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Karnataka class 12 commerce Accountancy Methods of depreciation

Karnataka class 12 commerce Accountancy Methods of depreciation:

Karnataka class 12 commerce Accountancy Methods of depreciation:

Methods of Calculating: Depreciation Amount The depreciation amount to be charged for during an accounting year depends upon depreciable amount and the method of allocation. For this, two methods are mandated by law and enforced by professional accounting practice in India. These methods are straight line method and written down value method. Besides these two main methods there are other methods such as – annuity method, depreciation fund method, insurance policy method, sum of years digit method, double declining method, etc. which may be used for determining the amount of depreciation. The selection of an appropriate method depends upon the following :

  • Type of the asset;
  • Nature of the use of such asset;
  • Circumstances prevailing in the business; As per Accounting Standard-6, the selected depreciation method should be applied consistently from period to period. Change in depreciation method may be allowed only under specific circumstances.

Karnataka class 12 commerce Accountancy Methods of depreciation:

Karnataka class 12 commerce Accountancy Methods of depreciation

Karnataka class 12 commerce Accountancy Methods of depreciation:

Straight Line Method This is the earliest and one of the widely used methods of providing depreciation. This method is based on the assumption of equal usage of the asset over its entire useful life. It is called straight line for a reason that if the amount of depreciation and corresponding time period is plotted on a graph, it will result in a straight line (figure).

It is also called fixed installment method because the amount of depreciation remains constant from year to year over the useful life of the asset. According to this method, a fixed and an equal amount is charged as depreciation in every accounting period during the lifetime of an asset. The amount annually charged as depreciation is such that it reduces the original cost of the asset to its scrap value, at the end of its useful life. This method is also known as fixed percentage on original cost method because same percentage of the original cost (infact depreciable cost) is written off as depreciation from year to year.

The depreciation amount to be provided under this method is computed by using the following formula:

Depreciation=(Cost of asset -Estimated net residential value)/Estimated useful life of asset.

Rate of depreciation under straight line method is the percentage of the total cost of the asset to be charged as deprecation during the useful lifetime of the asset. Rate of depreciation is calculated as follows:

Rate of Depreciation=(Annual Depreciation amount/Acquisition cost)x 100

Consider the following example, the original cost of the asset is Rs. 2,50,000. The useful life of the asset is 10 years and net residual value is estimated to be Rs. 50,000. Now, the amount of depreciation to be charged every year will be computed as given below:

Annual Depreciation Amount=(Acquisition cost asset-Estimated net residential value)/Estimated life of asset.

i.e=(Rs 250000-Rs 50000)/10=20000

Depreciation amount under straight line method

The rate of depreciation will be calculated as :

(i) Rate of Depreciation=(Annual Depreciation amount/Acquisition cost)x 100

From point (i), the annual depreciation amounts to Rs. 20,000.

Thus, the rate of depreciation will be =(Rs 20000/250000)x100=8%

Advantages of Straight Line Method Straight Line method has certain advantages which are stated below:

  •  It is very simple, easy to understand and apply. Simplicity makes it a popular method in practice;
  • Asset can be depreciated upto the net scrap value or zero value. Therefore, this method makes it possible to distribute full depreciable cost over useful life of the asset;
  • Every year, same amount is charged as depreciation in profit and loss account. This makes comparison of profits for different years easy;
  • This method is suitable for those assets whose useful life can be estimated accurately and where the use of the asset is consistent from year to year such as leasehold buildings.

Limitations of Straight Line Method Although straight line method is simple and easy to apply it suffers from certain limitations which are given below.

  • This method is based on the faulty assumption of same amount of the utility of an asset in different accounting years;
  • With the passage of time, work efficiency of the asset decreases and repair and maintenance expense increases. Hence, under this method, the total amount charged against profit on account of depreciation and repair taken together, will not be uniform throughout the life of the asset, rather it will keep on increasing from year to year.

Karnataka class 12 commerce Accountancy Methods of depreciation:

Written Down Value Method Under this method, depreciation is charged on the book value of the asset. Since book value keeps on reducing by the annual charge of depreciation, it is also known as ‘reducing balance method’. This method involves the application of a pre-determined proportion/percentage of the book value of the asset at the beginning of every accounting period, so as to calculate the amount of depreciation. The amount of depreciation reduces year after year.

The amount of depreciation goes on reducing. For this reason, it is also known ‘reducing installment’ or ‘diminishing value’ method. This method is based upon the assumption that the benefit accruing to business from assets keeps on diminishing as the asset becomes old (figure). This is due to the reason that a predetermined percentage is applied to a gradually shrinking balance on the asset account every year. Thus, large amount is recovered depreciation charge in the earlier years than in later years.

Karnataka class 12 commerce Accountancy Methods of depreciation:

Advantages of Written Down Value Method Written down value method has the following advantages:

  • This method is based on a more realistic assumption that the benefits from asset go on diminishing (reducing) with the passage of time. Hence, it calls for proper allocation of cost because higher depreciation is charged in earlier years when asset’s utility is higher as compared to later years when it becomes less effective.
  • It results into almost equal burden of depreciation and repair expenses taken together every year on profit and loss account;
  • Income Tax Act accept this method for tax purposes;
  • As a large portion of cost is written-off in earlier years, loss due to obsolescence gets reduced;
  • This method is suitable for fixed assets which last for long and which require increased repair and maintenance expenses with passage of time. It can also be used where obsolescence rate is high.

Limitations of Written Down Value Method Although this method is based upon a more realistic assumption it suffers from the following limitations.

  • As depreciation is calculated at fixed percentage of written down value, depreciable cost of the asset cannot be fully written-off. The value of the asset can never be zero;
  • It is difficult to ascertain a suitable rate of depreciation.

Karnataka class 12 commerce Accountancy Methods of depreciation:

Methods of Recording Depreciation In the books of account, there are two types of arrangements for recording depreciation on fixed assets:

  • Charging depreciation to asset account or
  • Creating Provision for depreciation/Accumulated depreciation account.

Karnataka class 12 commerce Accountancy Methods of depreciation:

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Karnataka class 12 commerce Accountancy Methods of depreciation:

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