Depreciation can be charged using different methods depending on the nature of the asset and business policy. The main objective is to systematically allocate the cost of a fixed asset over its useful life.
The major methods are explained below:
1. Straight Line Method:
Under this method of charging depreciation, the amount charged as depreciation for any asset is fixed and equal for every year. The amount of depreciation is deducted from the original cost of an asset. The concerned asset is depreciated with an equal amount every year until the book value of the asset becomes equal to the scrap value of the asset. It is also called the 'Equal Instalment Method' or 'Fixed Instalment Method'.
Merits of Straight Line Method:
1. Simple to calculate
2. Equality of Depreciation Burden
3. Assets can be Completely Written off
4. Knowledge of Original Cost and Up-to-date Depreciation
Formula for Calculating Depreciation:
1. When Scrap Value is Given:
2. When Rate of Depreciation is Given:
2. Written Down Value Method:
Under this method of charging depreciation, the amount charged as depreciation for any asset is charged at a fixed rate, but on the reducing value of the asset every year. The amount of depreciation is deducted from the written down value (i.e., cost less depreciation) of an asset and charged on the debit side of the Profit and Loss A/c as a loss. The concerned asset is depreciated with an unequal amount every year, as the depreciation is charged to the book value and not to the cost of the asset.
Merits of Written Down Value Method:
1. Based on Logical Assumption
2. Most Suitable
3. Equal Charge Against Income
4. Recognised by Authorities
Formula for Calculating Depreciation:
1. When Scrap Value is Given (To find the rate of depreciation)
2. When Rate of Depreciation is Given:
3.Units of Production Method:
These method also called the Activity Method in these charging depreciation based on the actual usage or output of an asset rather than the passage of time. Under this method, depreciation is directly proportional to the number of units produced or the number of hours the asset is used.
Merits of Written Down Value Method:
- Fair and realistic method
- Matches expense with actual production
- Suitable for manufacturing industries
Formula
Step 1: Calculate Depreciation per Unit
Depreciation per Unit=(Cost – Residual Value)/Total Estimated Production
Step 2: Calculate Annual Depreciation
Annual Depreciation=Depreciation per Unit × Actual Units Produced
4. Sum of the Years’ Digits Method
These is an accelerated method of depreciation. Under this method, higher depreciation is charged in the early years of an asset’s life and lower depreciation in the later years. This method assumes that the asset is more productive or useful in its initial years.
Merits of Written Down Value Method:
- Suitable for assets that become obsolete quickly
- Matches higher productivity in early years
Formula
Step 1: Calculate Sum of the Years’ Digits
If useful life = n years:
Sum of digits=n(n+1)/2
Step 2: Calculate Annual Depreciation
Depreciation=(Remaining Life/um of Years’ Digits)*(Cost – Residual Value)