Question 3 Depreciation (20 marks) There are several methods for determining the

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Question 3 Depreciation (20 marks) There are several methods for determining the amount of capital depreciation. Explain in a concise manner two of these methods and list a few of the advantages and disadvantages for each of them. (a) A pump was purchased for $20,000. If it is depreciated by 4% using the sinking fund method, what would be its annual depreciation charge if the book value of the property after 8 years is the same as if it had been depreciated at $2000 per year by the straight line method? (b) 14

Explanation / Answer

A) There are several types of Capital depreciation methods like 1) Staright line method 2) reducing balancing method 3) sinking fund method etc...

here we are discussing about Straight line and reducing balancing methods.

1) Straight Line method: this metod provides for depreciation by means of of equal periodic charges over the assumed life of the years. t

This metho also known as fixed installment or proportional method.

Depreciation= (cost of asset -estimated residual value)/Estimated useful life of asset.

Advantages:

i) The method is easy to understand and simple to operate.

(ii) It is frequently used in practice.

(iii) It recognises that the passing of time is a major factor in depreciation and the decline in value of an asset is directly proportional to its age.

iv) The method requires little work for calculating depreciation amounts.

Disadvantages:

(i) Since fixed assets do not wear out at exactly the same rate during their life, the straight line method in many cases becomes unrealistic.

(ii) Usually, repair and maintenance costs tend to increase in the later years of the life of an asset, it may be better to charge a higher rate of depreciation in the earlier years.

Reducing Balancing Method:

under this method depreciation charged on the book value of the asset. as the book value keeps on reducing by the annual charge of depreciation, it is also known as written down value method.

Advantages

* Reducing balance method is easy to understand and simple to implement. Depreciation is calculated every year on the opening balance of asset.

* Reducing balance method equalizes the yearly burden on profit and loss account in respect of both depreciation and repairs. The amount of depreciation goes on decreasing while the expenses on repairs goes on increasing, so that the total charge against revenue over different years remains more or less the same.

* Reducing balance method is acceptable for income tax purposes

* Reducing balance method matches the cost and revenue of the business. The greater amount of depreciation provided in initial years is matched against the higher amount of revenue generated by increased production by the use of new asset.

Disadvantages:

* Reducing balance method charges heavy amount of depreciation in earlier years.

* The formula to obtain rate of depreciation can be applied only when there is residual value of the asset.

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