Read this article to learn about the two methods involved in computation of depreciation. (i) Straight Line Method and Written Down Value Method (WDVM). (ii) Diminishing/Reducing/ Written Down Value Methods.
1. Straight Line or Fixed Installment Method:
This method is the simplest and most commonly used method of charging depreciation. Here, the amount of depreciation remains same over the expected useful life of the asset. That is why this method is called ‘Fixed Installment Method’. This method is also called as ‘Original Cost Method’ because a fixed percentage of the original cost of asset is charged as depreciation during the estimated useful life of the asset.
The amount of depreciation to be charged does not get affected by efficiency or productivity of the asset. In this method the basic assumption is that the asset is being used by the enterprise equally during the expected useful life. If we plot the allocated amount of depreciation during the useful life of the asset, we will find a straight line on the graph.
The depreciation to be charged under this method can be worked by using the following formula:
The merits of straight line method are as under:
This method is simple and calculations are easier to understand.
It is a consistent method since amount of depreciation charged each year is equal. So we can easily compare the past performance.
3. The whole cost can be charged as depreciation:
Under this method, the value of the asset can be reduced to its estimated scrap value (if the asset has some residual value) or nil (if the asset has no residual value). This is not possible under any other method.
4. Reasonable presentation:
The balance sheet shows reasonable and fair values of the assets.
Following are the demerits of straight line method:
It is well known that the efficiency of an asset falls and the expense on its repairs and maintenance increases gradually with the passage of time. However, under this method the
amount of depreciation remains constant. Thus, the total charges (repairs and maintenance plus depreciation) to profit and loss account increase in the later years.
2. Improper presentation:
Under this method, the book value is sometimes reduced to zero, however, it may happen that the asset is being used in the enterprise. In that case balance sheet does not show true and fair view of the enterprise.
This method becomes unsuitable for certain assets in which maintenance cost is higher in later years like plant and machinery, land and buildings etc.
This method is suitable where:
1. The estimated useful life of an asset can be easily determined and the assets which give almost equal utility in terms of productivity during the useful life of the asset like Trademark, Copyright etc.
2. The maintenance and repair cost of the assets is almost the same during the useful life of the asset like Furniture etc.
2. Diminishing/ Reducing/ Written Down Value Method:
Under this method, depreciation is charged as a fixed percentage on the book value of the asset every year. Instead of charging depreciation on the original cost, depreciation is charged on reducing balance of every year (cost of the asset minus depreciation). It is worth mentioning that though rate of depreciation remains fixed, the amount of depreciation declines as the book value of the asset reduces every year.
Under this method the formula for computing the rate of depreciation is as under:
Where, r = Rate of depreciation
n = Number of years of asset’s life
s = Salvage value
c = Cost of the asset
1. Equal burden on income statement:
In the initial year, the depreciation charges are more and repair expenses are less while in later years, depreciation charges are less and repair expenses are more. Therefore, the total burden on profit and loss account remains approximately the same throughout the life of the asset.
2. Complying with matching principle:
Under this method, higher amount of depreciation is charged on the profit and loss account in the initial years when the machine is more efficient giving higher production than the later years when machine becomes older and produces less.
3. Logical approach:
Written down value method is more logical method than the straight line method because in the initial years cost of the machine is high so more amount on account of depreciation is to be charged through profit and loss account. However, in the later years book value of the asset reduces, so less amount of depreciation is to be charged on the profit and loss account.
1. Improper presentation:
Under this method, the book value of the asset can never be written down to zero. However, it may happen that some assets have zero value after some time. Sometimes, to bring down the book value of the asset to the estimated scrap value some adjustments are to be carried out in the last year.
Under this method, the amount of depreciation cannot be determined easily. Lot of figure work is involved in this calculation. It becomes impossible when scrap value of the asset is zero.
This method is not suitable for those assets which give a uniform benefit during their entire useful life.
This method is useful:
1. Where the cost of maintenance and repairs are high in the later years as compared to the initial years e.g. plant and machinery.