Question

1. Briefly identify each of the three major methods of calculating depreciation (Straight-Line, Double Declining Balance, Units of Production). Why would that company choose one method over another?
2. Define: "cost of goods sold", "gross profit", and "net income"

Answer 1

1. Straight line depreciation

A straight line depreciation method calculates depreciation expense based on useful life of asset. The depreciable cost of asset is divided by estimated useful life of asset. The depreciable cost of asset is purchase cost minus the salvage value of asset. Under this method the depreciation expense is constant year on year basis

B. Double Declining balance method

This method calculates the depreciation expense on opening book value of assets of each year at double the rate of straight line method. The depreciation expense is higher in initial years and gets reduced year on year basis. The closing book value is equal to salvage value of asset

c. Units of production

This method calculates the depreciation expense based on units of activity for example: production units, machine hours, mileage usage, etc. The depreciation rate is variable in nature under this method and is charged based on usage basis

Choice of depreciation method

The choice of depreciation is based on nature of asset and its usage in business.

· Assets like buildings which have fixed estimated useful life are depreciated based on useful life of asset

· Assets like machinery and equipment which are having heavy usage are depreciated based on double declining balance method to reflect the actual wear and tear of asset.

· Assets like motor vehicle, delivery vehicle are depreciated based on units of activity since they represent the actual usage of asset in business.

2. Cost of goods sold is the cost charged for the units sold during the period. The cost of goods sold is computed on various methods like FIFO, LIFO or weighted average method

Gross profit is the profit earned on sales during the period by deducting cost of goods sold from sales. It represents the gross margin between selling price and product cost.

Net income is the income earned after providing for operating and other finance expenses and accounting for finance income and other revenues. It is the final outcome of income statement.