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Which of the following factors does NOT impact the useful life of a depreciable asset?
Which of the following factors does NOT impact the useful life of a depreciable asset?
What characterizes the straight line method of depreciation?
What characterizes the straight line method of depreciation?
Which of the following statements is true regarding the methods for allocating depreciation?
Which of the following statements is true regarding the methods for allocating depreciation?
Which principle mandates the consistent application of the depreciation method selected?
Which principle mandates the consistent application of the depreciation method selected?
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What does obsolescence refer to in the context of depreciable assets?
What does obsolescence refer to in the context of depreciable assets?
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What is the main cause of depreciation due to the continuous use of fixed assets in a business?
What is the main cause of depreciation due to the continuous use of fixed assets in a business?
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What does depletion refer to in the context of asset depreciation?
What does depletion refer to in the context of asset depreciation?
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Which factor is NOT typically considered when assessing the amount of depreciation?
Which factor is NOT typically considered when assessing the amount of depreciation?
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Which objective is aimed at ensuring the asset is recorded at its proper valuation?
Which objective is aimed at ensuring the asset is recorded at its proper valuation?
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How is historical cost defined in relation to a depreciable asset?
How is historical cost defined in relation to a depreciable asset?
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What is obsolescence primarily caused by?
What is obsolescence primarily caused by?
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Which of the following factors does NOT contribute to a permanent fall in the value of assets?
Which of the following factors does NOT contribute to a permanent fall in the value of assets?
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What does a permanent fall in market value of investments get recorded as?
What does a permanent fall in market value of investments get recorded as?
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What is a significant challenge associated with the WDV method of depreciation?
What is a significant challenge associated with the WDV method of depreciation?
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How does the WDV method treat an asset once it becomes obsolete?
How does the WDV method treat an asset once it becomes obsolete?
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Which of the following is NOT a demerit of the WDV method of depreciation?
Which of the following is NOT a demerit of the WDV method of depreciation?
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What is a consequence of the WDV method ignoring the interest factor?
What is a consequence of the WDV method ignoring the interest factor?
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What is a common misconception regarding the WDV method's asset accounting?
What is a common misconception regarding the WDV method's asset accounting?
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What is the primary characteristic of the straight line method of depreciation?
What is the primary characteristic of the straight line method of depreciation?
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In the straight line method, what happens to the asset's value at the end of its useful life?
In the straight line method, what happens to the asset's value at the end of its useful life?
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What information is required to calculate the annual depreciation using the straight line method?
What information is required to calculate the annual depreciation using the straight line method?
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Why is the straight line method considered to have less chance of profit manipulation?
Why is the straight line method considered to have less chance of profit manipulation?
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If a firm purchased a machine for Rs. 1,75,000 with installation charges of Rs. 45,000, what is the total initial cost of the asset?
If a firm purchased a machine for Rs. 1,75,000 with installation charges of Rs. 45,000, what is the total initial cost of the asset?
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What is a significant drawback of the Straight Line Method of Depreciation regarding total charges against income?
What is a significant drawback of the Straight Line Method of Depreciation regarding total charges against income?
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What is the formula to calculate annual depreciation in the straight line method if not explicitly given?
What is the formula to calculate annual depreciation in the straight line method if not explicitly given?
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Which of the following is ignored when calculating depreciation using the Straight Line Method?
Which of the following is ignored when calculating depreciation using the Straight Line Method?
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How does the straight line method visually represent depreciation when graphed?
How does the straight line method visually represent depreciation when graphed?
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Why is the Straight Line Method considered unsuitable for long-term assets?
Why is the Straight Line Method considered unsuitable for long-term assets?
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What is the estimated scrap value of an asset?
What is the estimated scrap value of an asset?
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How does the Straight Line Method of depreciation create undue pressure in later years?
How does the Straight Line Method of depreciation create undue pressure in later years?
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What challenge does the Straight Line Method present when it comes to funds for asset replacement?
What challenge does the Straight Line Method present when it comes to funds for asset replacement?
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Which of the following is not an identified demerit of the Straight Line Method?
Which of the following is not an identified demerit of the Straight Line Method?
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One of the limitations of the Straight Line Method is the difficulty in estimating which of the following?
One of the limitations of the Straight Line Method is the difficulty in estimating which of the following?
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What happens to the total charge against income when using the Straight Line Method over the years?
What happens to the total charge against income when using the Straight Line Method over the years?
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Study Notes
Causes of Depreciation
- Wear and Tear: Assets lose value due to constant use in generating income.
- Passage of Time: Every asset has a limited economic useful life. Value decreases as time passes, even if not actively used.
- Depletion: Natural resources like mines, oil wells, and quarries are depleted over time, reducing their value.
- Obsolescence: New technology renders outdated assets obsolete, decreasing their value.
- Accidents: Accidents permanently damage assets, reducing their useful life and market value.
- Permanent Fall in Price: A drop in the market value of an investment is recorded as depreciation.
Objectives of Providing Depreciation
- Determine true and fair profits by reflecting the asset's decreasing value.
- Present the asset at its correct value on the balance sheet.
- Prepare funds for replacing aging fixed assets.
- Accurately calculate the cost of production by incorporating depreciation.
- Comply with legal and tax regulations.
- Obtain tax benefits by deducting depreciation expenses.
Factors Affecting Depreciation Amount
- Historical Cost: The original price paid for the asset, adjusted for inflation and other factors.
- Expected Useful Life: The estimated period the asset will be used productively.
- Estimated Residual Value: The expected market value at the end of the asset's useful life.
Useful Life of a Depreciable Asset
- Legal or Contractual Limits: The asset's useful life is often restricted by legal or contractual terms.
- Extraction or Consumption: For assets like mines and oil wells, the useful life is determined by how much resource is extracted or consumed.
- Wear and Tear: Usage intensity and maintenance practices influence the rate of physical deterioration.
- Obsolescence: Technological advances, market demand shifts, and legal restrictions can all shorten an asset's useful life.
Relevant Accounting Principles
- Cost Principle: Assets are recorded at their historical cost.
- Matching Principle: Depreciation expenses are matched with the revenue generated by the asset.
- Going Concern Principle: Assets are assumed to be used in operations for the foreseeable future.
- Consistency: The chosen depreciation method must be applied consistently over time.
- Disclosure: Details about the depreciation method and its impact should be clearly communicated in financial statements.
Methods of Providing Depreciation
- Straight Line Method: Depreciation is charged at a fixed rate on the original cost every year. Also known as the Fixed Installment Method and Original Cost Method.
- Written Down Value (WDV) Method: Depreciation is charged at a fixed percentage of the asset's remaining book value.
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Other Methods:
- Sinking Fund Method: A portion of each year's depreciation expense is set aside for future asset replacement.
- Annuity Method: Calculates depreciation based on a series of equal annual payments.
- Insurance Policy Method: Uses insurance premiums as a guide for depreciation.
- Revaluation Method: Adjusts the asset's value based on market appraisals.
- Depletion Method: Used for natural resources like mines and oil wells.
- Machine Hour Rate Method: Depreciation is charged based on the number of hours the machine is used.
Straight Line Method
- Formula for Annual Depreciation: (Cost - Salvage Value) / Useful Life
- Formula for Rate of Depreciation: (Annual Depreciation / Cost ) * 100
- Graph: When plotted, depreciation appears as a straight line parallel to the x-axis, hence the name "Straight Line Method."
Merits of Straight Line Method
- Simplicity: A fixed amount of depreciation is charged every year, making calculations straightforward.
- Complete Asset Write-Off: When used for the asset's entire useful life, the asset's value is entirely depreciated, leaving only the scrap value.
- No Window Dressing: The fixed depreciation expense provides a consistent impact on profit year after year, reducing opportunities for profit manipulation.
- Transparency: The original cost and total accumulated depreciation are readily identifiable.
Calculation of Depreciation and WDV - Straight Line Method
- Example: A machine cost Rs.77,760, with a useful life of 5 years and an estimated scrap value of Rs. 31,250. Straight Line Method is used.
Year | Opening WDV (Rs) | Rate of Depreciation | Depreciation (Rs) | Closing WDV (Rs)
- ------ | -------- | -------- | -------- | -------- 1 | 77,760 | 11.92% | 9,302 | 68,458 2 | 68,458 | 11.92% | 9,302 | 59,156 3 | 59,156 | 11.92% | 9,302 | 49,854 4 | 49,854 | 11.92% | 9,302 | 40,552 5 | 40,552 | 11.92% | 9,302 | 31,250
Demerits of Straight Line Method
- Unequal Charge Against Income: The combination of depreciation and repair costs increases each year, leading to a growing charge against income.
- Interest Factor Ignored: The method doesn't account for the potential interest earnings if the asset's investment were held elsewhere.
- Undue Pressure in Later Years: The increasing total charge against income in later years can be disproportionate to the asset's decreasing efficiency.
- Difficulty in Estimating Scrap Value: Estimating the scrap value accurately can be challenging.
- Unsuitable for Long-Term Assets: Not well-suited for assets with long lifespans or that require significant additions or modifications.
- No Provision for Replacement: The method doesn't automatically allocate funds for replacing the asset, potentially creating a funding shortfall.
Written Down Value (WDV) Method
- Calculation: Depreciation is charged annually at a fixed percentage of the asset's decreasing book value (WDV).
- Formula for Annual Depreciation: WDV x Rate of Depreciation, where WDV is the previous year's closing book value.
Merits of Written Down Value (WDV) Method
- Matches Charges to Asset Efficiency: Depreciation expense reflects the gradual decline in the asset's efficiency.
- Tax Benefits: Depreciation expense is higher in earlier years, potentially reducing tax liabilities.
Demerits of Written Down Value (WDV) Method
- Difficulty Determining Rate: Choosing the correct depreciation rate to fully depreciate the asset can be challenging.
- Interest Factor Ignored: The method doesn't consider the lost potential interest earnings.
- No Replacement Funds: The method doesn't automatically allocate funds for asset replacement.
- Incomplete Write-Off: The asset may never be fully written off in the books, even when it is obsolete or no longer used.
- Limited Information on Cost and Depreciation: It becomes challenging to track the asset's original cost and accumulated depreciation.
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Description
This quiz explores the different causes of depreciation such as wear and tear, depletion, and obsolescence. It also covers the objectives for providing depreciation in financial reporting and management. Understanding these concepts is essential for accurate accounting practices.
