Question

discuss the procedure for selecting the combination of depreciable assets and the method of financing. in three pages.

Answer 1

Depreciation is the accounting process of converting the original costs of fixed assets such as plant and machinery, equipment, etc into the expense. It refers to the decline in the value of fixed assets due to their usage, passage of time or obsolescence.

Furthermore, depreciation is a non – cash expense as it does not involve any outflow of cash. Hence, depreciation as an expense is different from all the other conventional expenses.

However, there are different factors considered by a company in order to calculate depreciation. One such factor is the depreciation method. Thus, companies use different depreciation methods in order to calculate depreciation. So, let’s consider a depreciation example before discussing the different types of depreciation methods.

Various Depreciation Methods

Various methods are used by the companies to calculate depreciation. These are as follows:

Various Depreciation Methods

• Straight Line Depreciation Method
• Diminishing Balance Method
• Sum of Years’ Digits Method
• Double Declining Balance Method
• Sinking Fund Method
• Annuity Method
• Insurance Policy Method
• Discounted Cash Flow Method
• Use Based Method
  • Output Method
  • Working Hours Method
  • Mileage Method
• Other Methods
  • Depletion Method
  • Revaluation Method
  • Group or Composite Method

    1. 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.

    Straight Line Depreciation Formula

    The formula for annual depreciation under straight line method is as follows:

    Annual Depreciation Expense = (Cost of an asset – Salvage Value)/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

    2. 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.

    Diminishing Balance Method Formula

    Depreciation Expense = (Book value of asset at beginning of the year x Rate of Depreciation)/100

    3. Sum of Years’ Digits Method

    Another accelerated depreciation method is the Sum of Years’ Digits Method. This method recognizes depreciation at an accelerated rate. Thus, the depreciable amount of an asset is charged to a fraction over different accounting periods under this method.

    This fraction is the ratio between the remaining useful life of an asset in a particular period and sum of the years’ digits. Thus, this fraction indicates that the capital blocked or the benefit derived out of the asset is the highest in the first year.

    So, as an asset moves towards the end of its useful life, the benefit gained out of such an asset declines. That is to say, highest amount of depreciation is allocated in the first year since no amount of capital has been recovered till then. Accordingly, least amount of depreciation should be charged in the last year as major portion of capital invested has been recovered.

    Sum of Years’ Digits Depreciation Formula

    Following is the formula for sum of years’ digits method.

    Depreciation Expense = Depreciable Cost x (Remaining useful life of the asset/Sum of Years’ Digits

    Where depreciable cost = Cost of asset – Salvage Value
    Sum of years’ digits = (n(n +1))/2 (where n = useful life of an asset)

    4. Double Declining Balance Method

    This method is a mix of straight line and diminishing balance method. Thus, depreciation is charged on the reduced value of the fixed asset in the beginning of the year under this method. This is just like the diminishing balance method. However, a fixed rate of depreciation is applied just as in case of straight line method. This rate of depreciation is twice the rate charged under straight line method. Thus, this method leads to an over depreciated asset at the end of its useful life as compared to the anticipated salvage value.

    Therefore, companies adopt various approaches in order to overcome such a challenge. Firstly, the amount of depreciation charged for the last year is adjusted. This is done to make salvage value equal to the anticipated salvage value. Secondly, many companies choose to use straight line depreciation method in the last year to adjust the over depreciated salvage value.

    Double Declining Balance Formula

    Annual Depreciation Expense = 2 x (Cost of an asset – Salvage Value)/Useful life of an asset

    Or

    Depreciation Expense = 2 x Cost of the asset x depreciation rate depreciation method for financing are:

    Straight-Line

    Depreciating assets using the straight-line method is typically the most basic way to record depreciation. It reports equal depreciation expense each year throughout the entire useful life until the entire asset is depreciated to its salvage value. The example above used straight-line depreciation.

    Assume, for another example, that a company buys a machine at a cost of $5,000. The company decides on a salvage value of $1,000 and a useful life of five years. Based on these assumptions, the depreciable amount is $4,000 ($5,000 cost - $1,000 salvage value) and the annual depreciation using the straight-line method is: $4,000 depreciable amount / 5 years, or $800 per year.