Question

Why are the costs of plant/long term assets recovered through depreciation vs. expensed out during the period purchased? Choose one of the following depreciation methods to discuss: straight line, units of production, declining balance. Share how depreciation using this method is calculated and provide an example of when this would be the most ideal method for application.

Answer 1

     Depreciation is the systematic allocation of the depreciable amount of an asset over its useful life. The depreciable amount of an asset is the cost of an asset or other amount substituted for cost, less its residual value. The useful life of an asset is the period over which an asset is expected to be available for use by an entity, or the number of production or similar units expected to be obtained from the asset by the entity.
   Thus there are 3 important factors for computing depreciation:
   -  Estimated useful life of the asset
   -  Cost of the asset
   -  Residual value of the asset at the end of the of its estimated useful life
  
   Why cost of asset is recovered through depreciation ? Answer is explained with help of some points below
   (1) Correct income measurement: Depreciation should be charged for proper estimation of periodic profit or loss. In case an enterprise does not account for depreciation on Property, Plant & Equipment, it will not be considering loss in value of property, plant & equipment due to their use in production or operations of the enterprise and will not result in true profit or loss for the period.
   (2) True position statement: Value of the Property, Plant & Equipment should be adjusted for depreciationcharged in order to depict the actual financial position. In case depreciation is not accounted for appropriately, the property, plant and equipment would be disclosed in financial statements at a value higher than their true value.
   (1) Funds for replacement: Generation of adequate funds in the hands of the business for replacement of the asset at the end of its useful life. Depreciation is a good indication of the amount an enterprise should set aside to replace a fixed asset after its economic useful life is over. However, the replacement cost of a fixed asset may be impacted by inflation or other technological changes.
   (2) Ascertainment of true cost of production: For ascertaining the cost of the production, it is necessary to charge depreciation as an item of cost of production.
   Further depreciation is a non-cash expense and unlike other normal expenditure (e.g. wages, rent, etc.) does not result in any cash outflow. Further depreciation by itself does not create funds it merely draws attention to the fact that out of gross revenue receipts, a certain amount should be retained for replacement of assets used for carrying on operation.
  
   METHODS OF DEPRECIATION
   1. Straight Line method of depreciation
   Results in a constant charge over the useful life if the residual value of the asset does not change
   2. Decline Balance Method of depreciation
   Results in a decreasing charge over the useful life
   3. Unit of production method of depreciation
   Results in a charge based on the expected use or output
  
   PRODUCTION UNIT METHOD
   Under this method depreciation of the asset is determined by comparing the annual production with the estimated total production. The amount of depreciation is computed by the use of following method
   Depreciation for the period = Depreciable Amount x production during the period / Estimated total poduction
   The method is applicable to machines producing product of uniform specifications
  
   EXAMPLE :
   A machine is purchased for ` 20,00,000. Its estimated useful life is 10 years with a residual value of ` 2,00,000. The machine is expected to produce 1.5 lakh units during its life time. Expected distribution pattern of production is as follows:
   Year Production
   1/3/2020 20,000 units per year
   4/7/2020 15,000 units per year
   8/10/2020 10,000 units per year
   Required
   Determine the value of depreciation for each year using production units method.
  
YEAR   ANNUAL DEPRECIATION
Y1 to Y3   20000/150000 X ( 2000000-200000) = 2,40,000
Y4 to Y7   15000/150000 X ( 2000000-200000) = 1,80,000
Y8 to Y10   10000/150000 X ( 2000000-200000) = 1,20,000
  
   UNIT OF PRODUCTION METHOD SHALL BE CONSIDERED TO BE MORE PROPER METHOD DUE TO CONSIDERING THE FACT THE DEPRECIATION HAS BEEN CHARGED BASED ON UNIT OF PRODUCTION OR PRODUCTION VOLUME UNLIKE CHARGING FIXED AMOUNT OR REDUCED AMOUNT BY OTHER METHODS
   WE COULD CHANGE THE DEPRECIATION AMOUNT ACCORDING TO PRODUCTION PATTERN OF THE ASSET AND ITS FIRMLY FURURE CASH GENERATED TO THE ENTITY