Depreciation is the depletion in the book value of fixed assets due to wear and tear that occurs during their use. It is accounted as a charge against profit in each accounting period. This is essential to reflect the true value of fixed assets in the books. There are several methods prescribed to measure and record the depreciation on fixed assets.
This article looks at meaning of and differences between two popular methods of depreciation – straight line method and written down value method.
Definitions and explanations
Straight line method of depreciation:
Straight line method (SLM) of depreciation involves charge of a constant and generally fixed amount of depreciation across the useful life of the fixed asset. Depreciation is charged on the original cost recorded in the books of accounts. In this method, the charge of depreciation for each accounting period does not change unless there is a change in the value of the asset.
Depreciation under this method, is generally determined with reference to the assets useful life. For example, an asset costing $50,000 has an economic life of 10 years. The charge to depreciation each year in this case will be $5,000 ($50,000/10) i.e., equal for each of ten years.
The depreciation charge can also be expressed as percentage. This percentage can be derived by dividing the asset’s useful life by 1 and then multiplying by 100. In the same example as above, depreciation can be expressed as 10% [(1/10) × 100] per annum, the charge of depreciation being the same – $50,000 × 10% = $5,000.
Under SLM, the depreciation is charged each year till the value of the asset is reduced to zero or to its scrap value.
Written down value (WDV) method of depreciation:
Written down value (WDV) method of depreciation involves charging depreciation at a specified rate on the opening book value of the fixed asset for each accounting period. In this method, the depreciation charge is reduced from the book value in each accounting period, and this reduced book value becomes the base on which the depreciation is charged in the subsequent accounting period. In this method, the amount of depreciation is higher in the initial accounting periods and keeps reducing year after year.
WDV method depreciation is charged as a percentage of the asset’s book value. For example, a plant and machinery costing $50,000 is subject to depreciation at 10% p.a. The charge of depreciation for each of first three years will be computed as follows:
Depreciation for year 1: $50,000 × 10% = $5,000
Book value at the end of year 1: $50,000 – $5,000 = $45,000
Depreciation for year 2: 45,000 × 10% = $4,500
Book value at the end of year 2: $45,000 – $4,500 = $40,500
Depreciation for year 3: 40,500 × 10% = $4,050
Book value at the end of year 3: $40,500 – $4,050 = $36,450
Notice that the depreciation base (book vale in this case) for calculating the depreciation charge for each subsequent year reduces, resulting in a reduced depreciation charge year after year. Due to this characteristic, WRD method is also often termed as reducing balance method of depreciation.
Difference between straight line method and written down value (WDV) method of depreciation:
The eight key points of difference between straight line and written down value (WDV) method have been detailed below:
- SLM is a depreciation method in which a fixed amount of depreciation is charged over the useful life of the asset.
- WDV is a depreciation method in which depreciation is charged at a predetermined rate on the changing net book value of the asset as it appears at the beginning of each accounting period.
2. Depreciation calculated on
- Under SLM, depreciation is charged each accounting period on the original cost of the fixed asset.
- Under WDV, depreciation is charged each accounting period on the opening book value i.e., on the book value as reduced by the accumulated depreciation.
3. Quantum of depreciation – fixed or variable amount
- Under SLM, the amount of depreciation each year is fixed and remains constant for all accounting periods.
- Under WDV, the amount of depreciation is variable, and keeps reducing in each subsequent accounting period.
4. Write off of book value
- Under SLM, the book value reduces to its scrap value or to zero at the end of its useful life. Hence it is completely written off over its useful life.
- Under WDV, depreciation is charged on the reduced book value which means that the depreciation charge keeps reducing each year. Thus the book value is not completely written off.
5. Comparative impact on books
- When a business follows SLM, then in comparison to WDV, the depreciation charge to profit will be lower in initial years.
- When the business follows WDV, then in comparison to SLM, the depreciation charge will be higher in initial years. As the depreciation on reducing balance keeps reducing from year to year, the SLM depreciation will then eventually become higher than the WDV depreciation.
- SLM is preferred for fixed assets whose utility is equally spread across the years of its useful life. For example, intangible assets such as patents and copyrights have a specified legal life which means the businesses usually receive the benefits from such assets consistently across the years, hence, SLM may be preferred for their amortization.
- WDV is preferably applied for fixed assets that have a higher degree of wear and tear or obsolescence i.e., whose benefits are higher in the initial years than in subsequent years. For example, WDV method may be more appropriate in case of plant and machinery or technology related assets etc.
7. Expressed as
- Depreciation under SLM is expressed as the number of years across which the asset is to be depreciated or as a % of the original cost.
- Depreciation under WDV is generally expressed as a % per annum, which is then applied to the opening book value of the fixed asset each year.
8. Impact on profits
- Under SLM method, the impact on profits is consistent across accounting periods as the same amount is charged to profit and loss account in each accounting period.
- Under WDV method, the amount of depreciation is accelerated in initial years, hence the charge to profit and loss account is also higher in initial years. Thus the profit under WDV will be comparatively lower in initial years.
Conclusion – straight line method vs written down value (WDV) method:
Depreciation follows the accounting principle of matching revenues with expenses. This means that expenses are to be recorded in the books of accounts in the years in which the related revenues are also recognized. A fixed asset generates revenue for the business across several years; accordingly its cost is also apportioned across the several years by way of a depreciation charge. The appropriate method of depreciation depends on the nature of the fixed asset and how it will be used in the business.
Straight line method assumes that the depreciation is a function of passage of time and is logically suited for those assets that provide equal utility for each year of their useful life. Written down value (WDV) method, on the other hand, is often practiced for those assets whose utility reduces with their business usage rather than passage of time. The supporters of this method argue that a tangible fixed asset is mostly more productive during early years of its life and less productive during later years; hence, it is absolutely perfect to charge more depreciation in early years and less in later years.