Question

Property, plant and equipment are depreciable assets which means the amounts paid for these assets must be written down or depreciated over the useful life of the asset. There are many methods for depreciating assets but three widely used methods are addressed in this chapter. The methods are 1) straight-line depreciation; 2) declining balance depreciation (specifically double declining balance); and 3) units-of-production or units-of-activity or activity based depreciation. Below is a video explaining each method. Your assignment is in your own words describe each method and then compare the different depreciation methods and its effect on net operating income.

Answer 1

Depreciation is the allocation of cost of asset over its useful life. The basis of allocation of cost over its useful life depends on the method of depreciation followed.

Major methods of depreciation

1. Straight line method of depreciation

Under this method, the cost of asset is allocated to the useful life of asset equally. This is used for office equipment and the assets whose usage or wear and tear is equal of its useful life.

Straight line depreciation amount = (Cost - Residual value)/Number of years

Or

Straight line depreciation rate = 100%/number of years

This amount will be taken to expense every year

2. Declining balance method

Under this method, the assets cost is allocated to the useful life of asset in a pattern such that the depreciation is initially very high and is low for later half of years. The asset value will be reduced by the depreciation (calculated using a depreciation rate) of first year to get the closing depreciation of the first year, which will be second year opening balance. On this the same depreciation rate is applied and the resultant depreciation expense is reduced from such opening balance of second year to get second year closing balance and so on until the asset value comes down to residual value or end of useful life. This may be Double declining method or 150% declining method.

Double declining method rate of depreciation

= 200% [ 100%/number of years ] or 200% of Straight line depreciation rate

150% declining method rate = 150% of Straight line depreciation rate

3. Units of production

Under this method, the useful life of asset is taken in terms of "Total estimated units produced". That proportion of cost which bears the same ratio as Total units produced in Current year bears to Total estimated units of production over life of asset is taken as current year depreciation expense.

Depreciation Expense = (Current year Units produced/Total estimated units of useful life) x (Cost-Residual Value)

Let us take an example,

An asset with useful life of 10 years and 100,000 units of estimated production over its useful life is purchased by the Company Y at $5 million. The expected residual value is nil. Current year production is 15,000 units. Calculate depreciation under three methods.

Straight line depreciation rate = 100%/10 = 10%

Straight line depreciation = $5 million x 10% = $0.5 million

Net effect on Operating income = -$0.5 million

Double declining balance rate = 200% x 10% = 20%

Double declining balance method = $5 million x 20% = $1 million

Net effect on Operating income = -$1 million

Units of Production depreciation = (15,000/100,000) x $5 million

= $0.75 million

Net effect on Operating income = -$0.75 million

Note : Net effect on net operating income will also depend on Tax rate. Since tax rate is not given, it is ignored