Accounting theory and practice, Volume 2 (of 3) : a textbook for colleges and…

Other methods of calculating the depreciation charge are used, but they cannot be classified under any of the three groups discussed so far. They are a miscellaneous, mongrel breed, scarcely to be dignified in some instances as methods. Among these may be mentioned the following: (a) Maintenance Method (b) Replacement Method (c) Fifty Per Cent Method (d) Appraisal Method (e) Insurance Method (f) Gross Earnings Method (a) Maintenance Method In this case a periodic charge for depreciation is made, equal in amount to the cost of maintenance of the asset for the period. It is thus a definite but variable amount, depending upon the maintenance policy. (b) Replacement Method This is hardly a method of _calculating_ the depreciation charge, but rather of recognizing the fact of depreciation by charging all renewals and replacements to revenue. It is argued that in a large, widely extended plant after depreciation has reached the point where renewals are necessary, the charging of all renewals and replacements as expenses will take care of all accruing depreciation and secure a fairly uniform charge to product from period to period. Under this plan depreciation as such does not appear on the books but is taken care of under other titles. (c) The Fifty Per Cent Method This is somewhat similar to the replacement method in that it is applicable only after depreciation has reached the renewals stage. It is claimed for it that, in a property or class of asset consisting of many similar parts, as railroad ties, for example, after the stage of normal repairs has been reached so that the parts are in all degrees of repair from 0% to 100%, the normal maintenance and renewals policy will maintain the property or asset always in about 50% condition. Therefore the total depreciation for the asset or class is the other 50%, which never reaches a larger amount because of a constant renewal of parts. This 50% depreciation may or may not be carried on the books but it exists nevertheless. For the conditions under which it is applicable as above, the law of averages doubtless applies and makes the estimate a fairly good one. (d) Appraisal Method Here a physical appraisal of the asset or property is taken at the close of every fiscal period. The difference in value between the two appraisals for successive fiscal periods represents the depreciation for the period and would be brought on the books as such. (e) Insurance Method This is applicable only to large properties with assets widely distributed. Its operation “involves the actuarial principles of ordinary insurance. This means that the fund accumulated by depreciation charges should not be reserved as an accumulation until it can be spent for the purpose of replacing the identical property upon which the fund accumulated when such property is abandoned; and furthermore, that this fund should be expended, in whole or in part, during the year in which it is created, in the replacement of equipment.” (f) Gross Earnings Method Here the depreciation estimate is based on the gross earnings for the period. This does not necessarily mean that the depreciation estimate will be large when profits are large, and small or nothing when profits are small, although it may be made to apply in that way in individual cases. The policy of making ample reserves for depreciation in good years and scant reserves in poor years is not to be wholly condemned. Depreciation, however, has no relation to, or dependence upon, profits. Rather, profits depend on depreciation in the sense that they cannot exist until after charges for depreciation have been taken care of. Depreciation considered as a fixed per cent of gross earnings is almost the same in effect as the service output method, and has much to commend it. Condition Per Cent Before leaving the topic of method, it may be well to explain a term used in connection with the depreciation estimate, viz., condition per cent. The condition per cent of an asset is found by subtracting from 100%, the fraction which represents the ratio of the present accumulated depreciation to the total estimated depreciation. Thus, if an asset has depreciated in value one-quarter, its condition per cent is said to be 75 (100%-25%). Hence, condition per cent is easily calculated if depreciation has been estimated by any of the proportional methods. If, in addition to the standard notation used, we assume that: Dₘ = total amount of depreciation for m periods Vₘ = value of the asset at end of m’th period then, in general, condition per cent may be expressed by the formula: Dₘ (6) 100% - ---- D Evidently, therefore, ( Dₘ ) Vₘ = V(100% - ----). ( D ) Under the proportional methods Dₘ/D = nd. Therefore, condition per cent is 100%-nd. Under the sinking fund method, the calculation is more complex. Dₘ, the total amount of depreciation accumulated to date, i.e., after m periods, is the amount of the annuity A for m periods. From formula (3), Chapter XV, page 272, the amount of an annuity A is seen to be A(Rⁿ - 1) ---------- . r A(Rᵐ - 1) Therefore, Dₘ = ---------, r A(Rⁿ - 1) and D = ---------, r from which the ratio A(Rᵐ - 1) --------- Dₘ r Rᵐ - 1 --- = --------------- = -------- . D A(Rⁿ - 1) Rⁿ - 1 --------- r Accordingly, condition per cent under the sinking fund method is: Rᵐ - 1 (7) 100% - -------- . Rⁿ - 1