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Depreciating Methods in Accounting with Examples

Depreciation Methods in India with Examples to understand in layman Language

Depreciation methods are different ways of calculating how much value goods lose throughout their expected lifetime. Although assets play a key role in helping businesses provide goods or services, they become less valuable and less productive throughout their useful life. It’s therefore important that the cost of an asset is divided throughout its expected lifetime in a way that considers its declining value.

This is known as depreciation, and there are several different depreciation methods, which allow businesses to determine the projected loss of value of certain assets over time or based on actual physical usage. This allows for an effective allocation of costs throughout the useful life of the asset in the correct period.

In this article, we will be looking at two methods i.e. the straight-line method and the written down value method of depreciation.

What Is Straight Line Depreciation?

Straight-line depreciation is a common method of depreciation where the value of a fixed asset is reduced gradually over its useful life.

The default method used to gradually reduce the carrying amount of a fixed asset over its useful life is called Straight Line Depreciation. Each full accounting year will be allocated the same amount of the percentage of asset’s cost when you are using the straight-line method of depreciation.

This method was created to reflect the consumption pattern of the underlying asset. It is used when there no particular pattern to how the asset is being used over time. Since it is the easiest depreciation method to calculate and results in the fewest calculation errors, using straight-line depreciation to calculate an asset’s depreciation is highly recommended.

When we use the straight-line method of depreciation it represents the depreciation expense evenly over the estimated full life of a fixed asset. The calculation to get straight-line depreciation is fairly easy and as follows:

First, we determine the initial cost of the asset that has been recognized as a fixed asset

Then we subtract the estimated salvage value (the estimated resale value of an asset at the end of its useful life) of the asset. It's easiest to use standard use of life for each class of assets

After that, we determine the estimated useful life of the asset. It is easiest to use a standard useful life for each class of assets.

And then we divide the initial cost excluding the salvage value by the standard useful life of the asset.

For example, we have just bought a machine for Rs60,000. It has an estimated salvage value of Rs10,000 and a useful life of five years.

Purchase cost of Rs 60,000 – estimated salvage value of Rs 10,000 = Depreciable asset cost of Rs50,000

Therefore, the annual depreciation will come out as – Rs 50000/5 = Rs 10000 per annum.

Advantages of the straight-line method 

The straight-line method of providing depreciation has got the following advantages :

Simplicity:

This is the simplest method of providing depreciation. This can be easily understood even by an ordinary person. Calculation of depreciation according to this method is also very simple.

Assets can be completely written off:

According to this method, assets can be written off to zero. The depreciation is calculated on the original cost of the asset at the specified rate, so the value of the asset is fully split over the useful life of the asset.

Knowledge of total depreciation charged:

The amount of total depreciation charged can be easily known by multiplying the yearly amount of depreciation with the number of years, the asset has been used.

Suitable for small firms:

The straight-line method is the most suitable method for small firms. These firms use this method because it is easy, simple and suitable for the size of the firms.

Suitable for firms having a large number of old and new machines

The weaknesses of this method are removed if the firm has both old and new machines. More maintenance charges on old machines and lesser on the new machines balance each other. 

Useful for assets having lesser value

This method is the most suitable for charging depreciation on assets of lesser value such as furniture, fixture and patents etc. 

Disadvantages or limitations of the straight-line method

The straight-line method suffers from the following weaknesses: 

Undue pressure on final years:

The final years of the life of the asset have to bear more repairs and maintenance charges and also the same amount of depreciation. whereas initial years have to suffer lesser repair charges.

No provision for replacement:

The amount charged as depreciation is retained in the business and used in the routine affairs. The firm has to bother for arranging funds for the replacement of assets although depreciation has been charged every year. 

Loss of interest:

The amount of depreciation charged every year is not invested outside the firm, so no interest is received. In certain methods of depreciation, the amount of depreciation is invested outside the business in securities and interest is received.

Illogical method:

It seems illogical to charge depreciation on the original cost of the asset every year when the balance of the asset is declining year after year.

Unsuitable for assets having a long life and more value:

This method is not suitable for those assets which are subject to additions and extension from time to time, such as land and building and plant and machinery. It is not suitable for assets having more value also.

What Is Written Down Value (WDV) Method of Depreciation?

It is also known as Reducing Balance or Reducing Instalment Method or Diminishing Balance Method. Under this method, the depreciation is calculated at a certain fixed percentage each year on the decreasing book value commonly known as WDV of the asset (book value less depreciation).

The use of book value (the balance brought forward from the previous year) and fixed rate of depreciation result in decreasing depreciation charges over the life span of the asset.

While applying the depreciation rate both salvage or scrap value and removal costs are ignored. It is not possible to reduce the book value to zero; but it can be reduced close to its salvage value at the end of its useful life.

As this method equalizes the total charges of using the asset (i.e., the amount of depreciation plus repair charges) from year to year, it is considered more equitable than straight-line method. This is because depreciation charges decline each year whereas repair charges increase year by year.

For example, we have just bought a machine for Rs 1,00,000 and we charge 10% depreciation per annum.

Therefore, depreciation at the end of first year will be 10% of 1,00,000 i.e. Rs 10,000 and the book value will come down to Rs 90,000.

At the end of second year, depreciation charged will be 10% of Rs 90,000 i.e. Rs 9,000 and the book value will come down to 81,000.

Similarly, depreciation charged at the end of third year will be 10% of 81,000 i.e. Rs 8,100 and the remaining book value will be Rs 72,900.

This will continue till the book value of the machine reaches its scrap value.

Advantages of WDV

The major advantage of the reducing balance method is the tax benefit. Under the reducing method, the business is able to claim a larger depreciation tax deduction earlier on. Most businesses would rather receive their tax break sooner rather than later. From a financial accounting perspective, the reducing balance method makes sense for assets that lose their value quickly, like new cars and other vehicles. For these assets, reducing balance depreciation better matches depreciation expense with the actual decline in fair market value.

Disadvantages of WDV

There are some tax scenarios in which a company may not want a bigger tax break early on. If the company already has a tax loss for the year, it won't benefit from an extra tax deduction. Spreading out the deduction evenly can help businesses ensure they don't face sky-high tax bills in later years. For assets that don't lose their value quickly, like equipment and machinery, an accelerated depreciation method doesn't make logical sense. It may be more accurate to depreciate these assets based on how much they're used -- like the units of production method does -- rather than with the reducing balance method.

Depreciation follows the accounting principle of matching revenues with expenses. This means that expenses are to be recorded in the books of accounts in the years in which the related revenues are also recognized. A fixed asset generates revenue for the business across several years; accordingly, its cost is also apportioned across the several years by way of a depreciation charge. The appropriate method of depreciation depends on the nature of the fixed asset and how it will be used in the business.

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