Methods of Depreciation

There are several methods of allocating depreciation over the useful life of the assets. Those most commonly employed in industrial and commercial enterprises are the straightline method and the reducing balance method. Under the Straight Line Method, an equal amount is written off each year during the life of the asset. Under the Reducing Balance Method, the annual charge for depreciation decreases from year to year with the result that earlier years suffer to the benefit of later years. Also under this method, the value ofnan asset can never be completely written off. The rate of depreciation to be applied in the case of the Reducing Balance Method is substantially higher than that which must be applied under the Straight Line Method if an asset is to be written off within a certain period. For example, if an asset to the written off to 5% of its original cost over 13 years, under the Straight Line Method the rate of depreciation will be 7.3% but the equivalent rate under Reducing Balance Method will be 20%. The main advantage of the Reducing Balance Method is that during the first few years, when the charge on account of depreciation is heavier, the cost of repairs is usually small and thus, the total charge for each asset is distributed almost equal annually throughout its life, taking cost of repairs also into account. What is claimed as an advantage for the Reducing Balance Method is a drawback in the case of the Straight Line Method. This can be overcome building up a reserve for repairs and renewals. This is done an equal amount determined on estimating the average cost of repairs and renewals being annually charged to the Profit and Loss Account and credited to the provision for repairs account. Against this provision for the expenditure on repairs and renewals is charged as and when incurred, with the result that the annual charge for depreciation and repairs is equalised. The various important factors which the management should take into account while selecting a particular method are:

  1. type of asset;
  2.  the nature of the use of the asset;
  3.  circumstances prevailing in the business; and
  4. state of the economy-whether stable or inflationary.

For example, in a stable economic condition, a going concern with steady operations may select the straight line method. Further certain assets like patents and trade marks should also be depreciated on a straight line basis because of their nature conditioned a legally prescribed life. A company with uneven asset acquisition over the years may go for written down value method. The method of depreciation is applied consistently to provide comparability of the results of the operation of the enterprises from period to period. A change from one method of providing depreciation to another is made only if adoption of the new method is required statute or for compliance with an accounting standard or if it is considered that the change would result in a more appropriate preparation or presentation of the financial statement of the enterprise. When such a change in the method of depreciation is made, depreciation is recalculated in accordance with the new method from the date of the assets coming into use. The deficiency or surplus arising from recomputation of depreciation in accordance with the new method is adjusted in the accounts in the year in which the method of depreciation is changed. In case the change in the method results in deficiency in depreciation in respect of the past years, the deficiency is charged in the statement of Profit & Loss. In case the change in method results in surplus, the surplus is credited to the Profit & Loss Account in the year in which such change is made. Such a change in method is a change in the accounting policy and its effect is quantified and disclosed.

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