Fixed Installment Method or Straight Line Method or Original Cost Method of Depreciation

12/08/2008 21:02

 

Fixed Installment Method or Straight Line Method or Original Cost Method of Depreciation:

Learning Objectives:

  1. Define, explain and give example of fixed installment or straight line or original cost method.

  2. What are the advantages and disadvantages of of using this method?

Fixed installment method is also know as straight line method or original cost method. Under this method the expected life of the asset or the period during which a particular asset will render service is the calculated. The cost of the asset less scrap value, if any, at the end f its expected life is divided by the number of years of its expected life and each year a fixed amount is charged in accounts as depreciation. The amount chargeable in respect of depreciation under this method remains constant from year to year. This method is also know as straight line method because if a graph of the amounts of annual depreciation is drawn, it would be a straight line.

Formula:

The following formula or equation is used to calculate depreciation under this method:

Annual Depreciation = [(Cost of Assets - Scrap Value)/Estimated Life of Machinery]

Journal Entries:

The journal entries that will have to be made under this method are very simple. The journal entries will be as under:

1. Depreciation account
       To Asset account
  (Being the depreciation of the asset)
 
2. Profit and loss account
       To Depreciation account
  (Being the amount of depreciation charged to Profit and Loss account)

These entries will be passed at the end of each year so long as the asset lasts. In the last year, the scrap will be sold and with the amount that realised by the sale the following entry will be passed:

3. Cash account
       To Asset account
  (Being the sale price of scrap realised.)

Advantages:

  1. Fixed installment method of depreciation is simple and easy to work out
  2. The book value of the asset can be reduced to zero.

Disadvantages:

  1. This method, in spit of its being simplest is not very popular because of the fact that whereas each year's depreciation charge is equal, the charge for repairs and renewals goes on increasing as the asset becomes older. The result is that the profit and loss account has to bear a light burden in the initial years of the asset but later on this burden becomes heavier.
  2. Interest on money is locked up in the asset is not taken into account as is done in some other methods.
  3. No provision for the replacement of the asset is made.
  4. Difficulty is faced in calculation of depreciation on additions made during the year.

Scope of Application:

On account of the above mentioned advantages and disadvantages of fixed installment method, it is generally applied in case of those assets which have small value or which do not require many repairs and renewals for example copyright, patents, short leases etc.

Example:

On 1st January 1991 X purchased a machinery for $21,000. The estimated life of the machine is 10 years. After it its break up value will be $1,000 only. Calculate the amount of annual depreciation according to fixed installment method (straight line method or original cost method) and prepare the machinery account for the first three years.

Machinery Account

 

Debit Side

   

Credit Side

 
    $     $
1991 Jan. 1  To Bank account 21,000 1991 Dec. 31  By Depreciation account 2,000
      1991 Dec. 31  By Balance c/d 19,000
   
   
    21,000     21,000
   
   
1992 Jan. 1  To Balance b/d 19,000 1991 Dec. 31  By Depreciation account 2,000
      1991 Dec. 31   17,000
   
   
    15,000     15,000
   
   
1993 Jan. 1 To Balance b/d 17,000 1991 Dec. 31  By Depreciation account 2,000
      1991 Dec. 31  By Balance c/d 15,000
   
   
    17,000     17,000