1.0
INTRODUCTION
Different methods of
calculating provision for depreciation are mainly accounting customs, which may
be used by different concerns; taken into consideration their individual
peculiarities.
The following are the
main methods of providing depreciation:
i) Fixed Installment
Method or Straight Line Method
ii) Diminishing
Balance Method or Reducing Balance Method
iii) Annuity Method
iv) Revaluation
Method
v) Insurance Policy
Method
vi) Depreciation Fund
Method
vii) Sums of the
Digits Method
viii) Depletion
Method
ix) Machine Hour Rate
Method
Note that each method
will be discussed in details later.
2.0
OBJECTIVES
At the end of this note,
you should be able to:
• understand all the
methods of depreciation
• explain all the
methods
• do some
calculations or workings
• give some important
advantages and disadvantages of some of the methods.
3.0
MAIN CONTENT
3.1
Depreciation Methods
The following are the
main methods of providing depreciation.
3.2
Fixed Installment Method or Straight Line Method
This method is also
known as fixed percentage on original cost. Under this method, a fixed
percentage of the original value of the asset is written off every year so as
to reduce the asset account to nil or to its scrap value at the end of the
estimated life of the asset. To ascertain the annual charge under this method,
all that is necessary is to divide the original value of the asset (minus its
residual value, if any) by the number of years of its estimated life i.e.
Depreciation = Cost
Price of Asset - Scrap Value
Estimated Life of Asset
Annual Depreciation =
Cost Price of Asset - Scrap Value
Number of years
If for example, a
machine costing N1l,000 is estimated to have a life of 10 years and the scrap
value is estimated to N1,000 at the end of its life, the amount of depreciation
would be
N11,000 - N1,000 =
N1,000
10
Having done this, the
depreciation account is debited with the amount so obtained and credited the
particular asset.
If the charge of
depreciation is plotted annually on a graph paper and the points joined
together then, the graph will reveal a straight line, that is why it is also
called a straight line method.
Illustration
1
A Block Industry
purchased a machine worth 440,000.00 for cash on 2"d January, 1995 and put
it into use immediately. The machine was expected to have a useful life of 10
years at the end of which it will have an estimated residual value of
N5,000.00. From above information, you are required to show how you would
provide the annual depreciation on the machine.
Solution
N
Cost of Machine = 40,000.00
Residual Value = 5,000.00
Life Span = 10 years
Annual Depreciation = CP — SV
No of years
= 40,000 — 5,000
10
= 35,000.00
10
= N3,500.00 per year
3.3
Diminishing Balance Method or Reducing Balance Method
Under this method,
depreciation will be calculated at a certain percentage each year on the
balance of the asset which is brought forward from the previous year. You
should note that every year the installment of depreciation will reduce as the
beginning of balance of the asset in each year will reduce. It is usually
adopted for plant and machinery.
The advantages of
this method are:
• It tends to give a
fairly even change of depreciation against revenue each year.
• When additions are
made to the asset, fresh calculations of depreciation are not necessary.
Illustration
2
New Town Cooperative
Society Ltd, purchased a duplicating machine for the sum of N12, 500.00. It has
all estimated life of 4 years and a scrap value of N5, 120.00.
Calculate the
depreciation for each year, using the Reducing Balance Method with a rate of 20
per cent.
3.4
Annuity Method
Under this method,
amount spent on the purchase of an asset is regarded as an investment. Such
investment is assumed to earn interest at a certain rate. Every year, the asset
account is debited with the amount of interest and credited with the amount of
depreciation. This interest is calculated on the debit balance of asset account
at the beginning of the year.
You should note that
the depreciation will be different according to the rate of interest and according
to the period over which the asset is to be written off. The fixed amount of
depreciation as well as the rate of interest is so adjusted that at the end of
the working life of the asset, its book value is reduced to zero or to its
break-up value, if any.
3.5
Revaluation Method
Under this method,
the assets are revalued at the end of the accounting period and this value is
compared with the value of the asset at the beginning of the year. The
difference is treated as depreciation. Where purchase of asset is also made
during the year, then assets are valued at the start of the period; the
additions increase the value and then the assets are revalued at the end of the
period. The amount of decrease in value which the amount by which the asset is
deemed to have depreciated.
3.6
Insurance Policy Method
Under this method,
arrangements are made with an insurance company, which will receive premiums
annually and pay at the end of the fixed period, the required amount. Premiums
have to be paid at the beginning of each year.
3.7
Depreciation Fund Method
Under all the above
methods, ready cash may not be available when the time of replacement comes
because the amount of depreciation is retained in the business itself in the
form of assets not separate from other assets, which cannot be readily sold.
You should note that the amount written-off as depreciation should be kept
aside and invested in readily saleable securities. The securities accumulate
and when the life of the asset expires, the securities are sold and with the
sale proceeds a new asset is purchased.
3.8
Sum of the Digits Method
This is a variant of
the reducing installment or diminishing balance method. Under this method,
depreciation is calculated by the following formula:
Depreciation = Amount
to be x Number of Years of the remaining life written off of the asset
including the current year
The total of all the
digits representing
The assets (in years)
Suppose machinery was
purchased for N45,000.00 on 1st January, 1995 and depreciation was charged
following the sums of the digits method assuming the useful life to be 5 years.
Depreciation for five years will be calculated as follows:
1st
year = 5 x 45,000 =N15,000.00
5 + 4 + 3 + 2 + 1
2nd year = 4 x
45,000 = N12,000.00
5 + 4 + 3 + 2 + 1
3rd year = 3 x 45,000 =N9,000.00
5 + 4 + 3 + 2 + 1
4th year = 2 x 45,000 = N6,000.00
5 + 4 + 3 + 2 + 1
5th year = 1 x 45,000 =N3,000.00
5
+ 4 + 3 + 2 + 1
3.9
Depletion Method
This method is mostly
used in case of mines, quarries, etc. from which a certain quantity of output
is expected to be obtained. The value of mine depends only upon quantity of
minerals that can be obtained. When the whole quantity is taken, the mine looses
its value. The rate of depreciation is worked out only so much per ton. It is
obtained by dividing the cost of the mine by the total quantity of the minerals
expected to be available.
Illustration
A mine was acquired
at a cost of N2,000,000.00 on 1st July 1995. It was expected it would yield
N200,000 tons; 1996 — 40,000 tons and 1997 - 320,000 tons.
Write up the mine
account for the above years using depletion method of charging depreciation.
Solution
Rate
of Depreciation =
Cost of Mine .
Estimated Quantity to be raised
N2,000,000.00 = N10per ton
200,000
3.10 Machine Hour Rate Method
This method is useful
in case of machines. The life of the machine is fixed in terms of hours. Hourly
rate of depreciation is worked out by dividing the cost of the machine by the
total number of hours for which the machine is expected to be used.
Depreciation to be written off in a year will be ascertained by multiplying the
hourly rate of depreciation by the number of hours that the machine actually
runs in the year.
Illustration
A machine was
acquired on 1 s' April 1996 at a cost of N100,000.00. It is expected that its
total life will be 20,000 hours. During 1996, it worked for 5,000 hours and
during 1997 for 8,000 hours. Write up the machinery account for 1996 and 1997.
Solution
Rate
of Depreciation =
Cost of Mine .
Estimated Quantity to be raised
N2,000,000.00 = N10per ton
N 200,000
.
4.0
CONCLUSION
In this note, we have
explained some methods used in keeping intact the capital invested in
depreciable assets and to make provision for replacement, modernization and
expansion on most favorable terms. Depreciation is a process of allocation and
not that of generation.
The provision of depreciation helps the management to
retain this amount of profit in the business which otherwise would have gone to
the government in the form of taxes or to the shareholders in the form of
dividend. The change of depreciation is also necessary to determine the correct
Net Income and financial position of a concern so that financial statements may
give a true and fair view of the state of affairs of the business.
5.0
SUMMARY
In this note, we have
discussed different methods of calculating provision for depreciation. Each
method has its own advantages and uses. Under the straight line method, it
makes calculation of depreciation simple and can write down as asset to zero at
the end of its working life. The Reducing Balance Method tends to give a fairly
even charge of depreciation against revenue each year. Under the Annuity
Method, amount spent on the purchase of an asset is regarded as an investment.
Such investment is assumed to earn interest at a certain rate, and this will be
regarded as the amount to be charged as depreciation.
Revaluation Method is
used in case of bottles, crates, loose tools, packages, etc. while Depletion
Method is mostly used in case of mines and quarries. Under the Depreciation
Fund Method, ready cash will be available at the time of replacement. And the
Machine Hour Rate Method is useful in case of machines. The life of the machine
is fixed in terms of hours.
0 comments:
Post a Comment