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Depreciation and methods of depreciation

Depreciation is what happens when assets lose value over time until the value of the asset becomes zero, or negligible. Depreciation can happen to virtually any fixed asset, including office equipment, computers, machinery, buildings, and so on. One fixed asset that is exempt from depreciation is the value of land, which appreciates (increases) over time.

Various Depreciation Methods

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

Various Depreciation Methods

  1. Straight Line Depreciation Method

Under the straight-line method of depreciation, the cost of a fixed asset is spread evenly for each year that it is useful, functional and profitable. As such, the depreciation expense recorded on an income statement is the same each year.

The straight-line method is the most straightforward approach to calculating depreciation or amortisation. Whilst there are several other depreciation methods, the straight-line approach is the easiest to understand and is suitable for the needs of small businesses and freelancers.

  1. Diminishing Balance Method

According to the Diminishing Balance Method, depreciation is charged at a fixed percentage on the book value of the asset. As the book value reduces every year, it is also known as the Reducing Balance Method or Written-down Value Method.

  1. Sum of Years’ Digits Method

The sum of years’ digits method is a form of accelerated depreciation that is based on the assumption that the productivity of the asset decreases with the passage of time. Under this method, a fraction is computed by dividing the remaining useful life of the asset on a particular date by the sum of the year’s digits. This fraction is applied to the depreciable cost of the asset to compute the depreciation expense for the period.

Sum of years’ digits method attempts to charge a higher depreciation expense in early years of the useful life of the asset because the asset is most productive in early years of its life. Also the asset loses much of its productive efficiency in early years.

  1. Double Declining Balance Method

The double declining balance method is an accelerated form of depreciation under which most of the depreciation associated with a fixed asset is recognized during the first few years of its useful life. This approach is reasonable under either of the following two circumstances:

When the utility of an asset is being consumed at a more rapid rate during the early part of its useful life; or

When the intent is to recognize more expense now, thereby shifting profit recognition further into the future (which may be of use for deferring income taxes).

  1. Sinking Fund Method

Under depreciation fund method or sinking fund method, a fund is created with the amount of annual depreciation. An amount equal to annual depreciation is invested each year in government papers or in some other gilt-edged securities outside the business. The income earned from investment is deposited into the fund and immediately reinvested. This process is carried out throughout the life of the asset and at the end of its life a sum equal to the cost of the asset is accumulated in the fund. Then the whole investment is sold and a new asset is acquired with the sale proceeds.

The special feature of this method is that the sum required to buy the new asset is available from depreciation or sinking fund. As a result, the working capital of business is preserved. Sinking fund method is specially applicable to costly machines in large scale industries.

  1. Annuity Method

Under this method, it is assumed that the amount spent in the purchase of the assets is an investment which should earn interest. The amount spent in acquiring an asset is assumed as an investment and interest is charged at a certain rate on the diminishing balance of assets and is debited to assets account and credited to interest account which is transferred to profit and loss account. The asset is credited year by years with a fixed amount of depreciation. The amount of depreciation charged every year is such that in spite of asset being debited with interest every year, the asset is reduced to zero or its residual value. The amount of depreciation is calculated on the basis of annuity table.

When additions are made to asset account, calculations have to be revised. This method is used in the case of leases having large amount spread over a number of years.

  1. Insurance Policy Method

Under this method of depreciation, we buy the insurance policy. For buying the insurance policy, we pay the premium. Money received from insurance policy at the time of maturity will be used for buying new fixed asset. Every year, we charged depreciation which will equal to the insurance premium.

  1. Discounted Cash Flow Method

The discounted cash flow method is designed to establish the present value of a series of future cash flows. Present value information is useful for investors, under the concept that the value of an asset right now is worth more than the value of that same asset that is only available at a later date. An investor will use the discounted cash flow method to derive the present value of several competing investments, and usually picks the one that has the highest present value. The investor may not pick an investment with the highest present value if it is also considered a riskier opportunity than the other prospective investments.

  1. Use Based Method

Usage methods assume that the asset will contribute to the earning of revenues in relation to the amount of output during the accounting period. Therefore, the depreciation expense will vary from year to year.

  1. Output Method

The units-of-output depreciation method is based on the assumption an asset will produce a fixed number of units over its lifetime. The loss in value of the asset (depreciation expense) during an accounting period is directly related to the output of the asset in that same accounting period.

  1. Working Hours Method

Under this method, hourly rate of depreciation is calculated. The cost of the asset (less residual value if any) is divided by the estimated working hours. The actual depreciate for any given period depends upon the working hours during that year.

  1. Mileage Method

The mileage method of depreciation is carried out on vehicles (cars, buses, etc.). In this method, depreciation is calculated based on number of kilometres travelled by the vehicle and asset means vehicle

  1. Depletion Method

Depletion method of depreciation is mostly used by the companies that have assets that are natural resources like oil, gas, coal, mines, quarries or other wasting assets.

This method is named as ‘depletion method’ because the reduction of a natural resource or asset is known as depletion of that resource or asset and thus is used to depreciate assets that are natural resources. Such assets are also referred as wasting assets because their value deteriorates with the increasing extraction of resources. For example in case of a coal mine, more the coal is extracted more will be the depletion of the mine etc.

  1. Revaluation Method

A method of determining the depreciation charge on a fixed asset against profits for an accounting period. The asset to be depreciated is revalued each year; the fall in the value is the amount of depreciation to be written off the asset and charged against the profit and loss account for the period.

  1. Group or Composite Method

In financial accounting, Composite Depreciation (or Group Depreciation) is a method for calculating and claiming depreciation expense. The Composite method depreciates an entire group of related assets as a single entity rather than individually.

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