Causes and Objectives of Depreciation

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Questions and Answers

What is a key disadvantage of the Written Down Value (WDV) Method of depreciation?

It allows complete asset write-off when obsolete.

It easily determines the rate of depreciation.

It does not consider the interest factor in calculations. (correct)

It provides accurate information about accumulated depreciation.

Which of the following aspects is NOT a limitation of the WDV Method of depreciation?

The asset may not be completely written off.

It provides information about the asset's original cost. (correct)

There is no provision of funds for asset replacement.

Calculating depreciation rates is challenging.

How might the Straight Line Method of depreciation differ from the WDV Method regarding asset valuation?

It adjusts depreciation based on interest rates.

It results in a fluctuating asset value over time.

It accumulates depreciation at an increasing rate.

It offers consistent annual depreciation charges. (correct)

What is a significant impact of not investing the depreciation amount outside the business in the WDV Method?

Insufficient funds available for future asset replacement. Signup and view all the answers

Which situation best illustrates a major drawback of WDV depreciation regarding asset obsolescence?

An asset retains a book value even after being declared obsolete. Signup and view all the answers

What is the primary reason for using the straight-line method of depreciation?

It allocates an equal amount of depreciation expense over the useful life of the asset. Signup and view all the answers

Which of the following factors is NOT typically considered when calculating depreciation?

Current market demand Signup and view all the answers

What is a significant drawback of using the written down value method of depreciation?

It results in higher depreciation expenses in the early years. Signup and view all the answers

How does depreciation impact the financial statements of a business?

It is treated as a direct expense in the income statement, reducing taxable income. Signup and view all the answers

What is the main purpose of recording depreciation?

To reflect the actual economic value and wear of the assets. Signup and view all the answers

Which of the following is a common reason for asset depreciation due to depletion?

The natural consumption of resources Signup and view all the answers

What is the impact of obsolescence on depreciation?

It renders the asset unusable and reduces its value. Signup and view all the answers

Which method of calculating depreciation involves taking into account the estimated residual value?

Straight-line method Signup and view all the answers

What is a key disadvantage of the Straight Line Method of depreciation regarding total charges against income?

Fixed depreciation fails to account for rising repair costs. Signup and view all the answers

Why is the Straight Line Method of depreciation considered unsuitable for long-term assets?

It does not support extensions or improvements needed for longevity. Signup and view all the answers

What ignored factor can lead to financial loss when using the Straight Line Method of depreciation?

Potential interest from alternate investments. Signup and view all the answers

What is a common consequence of the fixed installation method in later years?

Increased financial pressure due to consistent depreciation. Signup and view all the answers

Which of the following is NOT mentioned as a demerit of the Straight Line Method of depreciation?

It provides an effective strategy for asset valuation. Signup and view all the answers

How do repairing charges change under the Straight Line Method of depreciation?

They increase progressively over time. Signup and view all the answers

What problem may arise from the Straight Line Method not setting aside funds for asset replacement?

Difficulty in finding funds when an asset becomes useless. Signup and view all the answers

In calculating depreciation, which aspect is emphasized as a demerit of the Straight Line Method?

Static depreciation rates not reflecting real asset decline. Signup and view all the answers

Study Notes

Causes of Depreciation

Wear and tear: Constant use of assets in business leads to a decline in their value over time.
Passage of Time: Every asset has an economic useful life. Its value decreases as time passes, regardless of usage.
Depletion: This refers to the reduction of natural resources. Wasting assets, like mines and oil wells, experience value decreases due to depletion.
Obsolescence: Advancements in technology can render older assets obsolete and outdated.
Accidents: Accidents can permanently damage assets, reducing their useful life and value.
Permanent Fall in Price: A significant decline in the market value of investments is recorded as depreciation.

Objectives of Providing Depreciation

Accurate Profit Calculation: Depreciation helps determine the true and fair profit by factoring in the asset's declining value.
Accurate Asset Valuation: It reflects the true value of assets on the balance sheet by accounting for their wear and tear.
Replacement Fund: Depreciation charges contribute to a fund for replacing the asset when it reaches the end of its useful life.
Accurate Cost of Production: Depreciation is included in the cost of production, providing a realistic calculation of the product's cost.
Legal Compliance: Accounting standards often require companies to recognize depreciation.
Tax Benefits: Depreciation is a tax-deductible expense, potentially lowering tax liability.

Factors Affecting Depreciation Amount

Historical Cost: The initial cost of acquiring, installing, and commissioning the asset.
Expected Useful Life: The estimated duration the asset will be functional in the business.
Residual Value: The estimated salvage value of the asset at the end of its useful life.

Historical Cost

It reflects the initial investment in the asset, adjusted for any subsequent changes like currency fluctuations or price adjustments.

Straight Line Method (SLM)

It charges a fixed amount of depreciation every year, calculated by dividing the depreciable cost (historical cost minus residual value) by the useful life.

Demerits of SLM

Unequal Charge Against Income: The total cost of using an asset (depreciation + repairs) increases each year due to rising repair costs, while depreciation remains constant.
Interest Factor Ignored: The initial investment in the asset isn't considered as a lost opportunity cost (interest).
Undue Pressure in Later Years: The increasing cost burden in later years can strain the business.
Difficult to Estimate Scrap Value: It's challenging to predict the asset’s future value accurately.
Unsuitable for Long-Term Assets: Assets with long lives may require additions and extensions, making SLM less suitable.
No Provision for Replacement: The depreciation charge isn’t set aside for replacement, potentially creating funding issues when the asset needs to be replaced.

WDV Method (Written Down Value)

This method calculates depreciation based on the asset's decreasing value each year. It applies a fixed depreciation rate to the asset's book value (historical cost minus accumulated depreciation).

Example: Comparison of SLM and WDV

This table compares the total charges under SLM and WDV. Note how WDV results in higher charges in the early years and lower charges in the later years.

Demerits of WDV

Difficult Rate Determination: Determining the right depreciation rate can be challenging, as the asset may not depreciate down to zero.
Interest Factor Ignored: It also doesn't account for the opportunity cost of the initial investment.
No Provision for Replacement: The depreciation charge is not segregated for replacement, similar to the SLM.
Asset Not Fully Depreciated: WDV might not fully depreciate the asset, even if it's obsolete and useless.
Original Cost and Accumulated Depreciation Not Clear: The asset's reduced balance doesn't reveal the initial cost or total depreciation accumulated.

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Description

This quiz covers the key causes of depreciation in assets, including wear and tear, time passage, depletion, and obsolescence. Additionally, it examines the objectives of providing depreciation, such as accurate profit calculation and asset valuation. Test your understanding of these important financial concepts!