Describe the different methods of providing for depreciation and give an instance of the type of asset to which the particular method might be applied. Which is, in your opinion, the best method ?
The principal methods of providing for depreciation are as follows
(1) The Fixed Instalment or Straightline Method. Under this method a fixed rate per cent on the original cost of the assets is written off every year. This is the most suitable method for general application.
(2) The Reducing Instalment System. Under this system a fixed rate per cent is written off on the diminishing value of the asset each year, so as to reduce the asset to break-up value, at the end of its life. This method is commonly used in connection with plant and machinery, as it is simple and separate calculations do not have to be made in the case of additions. The great weakness of this system is that it takes a very long time to write an asset down to its scrap value, unless a very high rate is used. If the rate is very high the revenue account will be debited with a very large amount of depreciation in the earlier years of the asset as compared with the later years of its useful life. According to de Paula, this system “is a thoroughly bad one and has resulted, in numerous cases, in totally inadequate provision for depreciation.”
(3) The Annuity System. Under this system the asset is regarded as earning a certain rate of interest. A fixed amount is written off each year which, after debiting the asset account with interest at the fixed rate per cent upon the diminishing value, will reduce the asset to nil at the end of its life. The method is specially applicable to the depreciation of long leases.
(4) The Depreciation Fund System or Sinking Fund Method. Under this method an equal amount is debited to the Profit and Loss Account each year, and credited to a Depreciation Fund Account, and an equivalent amount of money is invested outside the business. Usually, the investment is made in a fixed interest-bearing security, so that at the end of the life of the asset the investments will provide sufficient funds to replace the asset. This method is particularly suitable where a costly asset is to be replaced, e.g. the acquisition of a new lease.
(5) The Insurance Policy Method. Under this method an endowment policy is taken out for the life of the asset, so as to produce the amount necessary at the end of the particular period.
(6) The Revaluation Method. Under this method the asset is revalued each year and the loss disclosed on book value is charged Profit and Loss Account. This method should be resorted to where the nature of the asset is such that it is difficult to provide for depreciation on a mathematical basis, e.g. stock, loose tools, etc.
(7) The Depletion Unit Method. This method is applicable to wasting assets such as mines and quarries. Depreciation is usually provided for on the depletion unit basis. It means that such a sum is set aside each year out of profits as represents the expired capital outlay on the basis of output compared with estimated total workable deposits of the mine etc.
(8) The Machine Hour Method. Under this method, the cost of a machine is divided by the estimated total number of its working hours during the whole of is effective life; this gives an hourly rate of depreciation. The Profit and Loss Account of each year is then charged with depreciation, calculated at the hourly rate, for the number of hours during which the machine has been worked during the year. Among the various methods of providing for depreciation, the most commonly employed by industrial and commercial concerns are the straight line method and the reducing balance method. The straight line method, however, is the most suitable for general application.