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# Different Methods of Charging Depreciation

Auditing : Different Methods of Charging Depreciation

Different Methods of Charging Depreciation ## 1. Straight Line (Or) Fixed Instalment Method

This is the oldest and simplest method of charging depreciation. The life of the asset is estimated and depreciation is written off equally over the life of an asset. The amount of depreciation is such that the book value of the asset is reduced to zero at the end of life of the asset. The amount of depreciation is calculated as follows:

Amount of Depreciation (Rs.) = Original cost â€“ Residual or Scrap value / Estimated Useful life of the Asset

Rate of Depreciation (%) = [ Amount of Depreciation / Original Cost ] X 100 1. Simple to Understand: This method of calculating depreciation is very simple to understand.

2. Easy to Calculate: It is easy to calculate the amount and rate of depreciation.

3. Accuracy: In this method, the book value of the asset, i.e., cost price of the asset less depreciation, becomes zero or equal to its scrap value of the expiry of its useful life.

1. Difficulty in Calculating Depreciation: Calculation of depreciation is easy only when life of the original asset and its additions are similar. When both have varied life calculation becomes difficult and complicated.

2. No Provision for Replacement of Asset: This method does not provide any provision for replacement of asset on the expiry of its useful life.

3. This method increases the charge to the Profit and Loss Account over the years because the repairs to an old asset increases.

4. This method increases the cost of the asset over the years as the amount of depreciation is fixed over the years.

## 2. Diminishing or Written Down Value Method

In this method depreciation is charged at a fixed percentage on the reducing balance of the asset every year over the useful life of the asset. The amount of depreciation goes on decreasing every year. This method is very useful for plant and machinery where additions and extensions take place very often.

1. It is a simple method of providing depreciation as fixed rate is applied on book value or written down value of assets.

2. This method is quite popular.

3. It provides uniform charge for services of the assets throughout the life.

1. The method is slightly complicated.

2. If the asset has no residual value it is very difficult to calculate the rate.

### SUITABILITY

This method of charging depreciation is suitable when â€“ (a) the possibility of obsolescence are more, and (b) the amount of repairs and renewals increases as the asset grows older.

## 3. ANNUITY METHOD

Annuity method considers both the value of asset and the amount of interest on the investment made in the fixed asset. Besides, interest, a fixed amount of depreciation is calculated on the basis of depreciation from Annuity Table and is charged to Profit and Loss Account every year. The method is precise and exact from the point of view of calculations, so it is called a scientific method.

1. This method takes interest on capital invested in the asset into account.

2. It is regarded as most exact and precise from the point of view of calculations and is therefore most scientific.

1. The system is complicated and difficult to understand.

2. The ultimate consequences being that the net burden on profit and loss account grows heavier each year.

## 4. DEPRECIATION FUND METHOD

This method provides funds for the replacement of the asset at the end of its 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 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 replacement of the assets enables determine the 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 asset 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 wasting assets.

1. This method sets aside certain amount for replacement of asset by maintaining separate provision.

2. The sale proceeds of the investments are useful for replacement of the asset.

3. This method helps to strengthen financial position of a concern.

### DISADVANTAGES 1. This method creates complication and burden on funds each year as they are invested outside.

2. Prices of securities may fall at the time when they are to be realized as a result of which loss may have to be suffered.

## 5. INSURANCE POLICY METHOD

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. On maturity of the policy, insurance company will pay the amount and the amount will be used for replacing the asset.

1. Funds are readily available for replacement of the asset.

2. Funds are not used for other purposes as they are invested outside.

3. There is no risk in getting back the money as the policy is taken with the insurance company.

The drawback of this method is that it creates an increasing burden on the funds of each year as they are invested outside.

## 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 at 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.

Â·           It is easy to understand and simple to implement.

Â·           Depreciation is calculated every year in the opening balance of asset.

Â·           This method equalizes the yearly burden on profit and loss account in respect of depreciation.

Â·           This method charges heavy amount of depreciation in earlier years.

Â·           It is difficult to assess the life of these assets, calculation of depreciation becomes complicated.

Â·           The formula to obtain rate of depreciation can be applied only when there is residual value of the asset.

Â·           This method has limited applicability.

## 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. The depreciation rate is calculated by dividing the cost of the asset by the estimated quantity of product likely to be available. Annual depreciation will be the quantity extracted multiplied by the rate per unit.

For example, If a mine has 2 lakh tons of coal and the value of mine is â‚ą 5 lakhs, each ton of coal will cost â‚ą 2.50.

The quantity of coal taken out of the mine in a period will be multiplied by the rate per ton, i.e., â‚ą 2.50 and the resultant figure will be the amount of depreciation.

Â·     It provides a method to charge amortization or depreciation for the companies dealing in resources, as these assets are different in nature and consumption from other fixed assets like car, building etc.

Â·     The method is easy to understand.

Â·     The method is simply used for a periodic reduction in the cost of the asset.

Â·           The method is highly subjective especially the number of units to be extracted is difficult to estimate.

## 8. MACHINE HOUR RATE METHOD

Under this method, the life of a machine is estimated in terms of its working hours instead of years. The total number of hours in which a particular machine will work efficiently is estimated. The estimated number of hours is then divided by the cost of the machinery less residual value to ascertain the hourly rate of depreciation.

This method is considered more scientific and precise than either the fixed installment method or the reducing balance method.

Â·           It helps to compare the relative efficiencies and cost of operating different machines.

Â·           It is most scientific, practical and accurate method of recovery of manufacturing overheads.

Â·           It provides ready method for measuring the cost of idle machines.

Â·           It involves additional work in assessing the working hours of machines and thus it is a costly method.

Â·           It gives inaccurate results if manual labour is also used. Tags : Auditing , 12th Auditing : Chapter 7 : Depreciation
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12th Auditing : Chapter 7 : Depreciation : Different Methods of Charging Depreciation | Auditing