Other Methods Of Depreciation
Peter Marshall Bsc (Econ) BA MBIM is a Fellow of the Society of Business Teachers, and an experienced educator in business subjects. He is also a prolific author and his books have been translated and sold worldwide. He lives in London, UK.
The sum of the digits method
This method is more common in the USA than in Britain. It works in the opposite way to the diminishing balance method. The latter applies a constant percentage but to a progressively reducing balance, but the sum of the digits method applies a progressively small percentage to a constant figure (the initial cost figure). It is called the sum of the digits method because it involves summing the individual year numbers in the expected life span of the asset to arrive at the denominator of a fraction to be applied in calculating depreciation each year. The numerator is the year number concerned, in a reverse order.
For example if an asset had an expected useful life of 5 years then in year 1 the numerator would be 5, and in year 2 it would be 4 and so on, until year 5 when the numerator would be 1. Supposing an asset was expected to last 10 years before becoming worthless: we would add 1 + 2 + 3 + 4 + 5 + 6 + 7 + 8 + 9 + 10 = 55. In year one, we would depreciate by multiplying the original value by 10/55, in year 2 by 9/55 and so on until year 10 when we would write it down by only 1/55 of its initial value.
The machine hours method
We divide the initial cost value of a machine by the estimated number of machine hours in its useful life. The depreciation charge is then calculated by multiplying this quotient by the number of hours the machine has been used within the accounting year.
This method is appropriate wherever the erosion of value of an asset is directly related to its usage.
The revaluation method
This method means revaluing the asset each year. It may involve observation, and item counting, and taking into account factors such as current market prices.
It is useful in respect of small tools, for example, for which it would be silly to keep a separate asset account and provision for depreciation account for each little item. Revaluing is also useful in dealing with livestock, for their values go up and down; a dairy cow for example will be less valuable when very young than when fully grown, but then its value will decline as it gets old. Throughout its life this rise and fall in value may be further affected by changes in food prices in the market place. If revaluation is used, no provision for depreciation is needed.
The depletion method
This is used in the adjusting of values of ore bodies, mines, quarries and oil wells. The initial value of the mine, etc is divided by the quantity of ore or mineral that it contained at the beginning; the quotient is then multiplied by the quantity actually mined in the accounting year to give the amount of depletion in value.
The sinking fund method
This method, as well as depreciating an asset’s value in the books, builds up a fund for replacing it at the end of its useful life. A compound interest formula is applied to the estimated cost of replacement at the end of the asset’s life; it shows how much money must be invested each year (outside the firm) to provide the replacement fund when the time comes. This amount is then charged annually to the profit and loss account as depreciation. The credit entry is posted to a depreciation fund account. The amount is then suitably invested and the asset which thereby comes into existence is debited to a depreciation fund investment account, the credit entry obviously going to bank. This method is not popular now because there is so much uncertainty about inflation and interest rates.
The sinking fund with endowment policy method
This is similar but uses an endowment policy to generate the replacement fund on maturity. The premium is payable annually in advance.