Methods And Criteria For Computing Depreciation Of Assets

Various Methods of Calculating Depreciation

Depreciation may be defined as the decrease in the value of the asset over time due to various factors which affect the life of the asset (Li and Hall 2016). The various methods which are used in the process of computing depreciation are given below in details:

1. Straight Line method: This is the most simple and easy method of computing depreciation amount which is to be charged on the asset of the company. As per this method, the amount which is charged as depreciation remains the same every year over the useful life of the assets(Ibarra 2013). This is a widely used method of computing depreciation due to its simplicity in many companies.
2. Diminishing Value Method: This is another most used method for computing depreciation for the company. In this method a certain rate of depreciation is charged on the value of the asset in order to compute the depreciation amount of the asset(Lawrence and Okechukwu 2013). The amount of depreciation charged under this method changes every year depending upon the written down value of the asset on which depreciation is to be charged.
3. Unit of Production Method: As per this method, the amount of depreciation which is charged on the value of the asset depends on the units produced or total number of hours which the machine has over the useful life of the asset.
4. Sum of the Year’s Digit Method: In this method, the remaining useful of the asset is divided by the sum of the years and then the figure is multiplied by the depreciation base to determine the expenses relating to depreciation of an asset.
5. Double Declining Balance Method: In this method the expense relating to depreciation is larger in the initial years of the asset and becomes lower and lower in the later years of the useful life of the asset.

Depreciation of an asset allows the valuation of the asset to done correctly. An asset which is used continuously will be having certain wear and tear which are expenses to the company even though they are not in cash (Liapis and Kantianis 2015). If such expenses are not recorded then the asset will be overvalued and this will be overstating the assets in the balance sheet which is definitely not the case.

Requirement (i)

Requirement (ii)

Requirement (iii)

Figure 1: (Chart Showing Book Value of Assets under different Methods)

Source: (Created by Author)

Requirement (iv)

The depreciation method which are to be applied on an asset is based on the nature of the asset, estimated business use, residual value of the asset and useful life of the asset. The most important criteria for selecting a method of depreciation is that the depreciation method selected by the business should be able to reflect the asset cost allocated to accounting period in a systematic manner. For example, in case of depreciation under straight line method, a truck which has a useful life of 10 years and is valued at $ 1,00,000 with a residual value of $ 10,000. The value of the asset which will be calculated will be . The method uses straight line basis and the depreciation amount for all the years will be same $ 9,000.

In the case of Diminishing value method, suppose a truck is brought for $ 1,00,000 and the useful life of the truck is 10 years. The estimated rate at which depreciation is charges is decided to be 10% which will then be  will be charged as depreciation for the first year. In the second year, the same will be .

In the case of unit of production method, suppose a machine is brought for $1,00,000 and has a residual value of $ 10,000. The average production which can be expected from the same is around 9000 units. Therefore, the depreciation amount will be calculated .

Requirement (v)

Requirement (vi)

The estimated working hours of the machinery as given in the question is of 1400 hours. For the purpose of computing the hourly cost rate for the use of machinery it is required to get the value of the asset and the residual value of the asset if any available. The value of the asset is $ 25,60,000 and the residual value of the assets is $ 3,40,000. The calculation of the hourly cost of the asset will be  The hourly cost rate of the machinery will be taken into consideration for the purpose of estimating the total cost associated with a product and decisions regarding the use of the machinery will be taken accordingly.

Factors Affecting the Selection of a Depreciation Method

Requirement (vii)

The new alternative which is there also has a useful life of the asset and standard of service which is similar to the existing asset. The company should not switch to the new alternative which is available as it will be requiring additional investments which the company needs to incur. In addition to this, the performance of the machinery might not be same as existing one and this change might also alter the useful life of the asset.

The assets which are to be purchased by the business needs to match the requirements of the business. The purchasing decisions of an asset is determined by factors such a nature of the asset, use of the asset, useful life of the asset, estimated salvage value of the asset. In addition to this, the requirement of the business also plays a priority on the decisions about the purchasing of an asset. In case of rehabilitation of an asset, the effect of such rehabilitation is to be considered which will be on the asset. Such rehabilitation must be there so that the useful life of the asset can be extended or the performance of the asset might be increased.

The problems which are faced by businesses to assess whether an asset is to be purchased, rehabilitated or replaced depends on the alternative options which a business has for the purpose of business. In case of asset replacement, the prospects of the alternative options are considered by the use of NPV techniques and Capital Budgeting (Booth and Choudhary 2013). The major thing which the management of the company needs to consider is that whether the move of the business will result in increase in profitability of the business or operational efficiency of the business. This can be done with the help of various techniques which are available to the management of the business (Tian 2013). Another issue is that the additional cost which the management has to incur die the implementation of the new policy which might be relating to purchasing, rehabilitation and replacement of the machinery which is currently being used by the business. Thus, it can be said that various factors affect the decisions of the business for the purpose of decision making about the assets of the business (Pianosi et al. 2016).

Requirement (ii)

From the analysis of both the methods which is applied by the company for selection of the policy which is to be followed by the business, it is clear that the business needs to follow Rehabilitation policy related to the assets as such policy has a better NPV and also an internal rate of return as per the analysis (Bas 2013). The method which is used for the analysis are NPV and Internal Rate of return method. The advantages of using internal rate of return method are:

• It considers the time value of money concept which is essential to get an accurate estimate.
• It is a simple method to use and understand.

The Decision-Making Process for Purchasing, Rehabilitating, or Replacing an Asset

The disadvantages of using internal rate of return is that:

• The concept of economies of scale is ignored in the method.
• The assumptions which are taken in the IRR approach may not be accurate and impractical(Magni 2013).
• The method is not suitable for analysis of two different types of project which have different policies.

The advantages of using NPV analysis in estimation are given below:

• The method takes into consideration the concept of time value of money.
• The method is very useful in estimating the cost analysis of a project and reveals whether an investment will create value or not(Zhou et al. 2015).

The disadvantages of using NPV are given below:

• The method assumes cost of capital information and the method is not useful for analysis of business in different sized of budget.

Requirement (iii)

Requirement (iv)

Figure 2: (Chart Showing Sensitivity Analysis)

Source: (Created by Author)

Requirement (v)

The discount rate at which the choice between the rehabilitation and replacement of the asset will be different in case of 4% discount rate. This can be obtained through the analysis of sensitivity of the methods. A table below shows the meeting point of the two policies of rehabilitation and replacement below:

In addition to this, the graph which is shown in figure 2 also show that the trend lines meet at a point which is the 4% discount rate.

Requirement (vi)

Life cycle costing refers to the cost analysis of an assets considering all repairs, renewals which is used for evaluation of the economic benefits which are associated with the asset (Wittbrodt et al. 2013). The other consideration which can be considered for the decision-making process for an asset are the fact that additional expenses which the business will be incurring when the assets of the company is being replaced. Such additional cost will also affect the decision about the purchase, rehabilitation and replacement of the asset.

In addition to this, the environmental consideration is also an area of concern. Certain machinery uses resources which can harm the environment. Such activities of the business will only be increasing the cost of the business and therefore must be considered before taking decisions.

The company also needs to consider the aspect of various influences which the purchase, rehabilitation or replacement of an equipment may have on the local community as a whole. Such an impact may be favorable or unfavorable in nature. None the less the management of the company needs to consider such factors in the decision-making process of the company regarding the asset which is to be purchased, rehabilitated or replaced.

Reference

Bas, E., 2013. A robust approach to the decision rules of NPV and IRR for simple projects. Applied Mathematics and Computation, 219(11), pp.5901-5908.

Booth, A.T. and Choudhary, R., 2013. Decision making under uncertainty in the retrofit analysis of the UK housing stock: Implications for the Green Deal. Energy and Buildings, 64, pp.292-308.

Ibarra, V.C., 2013. The straight-line depreciation method used by selected companies and educational institutions in the Philippines. Journal of Modern Accounting and Auditing, 9(4), p.480.

Lawrence, O.A. and Okechukwu, U.A., 2013. Review of accounting gimmicks called depreciation. Open Journal of Accounting, 2(02), p.39.

Li, W.C. and Hall, B.H., 2016. Depreciation of business R&D capital (No. w22473). National Bureau of Economic Research.

Liapis, K.J. and Kantianis, D.D., 2015. Depreciation methods and life-cycle costing (LCC) methodology. Procedia Economics and Finance, 19, pp.314-324.

Magni, C.A., 2013. The internal rate of return approach and the AIRR paradigm: a refutation and a corroboration. The Engineering Economist, 58(2), pp.73-111.

Pianosi, F., Beven, K., Freer, J., Hall, J.W., Rougier, J., Stephenson, D.B. and Wagener, T., 2016. Sensitivity analysis of environmental models: A systematic review with practical workflow. Environmental Modelling & Software, 79, pp.214-232.

Tian, W., 2013. A review of sensitivity analysis methods in building energy analysis. Renewable and Sustainable Energy Reviews, 20, pp.411-419.

Wittbrodt, B.T., Glover, A.G., Laureto, J., Anzalone, G.C., Oppliger, D., Irwin, J.L. and Pearce, J.M., 2013. Life-cycle economic analysis of distributed manufacturing with open-source 3-D printers. Mechatronics, 23(6), pp.713-726.

Zhou, C., Gong, Z., Hu, J., Cao, A. and Liang, H., 2015. A cost-benefit analysis of landfill mining and material recycling in China. Waste management, 35, pp.191-198.

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