Custom «Methods of Depreciation» Essay Paper

Introduction

Depreciation is the reduction in the fair value of a fixed asset. It could be caused by wear and tear, obsolescence of the asset or accidents. It does not involve cash outlay, hence it is not included in the statement of cash flows. The depreciated value of the fixed asset is the net book value or the net realizable value that refers to the amount of money the asset can be sold for in the market. This amount is posted as an expense in the books of account of the company throughout the period in which the asset is in the business. The annual depreciation amount is debited in the depreciation expense account. There are different methods of depreciation, which include straight-line basis, reducing or declining balance method, activity based depreciation, sum-of-years digits method, units-of production method, units of time depreciation, group depreciation method and composite depreciation method. Depletion is the reduction of a reserve’s product. It is a method of depreciation used in mines, quarries, timber stands and oil wells. It is similar to depreciation, because they are both recovery systems for reporting of tax and accounting. There are two types of depletion - percentage depletion and cost depletion. The causes of depletion include excessive consumption, unequal distribution of resources, overpopulation and pollution or contamination of the resources.  

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This paper explicates the different methods of depreciation and depletion. It defines the different methods of depreciation and depletion clearly for easier understandability. In addition, this paper gives an illustration of the accounting treatment of each of these methods of depreciation and depletion. These methods would always give different results when similar values are calculated for depreciation and depletion. Therefore, organizations must be careful to choose a single method of calculating depreciation and depletion as this will assist in the avoidance of confusions.

According to Day (2008), the same concepts of accounting are applied in depreciation and depletion, which entails the reduction in the value of the asset over its life, but they are used by different companies and assets. Manufacturing and processing industries mainly use depreciation for the reduction in value of the fixed assets, while depletion is used by mining industries to account for the reduction in the reserve of the resources. Cost depletion is a method of allocating costs over a specific period, while percentage depletion involves each mineral being given a percentage depending on the gross income it earns to the business.

Rahman (2010) indicates that depreciation is calculated on tangible assets while depletion is calculated on resources, which are non-renewable. Depreciation is the reduction in the value of an asset caused by wear and tear, obsolescence or accidents while depletion is the reduction in the natural resources of a mining company (Tambakis, 2002). This reduction could be caused by exhaustion of the resources or natural environmental conditions. Depreciation allocates the original cost of an asset over its life while depletion allocates the cost of an asset over the period it earns revenue for the company (DUmler, Burton, & Kastens, 2000). Percentage depletion is calculated by multiplying the percentage allocated to each mineral by the gross income during the year. Cost depletion is calculated by getting the estimate of the amount of mineral and other resources and allocating a given amount of the cost of the resource to the amount of resource extracted during that period. For instance, if an oil company expects an oil well to produce 400,000 barrels of oil and it invests $200,000 in the extraction of oil, yet the actual amount extracted is 10,000 barrels in the first year, then the depletion will be calculated as:

Depletion deduction = {(10,000/400,000)*200,000} = 5,000

According to Gordon (1998), depletion could also be calculated by finding a base for depletion, which refers to the asset to be depleted, computing a depletion rate per unit and charging depletion according to the usage of units. The asset to be depleted comprises the cost of acquisition, which could either be leasing or buying, and the cost of exploration, which refers to the costs incurred to locate the assets. It also involves the development and restoration costs, which refer to the costs incurred by the company in the construction of mines, digging wells and purchasing mining equipment, as well as the costs incurred in returning mines to their initial conditions after depletion activities are complete (Ogle, 2010). The unit depletion rate can be computed using the following formula:

{(Depletion base – residual value)/Total units to be recovered}

Noland (2006) asserts that the depletion charge is then calculated by multiplying the depletion rate by the actual units used. While depreciation methods are calculated from the time when the asset is acquired, depletion methods are calculated from the time when the minerals earn a gross income. Assets are depreciated over their life until they are disposed of or until their residual value is reached, while depletion is calculated until the resource is exhausted or the costs incurred exceed the revenue earned by the company causing it to be liquidated. The depletion charge is an expense, it reduces taxable income, and it is debited in the depreciation expense account and credited in the provision for depreciation account. Since it is not a cash outlay, depletion is not charged to the cash flow account (Rahman, 2010).            

Straight-line depreciation is a simple and commonly used method of valuation of assets. It is computed by determining the residual value of assets at the end of their useful life, which is subtracted from the cost of assets and divided by their useful life. The cost of the asset includes the purchase price plus other initial costs, such as carriage inwards and installation costs. The amount of depreciation is equal during the life of the asset (Ogle, 2010).

Annual depreciation expense = (Cost of the fixed asset – Residual value) / the life of the asset.

If the asset was sold at a price higher than the net book value, the excess will be a gain on disposal and will be subjected to recapture of depreciation. It will be taken as an income to the business and will not be taxed, as it is a capital gain. However, if it is sold at a price lower than the net book value, it is considered tax deductible. For instance, the annual depreciation expense of a vehicle purchased at $10,000, which has a carriage inwards amount of $2,000, a salvage value of $ 2,000 and a life of 5 years, will be calculated as:

Annual depreciation= {(10,000+2,000)-2,000} /5= 2,000.

The annual depreciation amount will be 2,000. This method is easy to use and understand.

Declining is another method of depreciation. It gives a higher depreciation charge in the first years and a lesser charge in the subsequent years. Depreciation is calculated each year from the written down value. A fixed charge may also be used to calculate depreciation in which the straight-line rate is used (Rahman, 2010).

Depreciation expense = Depreciation rate * book value at the start of the year.

It differs from the straight-line method in that each year’s depreciation is calculated from the written down value. It gives a more accurate estimate of the net book value of the asset, since most assets are useful when they are still new than when they are old, and therefore, they can be sold at a higher price. Here, the residual value is not considered but the net book value does not go beyond the residual value. This process is repeated until the end of the life of the asset is reached or the residual value is reached (Gordon, 1998).

Activity-based depreciation method is calculated based on the level of activities of the asset. The activity may be the distance covered by a vehicle or the number of people it will transport over its lifetime from the day of purchase. If a vehicle is estimated to cover a specific number of kilometers during its lifetime, per kilometer depreciation will be calculated as cost – residual/miles. Depreciation is then calculated by multiplying the rate by the activity level. For instance, a vehicle that costs $100.000 with a residual value of $ 10,000 is expected to cover 300,000 miles during its  lifetime, the depreciation expense will be calculated as follows:

Depreciation rate = {(100,000-10,000)/300,000} this gives the rate of depreciation as $0.3 per kilometer. Hence, depreciation is 0.3*300,000=90,000. This method gives a more realistic net book value, since the asset is depreciated depending on the amount of work done (Tambakis, 2002).

Sum-of-years’ digits is a method of depreciation that gives a higher value of depreciation than the straight-line method does, but lesser than that calculated in the reducing balance method. It is calculated by multiplying the amount to be depreciated by a fraction computed from the number of years of life. The cost to be depreciated is the original cost – the salvage amount. The fraction is computed for each year from the first to the last. The numerator is the reverse of the number of years starting from the highest to the lowest from the fraction in the first year to the last respectively. The denominator is the sum of the years of the life of the asset. For instance, an asset with a cost of $ 50,000 and a useful life of five years will have its depreciation computed as follows:

1^st year depreciation = 5/15*50,000=16,667                         

2^nd year depreciation =4/15*50,000=13,333

3^rd year depreciation =3/15*50,000 =10,000

4^th year depreciation =2/15*50,000=6,667

5^th year depreciation =1/15*50,000=3,333

It can also be determined by using the formula (n^2 + n)/2, where n represents the life of the asset.

Unit of production depreciation method is calculated by determining the number of units expected to be produced by the asset over its life.

Depreciation expense = {(Cost of the fixed asset – Residual value)/ Estimated units of production}*Actual production (Noland, 2006). For instance, if an asset has a fixed cost of $10,000 a residual value of $2,000 and is expected to produce 20,000 units with an actual production of 10,000 units, depreciation is calculated as:

Depreciation = {(10,000 – 2,000)/20,000}*10,000 = 4,000

The calculation is stopped when the net book value equals the residual value. The sum of accumulated depreciation plus the residual value should equal the cost of the asset.

A unit of time depreciation is applied when the asset amount used is not the same over the years. It can be calculated if the asset is used for mining or in the exploration of resources. In a construction company, this method is best suited for equipment used for a specific purpose. Depreciation is calculated in the same way a unit of production depreciation is calculated. Depreciation is stopped when the book value equals the residual value or when the life of the asset is reached. The accumulated depreciation should equal the cost of the asset plus the salvage value (Rahman, 2010).

Group depreciation method is used in the presence of more than one assets account by making use of the straight-line method. These assets must be of the same nature for them to be compared, as well as the same life span. The amount to be depreciated equals the cost of the asset plus any additional costs, such as carriage inwards or installation costs minus the salvage value of the assets.

Composite depreciation method is calculated on a number of assets that are not of the same nature and have different lives. For example, in an office that contains photocopying machines and printers, composite depreciation can be calculated for these assets, though they are not of the same nature and have different lives. The composite life is obtained by dividing the cost to be depreciated by the annual depreciation expense. The composite depreciation rate is found by dividing the annual depreciation by the total amount of its original cost. The depreciation expense is then found by multiplying the composite depreciation rate by the remaining amount in the asset account. In this method, there is no profit or loss on the disposal of a fixed asset because the gain and loss from disposal after and before the composite life will cancel out.

According to Day (Day, 2008), the general posting of the annual depreciation is to debit depreciation expense and credit the accumulated depreciation account by the same amount. On the disposal of an asset, debit the cash account with the amount received, credit the asset account with the original cost of the asset disposed to remove it from the books of account. The difference between the two is then debited in the accumulated depreciation account. Depreciation expense is posted to the profit and loss account while the accumulated depreciation is posted to the statement of financial position at the end of the year (Rahman, 2010). Depletion is also posted to the books as an expense to the company. It reduces the effect of taxes on the company’s net profits.

In conclusion, depreciation is the reduction in value of a fixed asset while depletion is the reduction of the reserves of a natural resource such as mining or petroleum. Both have the same accounting concepts and refer to the reduction in the number of assets over their lives. They differ in terms of their application in that where depreciation is charged to assets of a manufacturing or processing company. Depletion is calculated in mining, felling and oil drilling. The different methods of depreciation include, straight-line method, which has a fixed rate over the useful years of the asset, reducing balance method, which has the highest charge in the initial years of the use of the asset and reduces as the asset is being used. Another method is activity-based depreciation, which charges depreciation based on the level of activity of the asset, e.g.the distance covered by a lorry. Another method is sum-of-years digits, which is calculated by multiplying the cost of the asset to be depreciated by a fraction. This fraction is determined by taking the highest year as the numerator and the sum of the useful years as the denominator. Another method is units of production, which uses units expected to be produced and the actual units produced to get the depreciation rate. This rate is then multiplied by the cost of the asset. Other methods include units of time depreciation and group depreciation that is calculated on different assets with the same life. Composite depreciation method is calculated on different assets that have different lives. Composite method does not report any gain or loss from the sale of a fixed asset. All methods of depletion include percentage and the cost method. Depreciation and depletion are both expenses that do not involve movement of cash and are not included in the cash flow statement. Depreciation is debited in the depreciation expense account. The same amount is credited in the provision for depreciation account. There is a profit or loss on the disposal of an asset after depreciation has been charged, while depletion is calculated from the gross income earned from the resource.