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Straight Line Method of Depreciation:

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:

  1. Straight line method or fixed installment method is very easy to employ because of its simplicity.

  2. The asset can be written off to zero value under this method.

  3. 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:

  1. This method assumes the same economic usefulness of the asset each year.
  2. 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)    
 

More study material from this topic:

Definition, explanation and causes of depreciation
Depreciation is not a matter of valuation but a means of cost allocation
Activity method of depreciation
Straight line method of depreciation
Sum of the years' digits method of depreciation
Reducing balance method
Annuity method
Depreciation fund method or sinking fund method
Insurance policy method
Revaluation method
Depletion method
Machine hour rate, mileage, and global method
Methods of recording depreciation
Reserves
Difference between general reserve and specific reserve
Difference between capital reserve and general reserve
Difference between reserve and reserve fund
Difference between provision and reserve

 

A D V E R T I S E M E N T

 

Financial Accounting Topics


  Introduction to Accounting
 ----------------------------------------------------------------------------
  Transactions and Accounting Equation
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  Analysis of Business Transactions
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  Journal, Ledger and Trial Balance
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  Accounting for Bills of Exchange
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  Special Journals
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  Cash Book
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Bank Reconciliation Statement
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  Final Accounts
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  Work Sheet
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  Capital and Revenue Items
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  Valuation of Inventories
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  Accounts of Non-profit Making Organizations
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  Statement of Cash Flows
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  Accounting Ratios Analysis
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  Depreciation, Provisions and Reserves
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  Accounting Dictionary
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  Financial Calculators
 
 
 
Managerial Accounting Topics

  Financial Statements
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  Cost Volume Profit Relationship
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  Variable Costing System
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  Materials and Inventory Cost Control
----------------------------------------------------------------------------
  Activity Based Costing System
----------------------------------------------------------------------------
  Standard Costing and Variance Analysis
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  Balanced Scorecard
----------------------------------------------------------------------------
  Capital Investment Analysis/Capital Budgeting
 

 

 

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