Depreciation is the amount of wear and tear that a particular asset has to face which results in their loss of value over a certain point of time. Initially, this asset helps in improving production quality of the company to which it is associated. However, after a certain point of time, it becomes liability for that company.
To ensure that this liability does not create problems in regards to getting the actual profit rate of the company, it is important that there be a rate against which depreciation is calculated to segregate it from rest of the business.
To calculate this depreciation rate, there are two modes:
Straight Line Method
Diminishing Balance Method
Though both these methods are extremely useful, yet there is a difference regarding which method should be followed.
Here is a distinction between these 2 methods.
- Zero Level:
STRAIGHT LINE METHOD:In this case, the total value of assets can be written down to zero in certain cases.
DIMINISHING BALANCE METHOD: In this case, it is important that a positive value is to be maintained at every step to ensure that the process used does not fall for any calculation mistake.
- Calculation of Depreciation:
STRAIGHT LINE METHOD:In this case, total depreciation is calculated at total cost of assets. This total cost of assets includes installation charges, building charges and such other charges.
DIMINISHING BALANCE METHOD: In this case, the reducing balance of assets is taken into consideration.
- Depreciation Amount:
STRAIGHT LINE METHOD: As per this method, it can be seen that every year has the same amount of depreciation being charged on the assets.
DIMINISHING BALANCE METHOD: In this case amount of depreciation keeps reducing with every year.
- Income Tax Laws:
STRAIGHT LINE METHOD: Though this method is applied in case of most small firms, the income tax department does not recognize this process.
DIMINISHING BALANCE METHOD: This is the most acceptable process by the income tax department.
- Effect on Profit and Loss Account:
STRAIGHT LINE METHOD: Since in initial years the assets have high productivity, hence depreciation and repairs are lower in monetary terms. However, with passage of years, cost of this increases, with high repairing and maintenance charges attached.
DIMINISHING BALANCE METHOD: In this case, similar charges are borne every year given that depreciation rates decrease and repairing costs increase.
- Suitable for:
STRAIGHT LINE METHOD: This is suitable for those assets which are of lower value.
DIMINISHING BALANCE METHOD: This is specifically suitable for those assets which have very high value associated with them.