Methods of Depreciation
Cost of fixed asset must be charged to the income statement in a manner that best reflects the pattern of economic use of the asset. Most common methods of depreciation include Straight Line Method and Reducing Cost Method.
Straight Line Depreciation Method
Straight line method depreciates cost evenly through out the useful life of the fixed asset. Straight line depreciation is calculated as follows:
Depreciation per annum = (Cost - Residual Value) / Useful Life
Where:
- Cost includes the initial and any subsequent capital expenditure.
- Residual Value is the estimated scrap value at the end of the useful life of the asset. As the residual value is expected to be recovered at the end of an asset's useful life, there is no need to charge the portion of cost equaling the residual value.
- Useful Life is the estimated time period an asset is expected to be used from the time it is available for use to the time of its disposal or termination of use. Useful life is normally calculated in units of years but it may be calculated based on an alternative basis. Useful life of an oil extraction company may for example be the estimated oil reserves.
Test Your Understanding
Which of the following is true regarding Straight Line Depreciation?
It prevents bias in situations when the pattern of economic benefits from an asset is hard to estimate
Since straight line method charges cost of a fixed asset evenly over its entire useful life, it prevents deliberate manipulation of profits through the use of a depreciation method that either accelerates or decelerates the charge of depreciation expense even though the pattern of economic benefits expected to be derived from the use of the asset is uncertain.
Once straight line depreciation charge is determined, it is not revised subsequently
Although straight line depreciation charges the cost of fixed asset evenly over its useful life, the amount of charge may be revised as often as required to reflect changes in estimates involving the asset's useful life and residual value.
Example
An asset has a useful life of 3 years.
Cost of the asset is $2,000.
Residual Value is $500.
Annual Depreciation cost will be $500 = (2000 - 500) / 3years
Straight line depreciation method is appropriate where economic benefits from the asset are expected to be realized evenly during its useful life. It is also convenient where no reliable estimate can be made regarding the pattern of economic benefits over an asset's useful life.
Next page contains explanation and example on how to calculate depreciation using Reducing Balance Method
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