Methods of calculating depreciation amount
There are two methods of calculating depreciation amount which are mandated by the law and implemented by professional accounting practice in India. These methods are known as the Straight line method and the Written down value method.
Apart from these two main methods there are also other methods such as – the annuity method, the depreciation fund method, the insurance policy method, the sum of years digit method, the double declining method, etc. which may be used for determining the amount of depreciation.
The choice of the appropriate method relies on the following:
- Type of the asset;
- Nature of the use of such asset;
- Circumstances prevailing in the business;
According to Accounting Standard-6, the selected depreciation method should be applied consistently from period to period. Change in depreciation method may be permitted only under explicit conditions.
1. Straight Line Method:
Straight-line depreciation is the easiest and most mainstream method; it charges an equal amount of depreciation to each accounting period. This method depends on the assumption of equal usage of the asset over its entire useful life.
It is additionally called the fixed installment method as the amount of depreciation stays constant from year to year over the valuable life of the asset. As per this method, a fixed and an equivalent amount is charged as depreciation in each accounting period during the lifetime of an asset. This will eventually reduce the value of the asset to its scrap value by the end of its useful life.
This method is otherwise known as fixed percentage on original cost method because the same percentage of the original cost, in fact depreciable cost is written off as devaluation from year to year.
The depreciation amount to be given under this method is figured by utilizing the following formula:
(Cost of asset – Estimated net residential value)/ Estimated useful life of the asset
Under the straight line method the rate of depreciation is the percentage of the total cost of the asset to be charged as depreciation during the useful lifetime of the asset. Rate of depreciation is determined as follows:
(Annual depreciation amount/Acquisition cost) x 100
Advantages of Straight Line Method: There are certain advantages of the straight line method which are expressed underneath:
- It is extremely basic, straightforward and easy to apply. Simplicity makes it a well known method in practice;
- Assets can be depreciated upto the net scrap value or zero value. Along these lines, this method makes it possible to distribute full depreciable expense over valuable life of the asset;
- Every year, the same amount is charged as depreciation in profit and loss account. This makes comparison of profits for various years simple;
- This method is appropriate for those assets whose valuable life can be assessed precisely and where the utilization of the asset is consistent from year to year for example, leasehold buildings.
Limitations of Straight Line Method: Although The straight line method is straightforward and easy to apply it suffers from certain constraints which are given underneath:
- This method depends on the flawed assumption of same amount of the utility of an asset in various accounting years;
- With the progression of time, work proficiency of the asset decreases and repair and furthermore, maintenance cost increases. Henceforth, the total amount depreciation and repair undertaken on the asset together, won’t be uniform throughout the life of the asset, and will continue increasing from year to year.
2. Written Down Value Method:
Depreciation is charged on the book value of the asset under this asset. Since book value continues to lessen by the yearly charge of depreciation, it is moreover known as reducing balance method.
This method includes the application of a pre-decided proportion/percentage of the book value of the asset at the start of each accounting period, to compute the measure of depreciation. The amount of depreciation decreases year after year.
Advantages of Written Down Value Method:
- This method depends on a more realistic assumption that the advantages from assets continue decreasing (lessening) with the progression of time. Subsequently, it calls for proper distribution of cost because higher depreciation is charged in earlier years when asset utility is higher when compared to later years when it becomes less successful.
- It results into practically equal burden of depreciation and repair costs taken together consistently on profit and loss account;
- Income Tax Act accepts this method for various tax purposes;
- As a large part of cost is written off in earlier years, loss due to obsolescence gets reduced;
- This method is appropriate for fixed assets which last for long and which require increased repair and maintenance costs with passing of time. It can likewise be utilized where obsolescence rate is high.
Limitations of Written Down Value Method: This method is based upon a more realistic assumption but it still suffers from the following limitations:
- As depreciation is determined at a fixed percentage of written down value, depreciable expense of the asset can’t be completely written off, i.e., the asset value can never be reduced to zero;
- It is hard to determine an appropriate rate of depreciation.
Thus, the methods that are most popular for calculating the depreciation amount are straight line method and written down value method.