9.5 Change in the method of depreciation
9.1 Meaning of Depreciation:
Provision is created in a company‟s account towards depreciation to account for the wear and tear of its assets caused by usage, passage of time, technological obsolescence, etc. while depreciation does not involve payment of money to any third party, it is nevertheless an accounting entry in the books.
Depreciation is the acquisition cost of an asset (less the expected salvage value) spread over the economic life of that asset. The purpose of charging depreciation over the economic life of the asset is to match the cost of the asset over the period for which revenue is earned by using the asset.
9.2
DEPRECIATION METHODS
The two methods which are basically used for charging depreciation are
1.Straight Line Method
Under the straight-line method, the net acquisition cost or construction cost is charged off in equal proportion during the useful economic life and the quantum of the depreciation is arrived at by dividing the net acquisition or construction cost by the number of years of useful economic life. The net acquisition or construction cost is calculated by deducting salvage value from the acquisition or construction cost.
Depreciation =
For example, if the cost of an asset is Rs.1,00,000, the expected salvage value is Rs.20,000 and the estimated useful life is 8 years, the annual depreciation would be = Rs.10,000 or 10% per annum.
This method has the following advantages:
1. the amount of depreciation and the rate does not change over the useful economic life of the asset;
2. the calculation is relatively simple; and 3. it realistically matches cost and revenue.
Under this method the depreciation charged in the various years will not be equal over the useful life of the asset. This is because the depreciation charge every year is calculated as a percentage of the outstanding balance of the asset as at the beginning of that particular year and not on the original cost of the asset.
While preparing final accounts, if depreciation is shown as an item under adjustments, calculate the amount of depreciation and charge it off to profit and loss account by debiting P & L account and crediting depreciation; show depreciation as a deduction from the asset value on the assets side of Balance Sheet.
If depreciation is shown in the trial balance, then, the amount of depreciation should be charged to only P & L account.
The percentage of depreciation to be charged under the declining balance method can be determined as under
r = 1 – (or) 1 – (s/c)1/n
where,
r = rate of depreciation under the written down value method n = estimated useful life of the asset in years
s = residual value or scrap value of the asset c = original cost of the asset.
Please note that if the residual or scrap value of an asset is zero, the rate of depreciation cannot be determined using the above formula.
Illustration 1
Original Cost of the Machine- Rs.1,00,000 Estimated Scrap Value - Rs.30,000
Useful Life - 6 years
The calculation of depreciation for each of the years would be as follows:
r = 1 – (30,000/1,00,000)1/6 = 18%
At the end of the 1st year, the depreciation is calculated by applying the rate to the original cost. Then the written down value is arrived at by deducting the depreciation so arrived at from the original cost. At the end of the 2nd year, the depreciation rate is applied to the written down value at the end of the 1st year. This depreciation amount is again deducted to arrive at the written down value at the end of the 2nd year. In the above
mentioned asset the depreciation calculations will be as follows:
Year Calculation of
depn. Depreciation Written down value
1 1,00,000 x 18% 18,000 82,000 2 82,000 x 18% 14,760 67,240 3 67,240 x 18% 12,103 55,137 4 55,137 x 18% 9,925 45,212 5 45,212 x 18% 8,138 37,074 6 37,074 x 18% 6,673 30,401
(The small difference between the estimated scrap value and the written down value at the end of the sixth year is due to approximation of the depreciation rate)
The following are the advantages of Diminishing Balance Method.
1. It matches the service of the asset in the sense that higher depreciation is charged in the initial years, when the machine is most efficient compared to later years.
2. It recognizes the risk of obsolescence by concentrating the major part of the depreciation in the early years of the life of the asset.
3. It equalizes the expenses of depreciation and repair charges taken together. It is assumed that repairs are the lowest in the initial years and higher in the later years while the depreciation under this method is higher in the initial years and lower in the later years.
4. It results in a better cash flow through tax deferral as under this method the net income to be taxed is lower in the initial years and higher in the subsequent years.
The disadvantages of declining balance method are:
1. It requires elaborate bookkeeping.
2. As the amount of the depreciation varies from year to year, intra-enterprise comparability is lost and that income is understated in early years and overstated in subsequent years.
Explanation: In the above diagram we see that irrespective of the time period the amount of depreciation charged is same under the straight line method. But in case of written down value method, the amount of depreciation charged falls down as the time period increases. The depreciation charged under this method is more in the initial years and keeps on falling as the number of years of usage increase.
We can draw the following differences between the diminishing balance method and straight line method. They are:
Straight Line Diminishing Balance
1 A fixed amount of depreciation is charged A fixed rate of depreciation is charged 2 The rate of depreciation is the reciprocal
of the life of the asset
The rate of depreciation is ascertained by applying the formula
3 The asset may or may not have scrap value
The asset must have a significant scrap value
4 The amount of depreciation per year is same
The amount of depreciation goes on reducing with each passing year. 5 In the first year, the depreciation is
charged on the cost of the asset, less scrap value, if any
In the first year, the depreciation is charged on the asset
6 At the end of its life, the book value of the asset becomes zero
The book value of the asset never reduces to zero.