Question

Prepare a report for management, stating the advantages and disadvantages of each depreciation method. Include in the report your recommendations on the choice of method consistent with the requirements of IAS 16/AASB 116. Support your recommendations with schedules showing the total annual cost of operating the machinery, and the profit after depreciation.

Answer 1

Methods of Depriciation

1. Straight Line

The straight line method involves determining the cost to depreciate and dividing that amount by the number of years the company expects to use the asset. The advantage of using the straight line method involves the ease of calculating the annual depreciation amount. The disadvantage of using the straight line method is that this method does not consider the rate the asset will actually depreciate in value.

2. Units of Production

The units of production method involves determining the cost to depreciate and dividing that amount by the estimated production units the company expects to manufacture over the life of the asset. The advantages of using the units of production method include the ease of calculating the annual depreciation amount and that the depreciation is matched to the production quantity. The disadvantage of using the units of production method is that this method assumes the asset will depreciate evenly over its productive life.

3. Declining Balance

The declining balance calculates annual depreciation by calculating a depreciation rate and multiplying it by the remaining asset value. The advantage of using this method is that it accelerates the depreciation recorded early in the asset’s life. Another advantage is that the accelerated depreciation reduces the taxable income and the taxes owed during the early years. A disadvantage of this method is that the calculation is more complex.

4. Sum-Of-Years Digits

The sum-of-years digits calculates annual depreciation by calculating a depreciation rate by adding up the digits for each year in the life of the asset. Each year the company takes the number of years remaining, divides it by the total digits calculated and multiples this by the asset value. The advantage of using this method is that it accelerates the depreciation recorded early in the asset’s life. Another advantage is that the accelerated depreciation reduces the taxable income and the taxes owed during the early years. A disadvantage of this method is that the calculation is more complex.

Recommendations on the choice of method as per IAS 16

For all depreciable assets: The depreciable amount (cost less residual value) should be allocated on a systematic basis over the asset's useful life.

The depreciation method used should reflect the pattern in which the asset's economic benefits are consumed by the entity, a depreciation method that is based on revenue that is generated by an activity that includes the use of an asset is not appropriate. So as straight line method is consistent as per IAS 16.

Schedule

Particulars	Rs. in Lakhs
Sales	12000
Less Cost of Goods sold	7000
Total operating Income	5000
Employee Benefit Expenses	500
Finance Cost	800
Repair and Maintenance cost	700
Total profit before depriciation	3000
Deprication (WN 1)	500
Profit after depriciation	2500

WN 1

Particulars	Rs. in Lakhs
Purchase Price of the Machinery	5000
Useful Life (in years)	10
Depriciation (5000/10)	500