Two main methods are preferred for calculating depreciation. And those methods are the Straight line Method (SLM) and Written Down Value (WDV). Though before deep diving into the methods. We must first understand, what is depreciation.
Depreciation is a slow decrease in the value of an asset over time due to many factors.
Now, let's talk about the most important difference between both of the methods, i.e., the Straight Line Method (SLM) and the Written down value (WDV) method.
SLM vs. WDV
The most common difference between these methods is the way to calculate the depreciation value. In the Straight line Method, the value of an asset depreciates in a constant time. Whereas, in the Written Down Value (WDV), the asset depreciates at a varying rate.
As we go further into the article, we will understand the difference between these methods clearly.
Difference Between SLM and WDV in Tabular Form
|Parameters of Comparison||SLM||WDV|
|Definition||A method where asset value is evenly depreciated every year.||A method where asset value is not evenly depreciated every year.|
|Calculation||The depreciation is calculated by dividing the value by its useful life.||The depreciation is calculated by multiplying the net book value with a constant percentage.|
|Rate of Depreciation||The rate never changes in this method.||The rate varies in this method. It has been found that initially, the rate is higher in the starting years, and later, it decreases.|
|Impact on profit||The impact on profits is regular and consistent. The depreciation expense of each year remains the same.||The impact on profit is more in this case. The rate is higher in the early years, thus the profits reduce rapidly.|
|Book value||Book value decreases at a constant rate over its shell life.||Book value decreases rapidly at the start and over time it slows down.|
What is Straight-line Depreciation (SLM)?
A very common and popular method of depreciation, chosen by many organisations is the Straight-Line Depreciation (SLT) method. As the name suggests, it is a straightforward method and easily understandable by everyone.
Straight-line depreciation follows a systematic approach, where we distribute the cost of the asset uniformly over its useful life. Here we assume that the asset depreciates every year at a constant rate, resulting in a deduction from its scrap value. It is known as a straight line because when the depreciation expense is plotted on a graph it gives a straight line. The amount that is depreciated in an equal amount every year, is charged on the debit side as a loss in the profit and loss account. This method is also known as the "Equal Instalment Method" or " Fixed Instalment Method."
Cost of the Asset- The initial cost of an asset includes the purchase price, transportation charges, installation fees, and any other costs required to make the asset set for use.
Salvage Value- It is also known as the scrap value or the value company expects from the asset, after its life. It stands for the amount, a business expects from the selling or disposing of an asset.
Useful Life- The estimated time of an asset for which it will generate profit and be a productive asset for the company. It is taken in years.
Depreciation Expense- The annual amount deducted due to wear and tear, obsolescence, or other factors that lead to a decline in the asset's value.
Calculation of Straight-Line Depreciation
Step 1: Determine the Cost of the Asset
The first step involves the determination of the initial cost of the asset. We consider the purchase price and any other required to make the asset into working.
Step 2: Estimate the Useful Life of the Asset
It is the time over, which an asset is engaged to contribute to the business. It is estimated based on the factors like wear and tear, technological advancements, and industry standards.
Step 3: Subtract the salvage value
It is the final amount estimated after its useful life.
Step 4: Calculate the Annual depreciation expense
We calculate this by dividing the depreciable base by the useful life. The final formula is:
Annual Depreciation Expense= Initial Cost - Salvage Value/ Useful life
Example of Straight-Line Depreciation
For example, A business purchases a device for $10,000 with a useful life of 5 years, and a salvage value corresponds to $2,000.
Step 1: Initial Cost= $10,000
Step 2: Useful Life= 5 years
Step 3: Salvage Value= $2,000
Depreciable Base= Initial cost - Salvage Value
Annual Depreciation Expense= Depreciable Base/ Useful Life
So, the annual Depreciation expense is $1,600 over a useful life of 5 years.
Advantages of Straight-Line Depreciation
- Simplicity and Ease of Understanding- It is straightforward to calculate, even for people not from an accounting background. The concept is simple and easily understandable, where the asset is evenly throughout its useful life. Both specialists and non-specialists can apply this method of Depreciation.
- Predictable Expense Allowance- Due to the even distribution of its useful life, it is easy to predict the annual depreciation expense. This consistency in the charts of each year help businesses to plan future goals and take essential decisions for asset replacement. It benefits when budgeting for maintenance costs, insurance coverage, or equipment replacements.
- Tax benefits- It offers tax advantages to businesses. It benefits them by reducing their taxable income by deducting the Depreciation Expenses. Through this, the company can easily reduce their taxes throughout the useful life of the asset.
- Asset Valuation- It also keeps the company's balance sheet accurate and realistic valuation of assets. And as Depreciation continues, the book value aligns with the scrap value.
Limitations of Straight-Line Depreciation
- Equal Allocation of cost- In this method, they assume that asset value goes down uniformly. But in practice, most assets lose their value rapidly and unevenly. For example, technological equipment and vehicles go outdated, which results in higher depreciation. This method fails to accommodate for unequal distributions.
- Inaccurate reflection of market value- This method does not consider the changes in market value. So, not relying on the market value may result in inaccurate financial statements. It creates a problem when determining the asset's value for financial reporting, investment decisions, or selling purposes.
- Ignoring Inflation and technological advancements - It does not consider the effects of inflation into account. As time passed, inflation reduces the purchasing power of money, which may increase by replacing the cost of the asset. Whereas technological advancements can make the asset absolute and reduce its value significantly.
What is Written Down Method?
The written-down method is another method used to find the Depreciation of assets. It is also based on the same principle of wear and tear, obsolescence, or other factors.
Under this method, Depreciation is calculated by considering the fixed percentage of the leftover value of the asset every year. It does not depreciate uniformly as SLM, whereas the depreciation is higher in the early years and lower in later years. This method is also the "Diminishing Balance Method" or the "Reducing Balance Method."
- Initial cost of the asset- It considers the purchase price and additional costs required to put the asset under work, including delivery or installation charges.
- Estimated Useful life of the asset- It is the expected time, till which the company will use the asset for business before it requires replacement.
- Determine the Depreciation rate- It is expressed in percentage and represents the part of the asset's value, i.e., depreciated every year. The rate is higher than Straight Line Method (SLM) to show accelerated depreciation in the starting years.
- Annual depreciation expense- Multiply the remaining amount of the asset by the depreciation rate. The remaining amount is the Subtraction of initial cost and accumulated depreciation from past years.
- Update the Remaining Value- Find the new remaining value by subtracting the annual depreciation expense with the remaining value, at the end of each year.
- As it continues, the book value gets closer to the scrap value. And the moment, book values match the scrap value, the asset has reached its endpoint.
Advantages of WDV
- Accelerated Depreciation - It allows higher depreciation expenses, which gives a better decline in t value of assets. This is beneficial for businesses by making the asset more productive.
- Tax Benefits- In this method, the higher depreciation of the year results in greater tax deductions and potential tax savings.
- Flexibility - It provides flexibility to the business. It can change or select a rate using its asset's expected pattern of decline.
- Reflects actual asset value- In the WDV method, we recalculate the depreciation every year using the remaining value, which provides an accurate representation of the value of an asset, when compared with SLM.
Calculation of Written down Value (WDV) method
Suppose a company purchases a device for $10,000 with an estimated useful life of 5 years and no salvage value. Find the depreciation expense for each using the WDV method.
Depreciation Expense = (Initial cost- Accumulated Depreciation) *Depreciation Rate
Depreciation Expense = (Initial cost- Accumulated Depreciation) *Depreciation Rate
Accumulated Depreciatioafterof Year 2=$2,000+$1,600= $3,600
Net book= $10,000-$3,600=$6,400
This process continues till the end of the useful life. The depreciation expense slowly decreases over time, showing the reducing value of the reduced asset.
SSLM, this method also accounts for giving the declining use of the assets. It gives a systematic approach to finding the cost of the given asset over its useful life. And the prime goal is to give an estimation of when should an item be replaced or disposed of.
Difference Between SLM and WDV in Points
- In the method of SLM, the value is depreciated evenly over its shell life. Whereas, the case of WDV is different. In this method, the value of it's depreciated at varying rates and the depreciation is faster.
- In the SLM the depreciation occurs by a constant value every year. It does not change. If the value is depreciated by $1,000, then it will depreciate by that value every year till its shell life. Whereas, WDV is different. First of all, the value changes every year. Though the rate is constant. But the value change. Because every year depreciated value is calculated concerning the previous value. Found it difficult to understand? Let's take an example. If the depreciated value after a year comes out to be $5,000, then we will calculate the depreciation based on this value.
- The book value in SLM decreases linearly and it follows a regular cycle. Overall it is based on a simple calculation. Whereas, the book value in WDV decreases rapidly and does not follow a regular cycle. So, the final value is a little difficult to calculate in this method.
- In SLM, the salvage value can be estimated and it reaches in a definite amount of time. Though, the salvage value in WDV cannot be estimated and the value is lesser than SLM's value. Thus alarming an earlier replacement of an asset.
- SLM is generally used for those assets, which seem to face wear and tear at a regular rate. For example, cars and buildings. Whereas, WDV is a little different. It is used for those assets, which can face early wear. For example, machinery or technology equipment.
Without knowing we have reached the end of the article. So let's do a recap of what we have learnt till now.
In conclusion, both methods are different approaches for calculating the same thing, i.depreciationtion. Bapplylietoor different assets. In SLM value decreases at a constant rate and the same does not happen in WDV. In WDV, the asset faces a faster decrease in varying rates.
WDV is difficult to understand. And SLM is easier to understand. SLM fails to calculate for some regular shares. It cannot be used for technological equipment, which faces a decline at a faster rate. It is suitable for vehicles and buildings, which face a decline in rate constantly.
Overall, both methods are useful in calculating depreciation. Everything depends upon the right time when a method should be used.