Economists consider depreciation as capital consumption. For them, there are two distinct ways of measuring depreciation either by assuming the value of depreciation of equipment to its opportunity cost or to its replacement cost that will produce comparable earning.
Opportunity cost of equipment is the most profitable alternate use of that is foregone by putting it to its present use. The problem is to measure the opportunity cost. One method of measuring the opportunity cost, as suggested by Joel Dean, is to measure the fall in value during a year. By using this method cannot be applied when capital equipment has no alternative use, like a thermal-power project. In such cases, replacement cost is an appropriate measure of depreciation. Under this method, the cost of the new asset and the residual value of the old asset are taken as the depreciation of the asset. But depreciation is recorded only at the time of replacement of an asset. This method is used in public utility concerns like railway, electricity companies. To accountants, depreciation is an allocation of under expenditure over time. Such allocation or charging depreciation is made under unrealistic assumptions such as stable prices and a given rate of obsolescence. There are different methods of charging depreciation, which are of utmost importance. The use of different levels of profit reported by the accountants. It will be clearer after considering the following example: Suppose a firm purchases a machine for 10,000 USD with an estimated life of 10 yrs. The firm can apply any of the following four methods of charging depreciation and the amount of depreciation for the given example by using the different methods is as follows:
- Straight-line Method
- Reducing Balance Method
- Annuity Method
- Sum-of the Years Digit Method
Under the straight-line method, the amount of depreciation remains the same throughout the life of the asset. Depreciation is calculated according to a fixed percentage on the original cost. The amount and rate of depreciation is calculated as under:
- Amount of depreciation = (Historical cost-Residual value)/Economic life of the asset
- Rate of depreciation = (Amount of depreciation x 100)/Historical cost
Residual value is the realizable value of an asset at the end of its economic life. Keeping in view the above example, the amount of depreciation will be 10,000/10 = 1,000 USD. It will be same for each year. The rate of depreciation will be
1000 x 100/10,000 = 10 %
Under the reducing balance method, depreciation is charged at a constant rate or percent of annually written down values of the machine or any equipment. Assuming a depreciation rate of 20 per cent, the amount of depreciation for different years will be calculated as under :
- Amount of Depreciation = (Historical value x Rate of depreciation) /100
But the amount of depreciation for the first year will be deducted from the successive years. Therefore 2000 USD in the first year, 1600 USD in the second year, 1280 USD in the third year, and so on.
Under the annuity method, rate of depreciation is fixed and is calculated as under:
- d = (C + Cr )/n, where n is the total number of years of capital, C is the total capital and r is the interest rate.
The amount of depreciation in this method is calculated with the help of annuity table.
Finally under sum-of-the year’s digits approach, the total years of equipment life are aggregated. Depreciation is then charged at the rate of the ratio of the last years digits to the total of the years. With respect to the given example, the aggregated years of the equipment’s life’s will be 1+ 2 + 3 +… +10 = 55. Depreciation in the 1st year will be 10,000 x 10/55 = 1818.18 USD, in the 2nd year it will be 1,000 x 9/55 = 1636.36 USD and in 3rd year it will be 10,000 x 8/55 = 1454.54 USD, and so on. These four methods of depreciation results in different methods of depreciation and subsequently different levels of profit.