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Question

Discuss in detail the straight line method and written down value method of depreciation. Distinguish between the two and also give situations where they are useful.

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Solution

Straight Line method

It is a simple method of charging depreciation. Under this method, depreciation is charged on the original cost of an asset, at a fixed rate of percentage. In this method, amount of depreciation remains same from year to year and asset’s value becomes zero at the end of its useful life.

Amount of depreciation is calculated as under:

Advantages of Straight Line Method

  1. It is simple to calculate.

  2. Asset can be completely written off, i.e., asset can be depreciated until the net scrap value is zero.

  3. Same amount of depreciation is charged every year. Therefore, it helps in easy comparison of Profit and Loss Account for different years.

  4. It is used for assets that have low repairs and maintenance expenses and are continuously used over a period of time.

Limitations of Straight Line Method

  1. Burden of deprecation is more on profit and loss account in the later years, when repair and maintenance costs increase, as asset becomes older.

  2. Value of asset becomes zero in the books even if asset is still in usable condition in business.

Uses of Straight Line Method

  1. This method is useful where repairs and maintenance expenses on asset are low.

  2. It is also useful when an asset is continuously used from one year to another.

  3. It is useful when the value of assets, such as patent, copyright, goodwill, etc., becomes zero

Written Down Value Method

This method is applicable where depreciation is charged on the diminishing balance, i.e., book value of the asset. In this method, asset’s value goes on diminishing year after year and the amount of depreciation declines.

Rate of depreciation is calculated as follows:

Where,

R represents rate of depreciation

n represents expected useful life of the asset

s represents the scrap value

c represents the cost of the asset

Advantages of Written Down Value Method

  1. It is based on the logical assumption that asset is used more in the earlier years, so more cost is charged in form of depreciation.

  2. It is suitable for the assets where repairs are more in the later years, as depreciation is lesser and on a whole the combined burden of depreciation and repairs exerts equal pressure on the net profit over years.

  3. This method is accepted by the income tax authorities.

  4. As more depreciation is charged in the earlier years, so the loss due to obsolescence of the asset is reduced.

Limitations of Written Down Value Method

  1. It is difficult to calculate and is a time consuming process.

  2. The value of an asset cannot be zero, thus the asset cannot be completely written off.

  3. There arises shortage of funds for replacement of new asset. This happens due to the fact that the amount of depreciation is retained and used in the business. Consequently, at the end of the useful life of an old asset, business finds it difficult to arrange funds for its replacement.

Uses of Written Down Value Method

  1. It is useful when assets have long life.

  2. It is useful for those assets that require more repair and maintenance costs in the later years.

  3. It provides easy calculation to provide depreciation of additional asset purchased during a year.

Difference between Straight Line Method and Written Down Value Method

Basis of Difference

Straight Line Method

Written Down Method

Basis for calculation

Depreciation is calculated on the original cost of an asset.

Depreciation is calculated on the reducing balance, i.e., the book value of an asset.

Amount of depreciation

Equal amount is charged each year over the effective life of the asset.

Diminishing amount of depreciation (on the written down value of asset) is charged each year over the effective life of the asset.

Book value of asset

Book value of the asset becomes zero at the end of its effective life.

Book value of the asset can never be zero.

Suitability

It is suitable for the assets like, patents, copyrights, land and buildings, etc., which have lesser possibility of obsolescence and lesser repair charges.

It is suitable for assets that needs more repairs and maintenance costs in the later years like, plant and machinery, car, etc.

Effect of depreciation and repair on profit and loss account

Unequal effect over the life of the asset, as depreciation remains same over the years but repair cost increases in the later years.

Equal effect over the life of the asset, as depreciation is high and repairs are less in the initial years but in the latter years the repair cost increases and depreciation cost decreases.

Recognition under Income Tax Act

It is not recognised under the Income Tax Act.

It is recognised under the Income Tax Act.


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