Model Answer
0 min readIntroduction
Depreciation is the systematic allocation of the cost of a tangible asset over its useful life. It reflects the decline in the asset’s value due to wear and tear, obsolescence, or usage. Accurate depreciation accounting is crucial for presenting a true and fair view of a company’s financial position, impacting profitability, tax liabilities, and investment decisions. The choice of depreciation method isn’t arbitrary; it depends on the nature of the asset, its expected usage pattern, and the industry context. Different methods are employed to best match the expense recognition with the revenue generated by the asset, ensuring a more accurate portrayal of economic reality.
Methods of Depreciation and Their Circumstances
Several methods are available for calculating depreciation, each with its own advantages and disadvantages. The selection depends on the specific asset and the company’s accounting policies.
1. Straight-Line Method
This is the simplest and most commonly used method. It allocates an equal amount of depreciation expense to each year of the asset’s useful life.
- Formula: (Cost – Salvage Value) / Useful Life
- Suitable Circumstances: Best suited for assets that provide a relatively constant level of benefit over their useful life, such as office furniture, buildings (excluding land), and leasehold improvements.
- Example: A machine costing ₹1,00,000 with a salvage value of ₹10,000 and a useful life of 10 years would have an annual depreciation expense of (₹1,00,000 - ₹10,000) / 10 = ₹9,000.
2. Declining Balance Method (also known as Reducing Balance Method)
This is an accelerated depreciation method, meaning it recognizes higher depreciation expense in the early years of the asset’s life and lower expense in later years.
- Formula: (Book Value * Depreciation Rate). Depreciation Rate = 1 – (Salvage Value / Cost)1/Useful Life
- Suitable Circumstances: Appropriate for assets that lose value quickly due to obsolescence or technological advancements, such as computers, vehicles, and certain types of machinery.
- Example: A computer costing ₹50,000 with a salvage value of ₹5,000 and a useful life of 5 years. The depreciation rate is 1 – (5,000/50,000)1/5 = 0.391. Year 1 depreciation: (50,000 * 0.391) = ₹19,550.
3. Sum-of-the-Years’ Digits (SYD) Method
Another accelerated depreciation method, SYD calculates depreciation based on a fraction of the depreciable cost.
- Formula: (Cost – Salvage Value) * (Remaining Useful Life / Sum of the Years’ Digits)
- Suitable Circumstances: Useful for assets where the benefit derived is highest in the early years, similar to the declining balance method. It’s often used for assets that become obsolete quickly.
- Example: A machine costing ₹80,000 with a salvage value of ₹8,000 and a useful life of 4 years. Sum of the years’ digits = 1 + 2 + 3 + 4 = 10. Year 1 depreciation: (80,000 - 8,000) * (4/10) = ₹28,800.
4. Units of Production Method
This method allocates depreciation based on the actual usage or output of the asset.
- Formula: ((Cost – Salvage Value) / Total Estimated Units of Production) * Actual Units Produced in the Period
- Suitable Circumstances: Best suited for assets whose usage varies significantly from period to period, such as machinery in a manufacturing plant, vehicles based on mileage, or equipment based on operating hours.
- Example: A machine costing ₹60,000 with a salvage value of ₹6,000 and an estimated total production of 100,000 units. Depreciation per unit = (60,000 - 6,000) / 100,000 = ₹0.54. If the machine produces 15,000 units in a year, the depreciation expense for that year is 15,000 * ₹0.54 = ₹8,100.
| Method | Formula | Suitable Assets | Depreciation Pattern |
|---|---|---|---|
| Straight-Line | (Cost – Salvage Value) / Useful Life | Office Furniture, Buildings | Constant |
| Declining Balance | (Book Value * Depreciation Rate) | Computers, Vehicles | Accelerated |
| Sum-of-the-Years’ Digits | (Cost – Salvage Value) * (Remaining Useful Life / Sum of the Years’ Digits) | Assets with rapid obsolescence | Accelerated |
| Units of Production | ((Cost – Salvage Value) / Total Estimated Units of Production) * Actual Units Produced | Machinery, Vehicles (mileage-based) | Variable (based on usage) |
Impact of Accounting Standards: Indian Accounting Standards (Ind AS) and Accounting Standards (AS) provide guidance on depreciation. Ind AS 16 (Property, Plant and Equipment) outlines the requirements for recognizing and measuring depreciation, allowing companies to choose a method that reflects the pattern in which the asset’s future economic benefits are expected to be consumed.
Conclusion
The selection of an appropriate depreciation method is a critical accounting decision. While the straight-line method offers simplicity, accelerated methods like declining balance and SYD better reflect the economic reality of assets that lose value rapidly. The units of production method is ideal for assets with variable usage. Ultimately, the chosen method should align with the asset’s nature, its expected usage pattern, and the overall accounting policies of the organization, ensuring a fair and accurate representation of its financial performance and position.
Answer Length
This is a comprehensive model answer for learning purposes and may exceed the word limit. In the exam, always adhere to the prescribed word count.