Accounting - Depreciation

Depreciation

Two methods of depreciation are:

* Straight line method

* Diminishing balance method

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The methods differ in valuation and in the impact valuation has on the
profit reported and subsequent effect on the balance sheet.

The results of the application of the different methods apply in the
following ways:

Disposal value

* the straight line method deducts the disposal value of the asset prior
to calculation, whereas the diminishing balance method does not

Matching costs with revenue

* the straight line method assumes a consistent return to revenue over
the life of the assets

* diminishing balance assumes the asset earns greater revenue in the
earlier years of the asset's life

Obsolescence

* only the diminishing balance method allows for possible obsolescence by
attempting to write off the bulk of the asset cost as depreciation in the
earlier years of the asset's life

Calculation of depreciation

* the straight line method is most simple to calculate, providing the
same amount each year

* diminishing balance is based on the written down value of the asset and
requires deduction of previous accumulated depreciation prior to
calculation of depreciation for this accounting period

Merits/disadvantages

Straight line method

* simple to operate/calculate

* does not allow for obsolescence or the premature end of the economic
life of the asset

* helps long term planning as you know what is going to be the amount
allocated in future periods to depreciation

Diminishing balance method

* allows for obsolescence

* enables the recovery of cost of the asset at the earliest opportunity

* tendency to overstate depreciation (and therefore understate profit) in
the early years of the asset life

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