This article throws light upon the top seven methods for charging depreciation on assets. The methods are: 1. Fixed Installment 2. Diminishing Balance Method 3. Annuity Method 4. Depreciation Fund Method 5. Insurance Policy Method 6. Revaluation Method 7. Depletion Method 8. Machine Hour Rate Method.
Method # 1. Fixed Installment:
This is the oldest and simplest method of charging depreciation. The life of the asset is estimated and it is written off equally in all the years. The amount of depreciation is such that the book value of the asset is reduced to zero at the end of purposeful life of the asset. The amount is calculated by dividing the cost of the asset less estimated scrap value by the number of years the asset will be used.
The formula for calculating depreciation will be:
Depreciation = Cost of the asset – Scrap value at the end/Life of the asset (number of years)
The calculation of depreciation becomes difficult when some additions are made to the asset. In case the life of the additional asset is similar to that of the original asset then depreciation can be charged at the same percentage, if life of the additional asset is different than calculation of depreciation will be difficult for both the original and additional asset.
This point can be explained with an example. If the life of an asset is 10 years then depreciation will be 10% of the asset. In case some additional asset is purchased and its life is also 10 years then there will be no problem and rate of depreciation will remain the same for the whole asset. If the life of the additional asset is 8 years then depreciation for this asset will be 12½ % and not 10%.
In this case different percentage of depreciation will be calculated for original and additional asset. Another difficulty arises in charging repairs and renewal expenses.
With the passage of time, the amount of repairs will go on increasing and the result will be that the amount of depreciation and repairs combined will be debited more to profit & loss account in later years than in earlier years whereas the amount charged to profit & loss account should be equal in all the years.
This method is useful for small assets and also for assets requiring less amount of repairs and renewals, etc. The assets like furniture, patent, short leases can be properly depreciated with this method.
Method # 2. Diminishing Balance Method:
The depreciation is charged as a fixed percentage on the diminishing balance of the asset given charging depreciation, hence the name diminishing balance. The amount of depreciation goes on decreasing every year. The amount of depreciation and repairs charged to profit and loss account remains almost the same because depreciation decreases every year and expenditure on repairs increases with the passage of time.
The method does not reduce the asset to zero as in the fixed installments system. Some balance, though insignificant, remains in the asset account at the end of asset life.
This method is very useful for plant and machinery where additions and extensions take place very often. This method will not be used for those assets whose value is to be reduced to zero, i.e., patents, etc.
Method # 3. Annuity Method:
In both the methods discussed earlier, depreciation is provided only on the amount of asset and no attention is given to the amount of interest which might have been earned, had this amount been used elsewhere. Annuity method considers both the value of asset and the amount of interest. The interest is taken on debit balance of the asset.
The interest is debited to asset account and is credited to profit and loss account. A fixed amount is charged as depreciation every year. The amount of depreciation is calculated with the help of Depreciation Annuity Tables. The method is precise and exact from the point of view of calculations, so it is called a scientific method. This is the only method which takes into consideration interest on capital sunk in the asset.
As in the fixed installment system, this method also puts more burden on profit and loss account in the later years because depreciation remains the same but the amount of repairs increase every year.
Annuity method is not suitable for assets like plant and machinery because it requires the frequent additions and extensions.
On the other hand, it is useful for assets requiring considerable amount of capital but do not require additions or frequent replacements e.g., long leases, etc.
Method # 4. Depreciation Fund Method:
This method provides funds for the replacement of the asset at the end of its servicing life. The amount of depreciation is credited to an account called Sinking Fund or Depreciation Fund account which is shown on the liabilities side of the balance sheet. This amount is invested in outside securities.
Every year the amount set aside for depreciation along with the interest is again invested. The amount so invested is debited to an account known as Sinking Fund Investment Account and these investments are shown as an asset in the balance sheet. The amount of depreciation remains the same for the year.
The rate of interest available from investments and the time required for the replacement of the assets enables the determination of amount of depreciation. A reference to Sinking Fund Table gives the extra amount of depreciation to be charged year after year. The investments are sold when the asset is due for replacement and the amount so received is used for purchasing the new asset.
The value of assets is shown at its original cost in all years. In the last year, the asset is written off by transferring it to Depreciation Fund Account.
This method is suitable where intention is not to provide depreciation but also to provide for its replacement as happens in case of Plant and Machinery and many other wasting assets.
Method # 5. Insurance Policy Method:
This method is almost similar to Depreciation Fund Method. In depreciation fund method if investments are sold at a loss then the aim of replacement will be adversely affected. Insurance policy method overcomes this drawback. In this method an insurance policy is purchased for the value of the asset. This policy is taken up for the life of the asset and it matures at a time when the asset is to be replaced.
The amount provided for depreciation is paid towards insurance premium. The amount of premium remains the same in all the years. No entries for interest and reinvestments are required as in depreciation fund method. On maturity of the policy, insurance company will pay the amount and the amount will be used for replacing the asset.
Method # 6. Revaluation Method:
In this method the amount of depreciation is calculated by revaluing the asset at the end of each year. The difference between the value of the asset at the beginning and the end of the period is taken as depreciation. There can be an appreciation in value too. The amount of appreciation is debited to the asset and credited to profit and loss account.
This method can be used for specific assets like loose tools, horses, copy rights, trade marks, etc. It is difficult to assess the life of these assets, so calculation of depreciation becomes a problem. The nature of these assets is also different from other ordinary assets. This method has only a limited applicability.
Method # 7. Depletion Method:
This method is specially used for those assets which deplete with use. The cost of the assets is divided by total workable deposits. If a mine has 2 lakh tons of coal and the value of mine is Rs. 5 lakhs, each ton of coal will cost Rs. 2½. The quantity of coal taken out of the mine in a period will be multiplied by the rate per ton, i.e., Rs. 2½ and the resultant figure will be the amount of depreciation.
This method is suitable for mines, quarries, sandpits, etc.
Method # 8. Machine Hour Rate Method:
The life of the asset is estimated in hours. The value of the asset minus scrap value is divided by the estimated number of hours. In this way a machine hour rate is calculated. Machine hour rate determines the amount of depreciation per hour.
The number of hours a machine runs in year is multiplied by the machine hour rate and the amount of depreciation to be taken in that year is calculated. This method is considered more scientific and precise than either the fixed installment method or the reducing balance method.