IRR is then multiplied by the initial book value of the asset, and the result is subtracted from the cash flow for the period to find the actual amount of depreciation that can be taken.
11. 11. Advantages and Disadvantages of the Annuity Method of Depreciation  The annuity method of depreciation is useful for assets that have a high initial cost and a long life span, such as property and buildings secured under leases. It takes into account the interest lost on the money spent to buy the asset, which many depreciation methods don't do.  Some disadvantages of using this method are that it can be difficult to understand and that it may require frequent recalculations depending on the asset. Also, it can be burdensome to profit and loss accounting over time, as the level of depreciation diminishes with every year.
12. 12. Sinking fund method  Sinking fund method is a method of calculating depreciation for an asset in which apart from calculating depreciation, it also keeps aside a fund for replacing the asset at the end of its useful life.  This method is used when the assets that need to be replaced are of high cost.To avoid paying for the replacement of assets at a time, companies maintain a sinking fund that will help them recover the cost of the asset while also accounting for its depreciation.  Sinking fund method is put into use by large scale industries such as utility industries that have a requirement for expensive long-term assets to function.
13. 13. Advantages:  A sinking fund helps the company to pay its liability well in advance.  A company is able to pay the debt in time because a company has already pulled a money well before.  A sinking fund is also used to redeem the bond or any other liability in a mid-way also.  A sinking fund also increases the goodwill of the company by paying the debt in time, and this will increase the faith of investors and attract more investment. Disadvantages:  When a company uses the sinking fund to buy bonds before maturity, investor losses the interest on that particular time.  When a company uses this fund to purchase bonds at a discount or par value, so this will lose to the investors.  When a company has sufficient fund to buy back, the investors cannot take advantage of the company and that will make uncertainty to the investors.
14. 14. Insurance policy method  Insurance policy method is just like sinking fund method of depreciation, but in this method, the money is used to pay premium for insurance company. Premium will be charged at the start of the year. Money at the end of maturity can be used to buy a new asset.
15. 15. Advantages of insurance policy method are −  Insurance for fixed asset.  Risk loss is covered.  Funds for replacement of asset is available.  Better security. Disadvantages of insurance policy method are −  More expensive.  Not suitable for assets where additions are needed.  Difference between interest received and premium paid is more.