The Straight line method

It first calculates the depreciable base (cost less salvage) before dividing it by number of years (life of machine) to arrive at annual rate of depreciation. The straight-line method is the most straightforward method of Asset Value Depreciation. But:

§         Not all equipment deteriorates equally e.g. a car, over its useful life.

§         Methods based on actual usage: total life are too cumbersome to be practicable

For Example: Say a machine costs Rs. 10,000 and Rs. 1,000 (as additional set-up/installation/maintenance expenses) = Rs 11,000 but we anticipate/guess its Kabari (Scrap Value) at Rs. 3,000 at the end of its useful life, of say, 10 yrs,

we get:

Cost of Machine + Installation + Directly Associated Costs = Total Cost

Total Cost - Salvage Value (At end of 10 yr. Period) = Depreciable base

10,000 + 1,000 =11000 (Total cost)

11000 – 3,000 = 8,000 as the Depreciable Base

Depreciable Base = Rs. 8,000, Spread out over 10 yrs = Rs. 8000/10(Yrs) = Rs 800/- depreciation per year.

This happens when we accurately assess asset life, but:

• If the machine outlasts its estimated life, we stop depreciation thereafter.
• If it fetches more salvage value, we book a Gain. If salvage value is 5000, against 3000 (Book Value at end of 10 yrs), we show a Gain of Rs. 2000.
• If the machine becomes obsolete after a mere 3 years, depreciation is 3(yrs) x 800 (p.a.) = 2400/-, less scrap value Rs. 500/-, we have a net loss of

11,000 – 2400 = Rs. 8600 (book value) – 500 (salvage returns) = Rs 8,100 (loss).

Cost = 11000

Annual Depreciation = 800 x 3= 2400 = 8600 (Book value)

(Book value) 8600 – 500 (salvage value) = 8100 (Net loss)

Proportionate Annual Depreciation of Rs. 800 (8000 ¸ 10) is an example of the Straight Line Method of Depreciation.

 The Written Down Value Method

·         Written down value, applicable to machines that have high rates of depreciation in the initial year or two, and later taper it e.g. a car, is a usable method.

• Under this method, depreciation is charged at a fixed rate every year, ON THE REDUCING BALANCE. A certain percentage is applied to the previous year's book value, to arrive at the current year's depreciation/ book value, WHICH SHOWS A DECLINING BALANCE, WEIGHTED FOR EARLIER YEARS, AND LOWER AND LOWER FOR LATER YEARS, as the machine grows older.
• Accelerates depreciation taken in early years. Reduces the amount taken in later years. Ignores salvage value; starts with depreciable base = asset cost.

 Declining Balance Method

It can be of many types: For example,

• 200 per cent declining balance, OR
• Double declining balance, is one popular method

EXAMPLE OF DOUBLE DECLINING BALANCE METHOD:

[The Double Declining Method takes an amount (usually double, i.e. 200% of the amount that we take in the Straight Line Method) and applies it to the book value of an asset each year]:

Suppose the asset costing Rs.16,000 has AN ESTIMATED USEFUL LIFE OF 5 YEARS, the depreciation would be calculated as follows:

 YEAR DEPRECIABLE BASE PERCENTAGE (FIXED) DEPRECIATION 1 16000-0 x 0.40 6,400 2 16000-0-6400 x 0.40 3,840 3 16000-6400-3840=5750 x 0.40 2,304 4 16000-6400-3840-2304 x 0.40 1,382 5 Depreciation in the 5th year is only Rs. 74 to finally write off the entire machine depreciable base (Rs. 16000/-) less scrap value (Rs. 2000).

This example also shows accelerated, i.e. realistic, depreciation in early years of the machine's life, when its productivity/ book value is higher, as opposed to its fall in value in later years, and commensurate retarded depreciation.

Comparison of Methods of Depreciation:

·         Many companies choose straight-line method for reporting depreciation to shareholders because net income is higher in early year.

·         Because net income is lower in early years, some companies prefer the written down value method, especially for Income Tax purposes.