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What are the three methods of depreciation and meaning of amortization?

(This article explains three methods of depreciation applied on fixed assets and the meaning of amortization and difference between depreciation and amortization.)

Depreciation means writing off the value of an asset over a period of time due to wear and tear, age and obsolesces. There are three major methods of charging depreciation or recognition of the cost of the expiration of the cost of fixed assets viz. ‘straight-line method’, ‘written down value method’ and ‘Sum of the year’s digit method”. These different methods of depreciation are applied on fixed assets based on the plan that how the cost should be treated as expiring over the life of the assets. Depreciation is a major issue in the calculation of a company’s cash flows, because it is included in the calculation of net income, but does not involve any cash flow. Since depreciation is a non-cash transaction, a cash flow analysis requires the inclusion of net income with an add-back for any depreciation recognized as expenses during the period.

The straight line method is dividing the depreciable amount of an asset by the estimated number of years to its useful life. In Written down value method of depreciation that the depreciation is charged at a certain rate and it is applied to the residual value of the assets (the value of the asset after application of depreciation in the previous year). The Written down method is also known as Reducing Balance Method. In the case of ‘Sum of the years digit method’, the number of useful years of life left in the asset (is taken as numerator) is divided by the sum of the digits of numbers of years of useful life. Let us take an example to understand this method. Let us presume the original cost of an item is Rs.15000.00 and the useful life of that item is 3 years. In this case, the sum of the digit of the useful is 3+2+1=6. Under the Sum of the years’ digit method the first year’s depreciation will be charged at 3÷6×15000 =7500 Hence depreciation charged is Rs.7500.00 multiplied to the original cost of the asset, in the second year depreciation is charged at 2÷6×15000=5000 multiplied to the original value of the asset, and finally in the last year depreciation is charged at 1÷6×15000=2500. You may observe that at the end of the third year, the book value of the asset after depreciation becomes nil. In the other words, the accumulated depreciation at the end of predetermined useful life of the asset becomes equivalent to the original cost of the asset. In some cases, companies might not have provided for depreciation as per statutory requirements due to strain in profit and therefore show it as arrears of depreciation in the notes to balance sheet. The bankers normally indicate the arrears of depreciation by means of a foot- note to the analysis.
Why land- value is not depreciated?
Land value, generally will not come down, therefore land value is not depreciated. However, the lease- hold land is depreciated over the period of lease.
The difference between depreciation and amortization: The intangible assets like patent right, distribution right, franchise right, copy- right have limited useful life. The process of exhausting the value of intangible assets in the same way depreciation is charged is called amortisation. The depreciation is applicable only to tangible assets.
Read related article: How do you appraise a Profit and Loss statement?

(2) Comments

  1. Aswath

    Sir. regarding performance and financial guarantee, it is riskier for the banks to issue performance guarantee. Despite this fact banks charge lesser commission for performance guarantee compared to financial guarantee. Why it is so?

    1. Surendra NaikSurendra Naik - Post author

      In both the cases, the bank has to discharge the financial liability of the contract agreed to the guarantee or documentary credit, if the contract is partly or fully not performed by the customer. Commissions are taken by the banks on the basis of margin provided by the customer. For example the guarantee is covered by 100% cash security the commission is minimum, lower the margin higher the commission. To know more click the following link

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