Introduction
Fixed assets acquired by business organizations are expected to last for more than one accounting period, and as such, under the matching concept in Accounting, cannot be written off the books in the year of purchase, but rather its cost are apportioned over its expected life span (Nnopu, 2009). This apportionment or allocation is known as Depreciation.
The most commonly accepted definition of depreciation is a systematic and rational method of allocating costs to periods in which benefits are received (APB, 1970). In calculating depreciation, Thomas (1974) stated that no allocation method is fully defensible, and this posses a serious difficulty with depreciation. Before a value for depreciation can be arrived at, the following has to be ascertained: the historical cost of the assets; the expected life span; and residual or scrap value (if any).
Reasons for Depreciation
Several reasons have been advocated for introducing depreciation into the books of an organization. These include: decline in service potential through consumption, obsolescence, or deterioration. Under this assumption, any decline in service or productive potential should be written off as expenses (depreciation). Maintenance of capital this assumes that for the capital to be maintained or even replaced, that recovery of invested capital should be spread over the life of the asset to recover its cost. Replacement cost since assets by their nature will wear and tear, and needs to be replaced at a certain time in the future, depreciation is charged to provide for replacement.
Methods of Depreciation
The fact that plants and equipments are not meant to last forever necessitates the need to make provisions for the day when they will no longer be in active service either due to obsolescence, breakdown, or any other reason. According to Hendrickson (1977), during the 19th and the early part of 20th century, many firms treated the problem of depreciation by a periodic revaluation of assets or by charging either replacement or retirements to current expenses. However, accounting treatment of depreciation can be grouped into the following headings: Straight line or constant charge method; allocation according to usage (activity method); sum of the years' digit method; and double declining balance method.
Straight line method
The straight line method of depreciation charges a constant percentage of the cost of the assets as depreciation. It is a function of time rather than wear and tear. Obsolescence and deterioration are the main consideration in using this method. Under this method, the life of the asset is estimated and any residual or scrap value subtracted from the original or historical cost of the asset, and depreciation charge is spread evenly over the life of the asset.
For instance, a plant with a cost of $8000, with no scrap value, and an expected life of 8 years, will have a yearly depreciation charge of $1000. This is calculated thus: ($8000 - $0)/8; with the formula (C R)/L where C is historical cost of asset; R is Residual Value; and L is life span of the asset in years. This method is very simple and easy to use, but its shortcomings include ignoring the time value of money and charging a constant amount, despite the fact the productive ability and maintenance cost will vary throughout the life of the asset.
Activity method
The activity or use method assumes depreciation to be a variable rather than fixed cost. Under this method, the decline in asset value results from usage or activity rather than passage of time. This method is particularly important when the physical wear and tear is more important than obsolescence. For example, tyres are more likely to wear and tear from usage rather than become obsolete. If the tyre used as example cost $200 with no residual value, and expected 5,000 miles life span; the depreciation is calculated thus: ($200 - $0) / 5,000 = $0.04 per mile. The yearly depreciation then becomes the actual miles travelled multiplied by the cost per mile. The drawbacks of this method includes ignoring the fact that the tyres will wear and tear at a faster rate in later years or towards the end of its life span than in earlier period or when it was new; also, other factors apart from miles travelled such as the load capacity on the tyres, and the nature of roads travelled will also affect their wear and tear rate.
Double declining Balance Method
This method of depreciation as the name implies, doubles the rate of the straight-line method. It works by charging a constant percentage of the declining book value as depreciation. A precise formula can be used to arrive at the exact rate when the scrap value is positive (Hendriksen 1977), but it is beyond the scope of this present write up.
To calculate deprecation using the double declining balance method, first determine the scrap value, then, determine the rate of depreciation using the straight-line method already explained above (C R)/L, and finally double this rate (source of the name: double declining) to arrive at the double declining balance depreciation rate. Usually, the final figure arrived at might not be exactly the same with the scrap value; the exact figure can be arrived at using the formula advocated by Hendriksen (1977).
Sum of the years Digits method
This method of depreciation results in a decreasing charge over the expected life of an asset. Just like the double declining balance method, several factors can be used to justify a declining depreciation charge which include: i) Declining operating efficiency; ii). Increasing repair and maintenance cost; iii). Declining cash proceeds; iv). Uncertainty of revenues in later years due to obsolesce.
This method calculates the depreciation by cost less salvage value. First by adding up the number of years of expected life. For an asset with a life span of 5 years, it adds up thus: 1+2+3+4+5=15. First, the cost less salvage value is determined; the depreciation for the first year is calculated by using the fraction of the last year (5/15) multiplied by cost less salvage value. Likewise, the depreciation for the second year is calculated using the fraction for the penultimate year, and the others by working backwards, the total depreciation can be calculated. For an asset with cost of $7000, scrap value of $1000, the depreciation for the first year is calculated thus: 5/15 x ($7000 - $1000) = $2000.
Capital Allowance
Deprecation as an accounting expense has been universally accepted and recognised by all accounting bodies. But due to some levels of subjectivity inherent in its determination and calculation, certain countries to encourage uniformity adopt a Capital Allowance provision for tax purposes. With Capital Allowance, a specific rate is given for various assets: buildings, plants, equipments etc. with this method, the accountant cannot manipulate the profit by charging a huge rate for depreciation and decreasing the profit, thereby reducing the amount payable as company tax.
References
APB Statement No. 1 (1970) Basic Concepts and Accounting Principles Underlying Financial Statements of Business Enterprises, In E. S. Hendriksen (1977) Accounting Theory. Homewood, Illinois: Richard D. Irwin Inc.
Hendriksen, E. S. (1977) Accounting Theory. Homewood, Illinois: Richard D. Irwin Inc.
Nnopu, M. (2009) Difference between accrual basis accounting and cash basis accounting.
Thomas, A. L. (1974) The Allocation Problem: Part Two, Studies in Accounting Research No. 9. In E. S. Hendriksen (1977) Accounting Theory Homewood, Illinois: Richard D. Irwin Inc.