Definition and
Explanation:
Straight line method is also
known as fixed installment method and
original cost method. This method is very simple
and conceptually appropriate to employ. This is one
of the most widely used method for the calculation
of depreciation charge. By this method, the number
of years of use is estimated and the the cost is
then divided by the number of years to give the
depreciation charge each year.
Under this method , the amount of
depreciation will be equal each year, since
depreciation is charged at fixed rate on cost of
asset. This is the special feature of this method.
If the annual depreciation is plotted on a graph
paper, it will show a straight line, since the
amount of depreciation is equal every year. This is
why this method is called straight line method.
Formula:
Depreciation charge under this
method is calculated by using the following
formula:
|
Cost less
salvage value |
|
|
|
= |
Depreciation charge |
|
Estimated service life |
|
|
|
Example:
Assume a machine was bought for
$500,000 and we thought we would keep it for four
years and then sell it for $50,000 (salvage value)
the depreciation to be charged each year would be
calculated as follows:
|
Cost less
salvage value |
|
|
|
= |
Depreciation charge |
|
Estimated service life |
|
|
|
|
|
|
|
500,000 - $50,000* |
|
|
|
= |
$90,000 |
|
5 |
|
|
|
*Salvage
value |
|
|
|
Merits:
-
Straight line method or
fixed installment method is very easy to
employ because of its simplicity.
-
The asset can be written off
to zero value under this method.
-
This method is useful for
providing depreciation on leasehold
property, patent right, trade mark,
copyright etc.
Demerits:
There are two major objections to the straight line
method. These are:
- This method assumes the same economic
usefulness of the asset each year.
- The repair and maintenance expenses are
essentially same each period.
Another problem in the use of straight line
method or fixed installment method of depreciation
is that its use results in distortion in the rate of
return analysis (income/assets). The following
example shows how the rate of return increases,
given constant revenue flows, because the asset's
book value decreases.
| Year |
Depreciation
|
Book value |
Income after depreciation
expenses |
Rate of return (income/assets) |
| 0 |
|
$500,000 |
|
|
| 1 |
$90,000 |
$410,000 |
$100,000 |
24.4% |
| 2 |
$90,000 |
$320,000 |
$100,000 |
31.2% |
| 3 |
$90,000 |
$230,000 |
$100,000 |
43.5% |
| 4 |
$90,000 |
$140,000 |
$100,000 |
71.4% |
| 5 |
$90,000 |
$50,000 |
$100,000 |
200.0% |
|
Journal Entries:
Under this method depreciation
is recorded as follows:
| When depreciation
is provided: |
|
|
| Depreciation Account |
|
Dr. |
|
Asset Account |
|
Cr. |
| (Being depreciation
charged on -@- for the year) |
|
|
|
|
|
| When depreciation
is transferred to profit and loss
account: |
|
|
| Profit and Loss Account |
|
Dr. |
|
Depreciation Account |
|
Cr. |
| (Being depreciation
account transferred to profit and loss
account) |
|
|
|
|
|
| When asset is sold
on expiry of its useful life: |
|
|
| Bank Account |
|
Dr. |
|
Asset Account |
|
Cr. |
| (Being scrap of asset
sold) |
|
|
|
|
|
| If profit is
earned on sale of asset: |
|
|
| Asset Account |
|
Dr. |
|
Profit and Loss Account |
|
Cr. |
| (Being profit on sale of
scrap transferred to profit and loss
account) |
|
|
|
|
|
| If loss is
incurred on sale of asset: |
|
|
| Profit and Loss Account |
|
|
|
Asset Account |
|
|
| (Being loss on sale of
scrap transferred to profit and loss
account) |
|
|
|
