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In regulating depreciation in respect to income taxes, deduction is allowed only for loss due to wear and tear of property used in the trade or business. This does not include provision for obsolescence since it is provided that when an asset is actually determined to be obsolete the loss may be deducted at that time. However, obsolescence should usually be provided for periodically as well as depreciation from wear and tear, as the government's permission to make eventual deduction for loss from obsolescence does not justify a waiver of the fundamental accounting rule to provide for all possible losses.
Factors Bearing on Amount of Depreciation. In de termining the probable amount of depreciation on any fixed asset there are certain factors to be taken into consideration such as original or prime cost, probable life of the asset, repairs and replacements, residual or scrap value and the possibility of obsolescence.
1. The original or prime cost is the basis of all calculations. It should include all the elements of cost such as freight and cartage inward, cost of installation, etc.
2. The probable life of the asset, or the number of years it is estimated to be of use, is the next factor to be considered. This varies so extensively, even with the same kinds of machines, or other assets, that it is always a difficult item to arrive at with any degree of accuracy. About the only way of determining the life of an asset is by experience.
Earl A. Saliers, author of "Principles of Depreciation", says:
"But efficiency, the test of present usefulness, is not the only factor that determines value. Value depends upon_the length of time over which such usefulness will continue. Two similar machines may be equally efficient today; but one may continue to be useful for two years and the other for four. Can we say that they have equal value? There may be some uncertainty in individual cases; but the uncertainty is limited within certain bounds, and to a great degree vanishes when averages are considered, just as the uncertainties of lifetime vanish when large numbers of lives are considered. The lifetime of a single freight car is very uncertain but the average lifetime of a thousand cars is ascertainable to the fraction of a year."
3. Repairs and replacements of property affect the rate of depreciation, consequently, the auditor should not decide on the amount required for depreciation until he has scrutinized the Repairs and Maintenance account. He may find items charged to this account that should have been charged to the Reserve for Depreciation account because they represent expenditures that decrease the deterioration and should have the effect of reducing the depreciation charge.
The usual procedure in practice is to charge all items representing repairs and replacements to either expense or to the Reserve for Depreciation account. In deciding which account should be charged it is necessary to determine whether the expenditure is one provided for through cumulative depreciation allowances. Ordinarily small incidental items of repair, replacement and maintenance are charged to expense and larger items of renewal and replacement are charged to the depreciation reserve. Remember, that with either plan it is a deduction from income, but the point in question is, that the expenditure must not be charged to expense, and at the same time, another charge be made on account of depreciation. (See page 154 for Income Tax Procedure).
Like nearly all rules, there is an exception here in connection with old, run-down or partially worn-out assets purchased with the intention of remodeling, rebuilding or rehabilitating them so they can be operated efficiently again. In such cases, it is permissible to charge all repairs and renewals to the asset accounts affected, thereby capitalizing such expenditures.
4. The total amount of depreciation of an asset will be the difference between its original cost and its residual or scrap value when it ceases to be useful and must be discarded. Whatever can be realized from the sale of an asset at the time it is discarded reduces the loss and thereby the amount of depreciation.
5. Some assets are quite likely to become obsolete even before they have become useless through wear and tear. The possibility of obsolescence, therefore, is a matter for consideration.
Methods Used for Calculating the Depreciation. There are several methods advocated for calculating the proper amount or rather the annual rate of depreciation. We shall discuss briefly the principal methods used.
I. Straight Line Method. In this method the life of the asset is estimated and the cost of such asset less its scrap or residual value is written off over such estimated life. The amount of depreciation for each year is found by dividing the difference between the cost and residual value by the number of years of the estimated life of the asset.
To illustrate, let us assume that the cost of a certain machine is $81.00, its estimated life is four years, and its residual or scrap value is $16.00.
By deducting the scrap value, $16.00, from the cost, $81.00, we get $65.00, the amount the machine is expected to depreciate in four years, its estimated life. $65.00 divided by the number of years, four, shows $16.25, the annual amount of depreciation to be charged off. The amount of annual depreciation, $16.25 divided by the cost, $81.00, shows the rate of depreciation to be 20 5/81%
This is the simplest method for calculating depreciation and consequently is very popular. It is the method in general use, and is acceptable to the Interstate Commerce Commission and the Internal Revenue Department. The method has been criticized by some accountants and others for various reasons. Saliers says in this connection:
"It is free from interest complications, and its employment does not require a knowledge of the logarithmic or any other method of finding roots and powers of numbers. Speaking generally, there appears to be no reason why the straight line method does not approximate actual depreciation as nearly as any of the complicated curves at times advocated, apparently on the assumption that actual depreciation finds a counterpart in the accuracy of their mathematical computations.'
2. Diminishing Value Method. In this method it is customary to estimate a minimum life of the asset and then depreciate the residual value each year. That is, instead of basing the annual depreciation during the life of the asset on the original cost, as in the straight line method, it is based on the value of the asset at the beginning of that period after having deducted the total amount of previous depreciation. A percentage rate is ascertained which, when applied each year to the balance remaining after the similar deduction for the preceding year, will reduce the balance to the scrap value at the end of life of the asset.
Using the same problem as shown under the straight line method, it will be seen that it requires a rate of 3373% to reduce the asset to a scrap value of $16.00 in four years. Note the following calculations: Original cost of machine...
. $81.00 Less Depr. (3373% of $81.00).
27.00 Value beginning of second year
54.00 Less Depr. (3373% of $54.00)
18.00 Value beginning of third year.
36.00 Less Depr. (3373% of $36.00)..
12.00 Value beginning of fourth year...
24.00 Less Depr. (3373% of $24.00)..
8.00 Residual or scrap value....
$16.00 It will be seen that the amount of depreciation is greater at the beginning but decreases with the life of the asset. It is held by some that this is reasonable because the cost of repairs and maintenance is least while the asset is new but increases as the asset is used. Therefore, the total depreciation and upkeep will be nearly uniform each year. On the other hand, the concern is forced to charge off a larger amount of depreciation at the beginning of its existence when profits may be small. Another objection is the fact that it involves a complicated mathematical calculation, and the annual rate of depreciation gives little indication to the ordinary man of the period required to write off the asset.
3. Annuity Method. In this method the plan is to estimate an amount which, if annually set aside at interest, would at the end of the life of the asset amount to the difference between cost and scrap values. A sum is determined which, when set aside each year at compound interest, will accumulate, during the life of the asset, and will just equal the scrap value at the end of its estimated life.
Hatfield, in his Modern Accounting, says:
"It rests upon the assumption that the cost of production includes not only repairs and the depreciation of machinery, but as well, interest on the amount of capital invested in the asset. Depreciation on this theory should be a sum figured as a constant annual charge sufficient not only to write off the decline in value, but also to write off annual interest charges on its diminishing value.'
Using the same problem as above, it will be seen that the annual amount of depreciation is equivalent to a rate of 27 47/162% based on the original cost. Note the following calculations: Original cost of machine.
$81.00 Interest at 10%..
38.II Depreciation fourth year (27 47/162%)... 22.II Residual or scrap value...
.. $16.00 (Interest at the rate of 10 per cent was used for convenience in arithmetical calculations.)
This method is objectionable because of the inclusion of interest on invested capital. Of course, the writing up of the asset is offset by the increased depreciation. The method is inconsistent unless interest is charged on all the capital invested.
4. Production Unit Method. In this method the estimated life of an asset is based on its production. The plan is to charge off an established rate per unit of output. It may be applied to such assets as diminish in value in exact ratio to the amount used. For instance, if the machine mentioned above was designed to produce 1,000,000 units at a total cost of $1,000.00, the depreciation charge would be i mill per unit of production.
Comparison of Methods for Calculating Depreciation. Walton says with regard to the significance of each method:
"(a) The Straight Line Method distributes the burden of depreciation equally over all the years, without regard to the constantly increasing repairs.
“(b) The Diminishing Value Method starts with a heavier burden of depreciation which gradually diminishes, the theory being that as the repairs increase on account of the increasing deterioration of the asset, the decreased depreciation tends to equalize the burden over the years. It also provides for a residual or scrap value, as the carrying value never reaches zero.
"(c) The Annuity Method takes into consideration not only the cost of the asset, but also the interest on the diminishing value. As the credit to interest diminishes each year and the charge for depreciation remains constant, the net expense increases annually. In addition, few accountants are in favor of considering interest on the cost of fixed assets as an operating expense.'
Dicksee, a prominent authority, favors the first method for short-lived assets, the second for machinery in general, and the third for long-time terminable leaseholds and similar assets. Where courts have prescribed depreciation, they have generally allowed the basis of calculation to be left to the discretion of the company. This is also true with the Internal Revenue Department. The Interstate Commerce Commission prescribes the first method for figuring depreciation. It is compulsory with concerns coming under the Commission's Control.
Accounting Procedure with Regard to Depreciation. Either a reserve for depreciation or a reserve fund may be created, or the asset account may be credited direct for the amount of the depreciation.
(a) Writing Down the Asset. If the amount is credited direct to the asset account, it is known as writing down the asset. The principal objection to this plan is that the original cost of the asset is lost sight of. From an accounting standpoint, the asset accounts should show costs of assets on hand at the date of the Balance Sheet. If the depreciation is credited direct to the accounts with assets, this policy is interfered with making it necessary to analyze the accounts in order to ascertain the cost of assets.
(b) General Reserve for Depreciation. Some firms create a general reserve for depreciation. This is considered poor accounting for the reason that the account includes the depreciation on all classes of assets and it is impossible to ascertain