Generally, methods for providing depreciation are based on the formula developed on a study of the behavior of the assets over a period of years for readily computing the amount of depreciation suffered by different forms of assets. However, various accounting institutes focus on a few methods and overlook the other methods. Due to space constraint, we will explain only two most commonly used depreciation methods here.
The two methods for providing depreciation are the Straight Line Method and the Reducing Balance Method. The Straight Line Method is the most suitable and accurate method to adapt in most case. The income tax rules, however, prescribe the Reducing Balance Method except in the case of assets of an undertaking engaged in generation and distribution of power.
Straight Line Method: An equal amount is written off every year during the working life of an asset so as to reduce the cost of the asset to nil or its residual value at end of its useful life. The advantages of this method are that it is simple to apply and give accurate result results especially in the case of leases, patent and copyrights, and also in case of plant and machinery. This method is even known as Fixed Instalment Method.
So, it is very simple. And it is like apportioning some expenses every year. So, no need to attend any accounting institute for this purpose.
Reducing Balance Method: Under this method, a fixed percentage of diminishing value of the asset is written off each year, so as to the asset to its break – up value at the end of its life, repairs and small renewals being charged to revenue. This method is commonly used for plants, fixtures, etc. Under this system, the annual charge for depreciation decreases from year to year, so that the earlier years suffer to the benefit of the later years. Also, under this method, the value of the asset can never be completely extinguished, which happens in the early explained Straight Line Method.
Many accounting institutes and academies stop at this juncture instead of teaching students exact formulae of arriving at the proper depreciation rate. But our accounting institute in Ahmedabad focuses on every nitty-gritty of this method since this method is generally the only allowed method of calculating income tax applicable to the firm.
In this method, Depreciation goes on decreasing every year. The formula is –
Suppose that the fixed asset purchase price is 10,000, the scrap value is 1,000, and the depreciation rate is 30%.
Using the Reducing balance method, 30% of the depreciation base (net book value minus scrap value) is calculated at the end of the previous depreciation period. Calculation of depreciation for the first three years is shown in the following table.
If you have any questions related to this topic, we will be happy to revert to you or you can visit our accounting institute in Ahmedabad and attend a free demo class of depreciation accounting.