In the field of accountancy, several methods of charging depreciation are adopted by different entities. However before beginning with the discussion I would like to clarify that the methods of charging depreciation must not be confused with the methods of accounting for depreciation.
Methods of charging depreciation basically means the methods by which we estimate the amount to be depreciated every year. Whatever method we follow, there are some common factors on which their calculation depends. These factors are listed below:
- Original Cost (or Historical Cost) of the Asset to be depreciated: All the costs to bring the asset to its present location and condition and to make it ready for use in the business are included in the historical cost. This is a known figure and no estimates are required to be made for this.
- Useful life of the Asset: It is the estimated period over which the services of an asset will be enjoyed. The useful life of an asset depends on many factors such as legal or contractual provisions, level of use of the asset, degree of maintenance and technological developments. Generally the useful life of an asset is shorter than its physical life.
- Estimated residual value or scrap value: It is the value estimated to be realised after complete commercial utilisation of a fixed asset.
Thus in the list of the above three factors, we can see that two are estimates. So we can get an idea that the factors on which the calculation of depreciation is dependent are mostly estimates and not based on actual or factual data. Therefore we can conclude that the amount of depreciation that is to be provided every year in the books of accounts is actually an accounting estimate and there are different methods which we can follow to derive at this estimated amount. These are called the Methods of Depreciation.
Let us take a look at the most popular methods of depreciation:
- Straight Line Method or Fixed Installment Method
- Written Down Value Method or Reducing Balance Method
- Sum of Years Digit Method
1. Straight line method or Fixed installment method:
The straight line method is the simplest method of depreciation in which every year a fixed amount is written off as depreciation from the value of the Asset. This amount is arrived at by dividing the original cost (less the estimated salvage value, if any) of the asset by the number of years of its estimated life.
Let us try to understand the same with an example:
Suppose that a Machine costs Rupees 100000 and has an estimated useful life of 8 years and a Salvage value of Rupees 20000. If we follow the straight line method or fixed installment method of depreciation for the machine then the amount to be depreciated every year would be as follows:
Depreciation = (Cost – Estimated Salvage value)/ Estimated useful life = (100000 – 20000)/ 8 = Rs. 10000.
So the machine will be depreciated as shown in the table below:
|Year||Cost||Depreciation||Net Book Value (at the end of the year)|
So from the above example you can see that the net residual value after the estimated life of the Asset that is 8 years comes to Rupees 20,000 which is equal to the estimated salvage value of the Asset. So the basic objective here is to depreciate the Asset to such an amount which can be realised by selling off the Asset after the end of its estimated useful life.
Depreciation calculated on straight line basis can always be expressed as a fixed percentage of original cost of the Asset. In the above example the percentage of depreciation would be:
Yearly Depreciation/ Original Cost x 100% = Rs. 10,000 /Rs. 1,00,000 x 100% = 10%
Advantages of the Straight line method of depreciation:
- This is the simplest method of depreciation and the calculation is easiest of all other methods. Once the amount is calculated, amount is written off as depreciation in the books of accounts year after year in the estimated life of the asset is over. So there is no requirement to calculate the amount of depreciation every year.
- This method has the capability to reduce the book value of an asset to zero, if required.
- The burden of depreciation that is charged against the revenues every year remains the same as equal amounts of depreciation are charged every year to the profit and loss account.
- This method provides for improved comparability since there is no change either in the rate or the amount of depreciation and the life of the Asset.
Disadvantages of the Straight line method of depreciation:
In spite of having the above advantages, this method is not free of any disadvantage. The major disadvantages of this method are listed below:
- In the straight line method of depreciation, the amount of depreciation every year remains constant. However in case of some assets like Plant and Machinery, the repairing expenses increase year after year as the assets wear out due to use and passage of time. As a result the total charge to revenue will go on increasing year after year. Hence this method is not suitable for wearing assets like motor vehicles, plant and machinery etc.
- If there are any additions to the main asset then the calculation for depreciation made earlier will be not valid anymore and a fresh calculation of depreciation will be required.
Thus regarding to the Straight Line Method of depreciation we can conclude that in spite of being easiest in calculation, this method is not suitable for wearing assets. However this method is suitable for assets that depreciate due to efflux of time such as patents and leases and also for less costly assets such as furniture and fixtures.
That was all about the Straight Line Method of Depreciation. We will discuss the other methods in separate posts. Thanks for reading and happy learning!