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DEPRECIATION and ITS TYPES

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Q. Define Depreciation and Discuss types of Depreciation methods.

Ans. : DEPRECIATION:      The reduction in value of a tangible fixed asset due to normal usage, wear and tear, new technology or unfavorable market conditions is called Depreciation. Assets, such as plants and machinery, buildings, vehicles, etc., which are expected to last more than one year, but not for infinity, are subject to this reduction. It is allocation of the cost of a fixed asset in each accounting period during its expected time of use.
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Types of Depreciation
  • Straight Line Method
  • Diminishing Value Method
  • Annuity Method
  • Machine hour rate Method
  • Revaluation Method
  • Sum-of-the-years’ Digit Method
Straight Line Method
Also known as Original cost method, Fixed installment method and Fixed percentage method.
The simplest, most used and popular method of charging depreciation is straight line method. An equal amount is allocated for each accounting period. The rate of depreciation is the reciprocal of the estimated useful life of an asset, so, for example, the useful life of an asset is 5 years, the depreciation charged will be 1/5 = 20%.  
According to Straight Line Method,
Depreciation Amount = (Cost of asset − Salvage Value) / Useful life of asset in years
Example – Straight Line Method
Asset cost = 1,000,000
Depreciation Rate = 20%
1st year = 20/100*1,000,000
=>2,00,000
2nd year = 20/100*1,00,000
=>2,00,000
Advantages of Diminishing Value Method are:
  1. Simple and easy to understand.
  2. The book value of an asset can be reduced to Zero.
  3. A fair evaluation of an asset each year in the balance sheet.


Diminishing Value Method
Also known as Written down value method, Reducing installment method and Fixed percentage on diminishing balance.
According to the diminishing value method, depreciation is charged on reducing balance on a fixed rate. Depreciation, in this case, is charged over the useful life of an asset over its written down value. The percentage, at which depreciation is charged, remains fixed, however, the amount of depreciation goes on diminishing year after year.
Formula of Diminishing Value Method:


Where:
D = Depreciation Amount
n = Useful life of asset in years
r = residual value of asset
c = Cost of asset
Example – Diminishing Value Method
Asset cost = 1,000,000
Depreciation rate = 20% (DVM)
1st year = 20/100*1,000,000
=>2,00,000
2nd year = 20/100*(1,000,000-2,00,000)
=>1,60,000
Advantages of Diminishing Value Method are:
  1. More practical and easy to apply.
  2. Decreasing charge for depreciation cancels out increasing charges for repairs.
  3. This method is applicable for income tax purposes.

  Unit-of-Production Depreciation

T This method provides for depreciation by means of a fixed rate per unit of production. Under this method, one must first determine the cost per one production unit and then multiply that cost per unit with the total number of units the company produced within an accounting period to determine its depreciation expense.


Depreciation Expense =  
  Total Acquisition Cost - Salvage Value / Estimated Total Units

5.    Estimated total units = the total units this machine can produce over its lifetime
Depreciation expense = depreciation per unit * number of units produced during an accounting period

Sum-of-Year Method
The sum-of-year depreciation method produces a variable depreciation expense. At the end of the useful life of the asset, its accumulated depreciation is equal to the accumulated depreciation under the straight-line depreciation.
Depreciation In Year i
= ((n-i+1) / n!) * (total acquisition cost - salvage value)
Example: For $2 million, Company ABC purchased a machine that will have an estimated useful life of five years. The company also estimates that in five years, the company will be able to sell it for $200,000 for scrap parts.
n! = 1+2+3+4+5 = 15
n = 5

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Double-Declining-Balance Method
The DDB method simply doubles the straight-line depreciation amount that is taken in the first year, and then that same percentage is applied to the un-depreciated amount in subsequent years.
DDB In year i = (2 / n) * (total acquisition cost - accumulated depreciation)
n = number of years
Example
For $2 million, Company ABC purchased a machine that will have an estimated useful life of five years. The company also estimates that in five years the company will be able to sell it for $200,000 for scrap parts.

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The double-declining-balance method produces a very aggressive depreciation schedule. The asset cannot be depreciated beyond its salvage value.


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