Depreciation – Various Methods

Compound interest methods:

Sinking Fund Method>>

The sinking fund method is based on the assumption that the funds should be built up to replace the existing asset at the end of its service life. The provision of the equal annual installments is made from the profit and loss account every year. Such amount is earmarked as sinking fund and is invested in some outside securities. The interest on such investments is ploughed back by investing them in other additional securities. The sinking fund investments will grow year by year with the amount of the annual installment of sinking plus the interest earned on the past investment. Under this method, the annual depreciation will be equal to annual installment towards the sinking fund. There is an inverse relation between the value of the asset and the sinking fund. As the value of asset reduces by efflux of time the amount of sinking fund increases. At the end of the service life the value of the asset will be insignificant or nil. The investments of the sinking fund in the outside securities will be sold and the realization will be utilized to purchase a new asset. The annual installment of the sinking is decided on the basis of the required amount at the end of the service life and the years of service life with the help of ready made compound interest annuity tables i.e. to accumulate Rs 123,000 at the end of 8th year with an interest yielding advantage of investment at 12% the yearly installment would Rs 10,000. To facilitate the accounting records the approximations of the yearly installments are made to the nearest hundred or thousand.

Annuity Method:

The annuity method considers that an asset is a bundle of service to be achieved over the life of the asset. The depreciation cost of each year must include a portion of the cost of the asset plus a specified return on the investment in that asset. It is assumed that the yearly amount of the depreciation will be equal for all years. The amount of the annual depreciation will be ascertained on the basis of investment in existing asset, the life of the asset in years and the rate of return on investments in percentage. With the help of the readymade compound interest annuity table, on the basis of rate interest and life in years, the required annual amount of the deprecation will be calculated. The amount of the annual depreciation and the expected interest income will be credited to a separate account viz. Accumulated Depreciation Account.

The sinking fund method and annuity method are similar in nature and operation except with one basic difference. In the sinking fund method, the earmarked amount of depreciation are invested in some outside securities, while under the annuity method, the amount of the depreciation is retained in the business and are used for business operations.

Methods based on Output:

Unit of Output Method>>

This method considers the amount of service that an asset can provide in a given time period. Like other methods, this methods does not consider the useful life in terms of years but it considers the life in terms of units of service e.g. mileage, machine hours units produced etc under this method, the yearly depreciation is provided on the basis of the output obtained from that asset during the said period.

Under this method, the rate of depreciation is calculated on the basis of the depreciable value (i.e. acquisition Cost less Salvage Value) and the estimated production in units during the service life of an asset. Thus, the rate of depreciation will be calculated as under:

r = AC – SV / TP

Where r – rate depreciation; AC – acquisition cost; SV – Salvage value; TP – Total estimated production in units during the service life. The depreciation of any specific year will be ascertained by multiplying the aforesaid rate (r) to the actual production in units for the said period e.g. A truck acquired at a cost of Rs 130,000 has a scrap value of Rs 10,000 at the end of its service life. It is estimated that during its service life, it will run for 300,000 mils. During the year 1980, the truck rolled 20,000 miles. The depreciation for the year 1980 will be ascertained as under:

First the rate of depreciation (r) will be calculated as under:

r = AC – SV / TP = Rs 130,000 – Rs 10,000 / 3,00,000 miles

= Rs 1,20,000 / 3,00,000 miles = 0.40 Re. per mile

Now, for 20,000 miles rolled during 1980, the depreciation for 1980 would be Rs 8,000 (20,000 miles x 0.40).