Depreciation Methods: Straight Line, Reducing Balance and Units of Production

Three methods dominate. Straight line charges the same amount every year. Reducing balance charges a fixed percentage of what is left, so it front-loads. Units of production charges by use rather than by time. All three divide up one purchase price, so over the whole life every method charges the same total. Only the timing differs, and timing alone is enough to move any single year’s profit a long way.

Here is what sits underneath the instrument. A method is not a theory about wear. A method is a rule for cutting one fixed number into slices, and the number being cut is the depreciable amountThe cost of the asset less whatever the business expects to get back for it at the end. The difference is the total amount that will ever be charged as depreciation.: what the asset cost, less its residual valueThe amount a business expects to recover when it finally disposes of the asset. Where nothing is expected back, the residual value is nil and the whole cost is depreciated.. The calculator therefore settles the depreciable amount before it asks which method to apply. Once the number is fixed, the method decides only how much of it lands in each year. The method cannot change the size of the cake, only the size of the slices, and no method hands back a slice it has already served.

The register line sitting in those fields belongs to Anjani Stationers Private Limited. The business bought a second binding machine in year two for Rs 9,00,000, put it to use at the start of the year and estimated a six-year useful life with nothing expected back at the end. Cost, life and residual value are all any method needs. Worked by hand, that one machine shows how each method computes a charge, why the three columns add to the same total, what the difference does to reported profit, what happens when a business changes method, and where in a set of accounts the method is written down.

How does straight line compute a charge?

Straight lineA method that charges the depreciable amount evenly across the useful life, so the same figure appears in the accounts every year until the asset is written down. takes the depreciable amount and divides it by the number of years. Nothing else happens. Rs 9,00,000 less a residual value of nil is Rs 9,00,000, divided by six years is Rs 1,50,000, and that figure is charged in year one, year two and every year after until the machine is fully written down at the end of year six.

Once the three estimates are made there is nothing left for straight line to react to, so it is the only method whose charge can be stated for every year of the asset’s life on the day the asset is bought. Consider a two-year gym membership paid up front for Rs 24,000. Most people would say it cost Rs 1,000 a month without pausing to think, and would not charge themselves more in January for going more often. The instinct to spread the cost evenly is straight line, and most people already have it.

The strength and the weakness of straight line are the same fact. Straight line is stable, so a reader can forecast it and an auditor can check it in one line of arithmetic. Straight line is also indifferent, so a machine that ran flat out in year one and sat idle in year five carries the identical charge in both. Whether that indifference is a problem is a question about the asset and not about the method.

How does reducing balance compute a charge?

Reducing balanceA method that applies a fixed percentage to what is left of the asset in the accounts each year, so the charge falls as the remaining amount falls. Also called the written down value method. applies a fixed percentage, not to the cost, but to the carrying amountThe figure at which the asset currently sits in the accounts: its cost less all the depreciation charged on it so far. Also called the written down value. at the start of each year. The percentage never moves. The number it is applied to falls every year, so the charge falls with it. The same Rs 9,00,000 machine carries an illustrative rate of 30 per cent.

Year one charges Rs 2,70,000, 30 per cent of Rs 9,00,000, and leaves a carrying amount of Rs 6,30,000. Year two charges Rs 1,89,000, 30 per cent of Rs 6,30,000, and leaves Rs 4,41,000. Year three charges Rs 1,32,300 and leaves Rs 3,08,700. Year four charges Rs 92,610 and leaves Rs 2,16,090. Year five charges Rs 64,827 and leaves Rs 1,51,263. Notice what has to happen next, the arithmetic that catches people out: 30 per cent of a falling number never reaches nil, so the final year does not take 30 per cent of anything, it takes the whole remaining Rs 1,51,263 and writes the machine down to zero.

The final-year write-off is not a fudge. A business on reducing balance either switches to a straight line write-off near the end of the life or clears the remainder in the final year, and either way the six years come to Rs 9,00,000 exactly. The percentage was only ever a way of putting more of the cost into the early years; the remainder in year six is what is left once that has been done.

The everyday version is a second-hand two-wheeler. A two-wheeler loses a great deal of value the first year, less the second, less again the third, and by the sixth year the year-on-year drop is small. Reducing balance is a bet that the accounts should look like that. The method front-loads the charge. Reported profit is depressed in the early years and lifted in the later ones, on every asset the method is applied to, all at the same time.

How does units of production compute a charge?

Units of productionA method that charges depreciation by output rather than by time: the depreciable amount is divided by the total output the asset is expected to deliver, giving a rate for each unit it actually produces. throws the calendar out entirely. The depreciable amount divided by the total output the machine is expected to deliver across its whole life gives a rate for each unit, and that rate is charged on whatever the machine actually produced this year. Anjani Stationers estimates that the binding machine will bind 30,00,000 notebooks before it is finished, so Rs 9,00,000 over 30,00,000 notebooks gives Rs 0.30 a notebook.

Now the charge follows the shed rather than the calendar. An illustrative output profile has the machine binding 6,00,000 notebooks in its first year, rising to 7,00,000 in the second as the operators get quicker with it, then easing back to 6,00,000, 5,00,000, 4,00,000 and finally 2,00,000 in a quiet sixth year. At Rs 0.30 each those years charge Rs 1,80,000, Rs 2,10,000, Rs 1,80,000, Rs 1,50,000, Rs 1,20,000 and Rs 60,000. The six output figures add to 30,00,000 notebooks and the six charges add to Rs 9,00,000.

Units of production alone asks what the asset actually did rather than how long the business has held it, so it is the only one of the three whose charge falls when the business is quiet. A year binding 2,00,000 notebooks carries Rs 60,000 where straight line would have insisted on Rs 1,50,000. The appeal is exactly that: in a bad year the cost of the machine falls with the work it did. The difficulty is the same fact. The rate depends on an estimate of lifetime output that nobody can check from outside, and if the machine ends up binding far more or far fewer notebooks than expected the estimate has to be revisited.

An auto rickshaw driver has the same choice. Charge the vehicle by the kilometre and a month spent unwell with it parked costs nothing in vehicle cost; charge a flat monthly amount and the parked month costs as much as a busy one. Neither is wrong. The two charges answer two different questions, distance or time, about what consumes the vehicle, and the arithmetic follows whichever question was asked.

Why does the total end up the same whichever method is used?

Because all three are cutting up the same Rs 9,00,000. Miss that fact and a method choice looks like a way of making cost appear or disappear, and no method can do either. The depreciable amount is fixed by the cost and the residual value, both settled before the method is chosen. Every method takes that number, slices it, and hands the slices out to years. A method decides which years get the larger slices and can never decide how much cake there is.

Follow the consequence carefully, in both directions. A method that charges more early must charge less later, by exactly the amount it charged early. Reducing balance takes Rs 1,20,000 more than straight line in year one, so across the remaining five years it must take Rs 1,20,000 less in total, and it does. Anyone who says reducing balance is a conservative method is saying something true about year one and something false about year six, where reducing balance charges Rs 1,51,263 and straight line charges Rs 1,50,000, a difference of Rs 1,263 the other way.

The carrying amounts show the same fact from the other side. All three paths leave Rs 9,00,000 on the day the machine is bought and all three arrive at nil at the end of year six, by different routes. The destination is set by the cost and not by the method, so the routes may differ and the origin and the destination cannot.

What do all three look like on one machine, year by year?

The table below sets out the whole life of that machine under all three methods, on the same inputs the calculator opened with and with the illustrative 30 per cent rate and output profile. Each column reads downward, and the bottom row reads across.

Three columns of completely different numbers and one identical total. The largest single charge anywhere in the table is Rs 2,70,000 and the smallest is Rs 60,000, a spread of four and a half times on the same machine in the same six years. Every rupee of that spread is a rupee moved from one year to another, and not one rupee of it is a rupee created or avoided.

Now put the year one difference through the accounts. In the accounts a method choice stops being an exercise and becomes a number a reader has to interpret. Anjani Stationers reported earnings before interest and tax (EBIT) of Rs 41,50,000 in year two on revenue of Rs 2,70,00,000, an EBIT margin of 15.4 per cent, and the business uses straight line on everything it has bought. The Rs 1,50,000 charge on this machine is already inside that Rs 41,50,000. Swap in reducing balance at 30 per cent and the charge becomes Rs 2,70,000, Rs 1,20,000 more, so EBIT falls to Rs 40,30,000 and the margin to 14.9 per cent. Swap in units of production and the charge becomes Rs 1,80,000, so EBIT falls to Rs 41,20,000 and the margin to 15.3 per cent.

One machine, one year, a choice nobody outside the business made, and Rs 1,20,000 of EBIT sits on the outcome. The scale of that is worth holding on to. Rs 1,20,000 is 2.9 per cent of Anjani Stationers' EBIT, produced by a single asset that cost Rs 9,00,000 out of a gross block of Rs 64,00,000. Applied across the whole block, a different method produces a multiple of that effect. The published depreciation charge of Rs 11,00,000 for year two, plus Rs 1,00,000 of amortisation, gives the Rs 12,00,000 the accounts report. Both figures are the product partly of an estimate and partly of a method, and neither the estimate nor the method is visible in the number itself.

When would a business change method, and is the past restated?

A business changes method when the pattern in which it expects to consume the asset has changed. A changed pattern of consumption is the only reason the accounting recognises. If the binding machine was bought expecting steady work and is now running in short intense bursts around the school season, the pattern of consumption has genuinely changed and a different method may describe it better. Wanting a different profit figure is not a reason, and a change made for that purpose would not survive an audit.

Now the part that gets confused constantly. A change of depreciation method is treated as a change in estimateA revision to a judgement about the future, such as how long an asset will last or how it will be consumed. The revision is applied to the current year and the years after it, and earlier published figures are left alone.. The new method is applied from the year of the change onwards, and the years already published are left exactly as they were. Nothing is restated, nothing is redrawn, and last year's comparative column in this year's accounts still reads what it read when it was first published.

A change of inventory cost formula runs the opposite way: it is treated as a change of accounting policy, applied backward as well as forward, with the comparative figures restated so that the earlier year is shown as if the new formula had always been used. Two changes, both described in ordinary English as a change of method, and two opposite treatments. The difference holds by its reason rather than by its name. A depreciation method is an expression of a judgement about the future, and history is not rewritten because a view of the future moved. A cost formula is a rule for measuring the same past transactions, and if the rule changes the past has to be re-measured or the two years cannot be compared at all.

The consequence for a reader is practical. When a business changes depreciation method, this year and last year were prepared on different bases and the accounts will not have flagged it by moving any prior figure. The only warning is a sentence in the notes. When a business changes an inventory cost formula, the prior column has moved, and a reader comparing this year's accounts against last year's published copy will find two different numbers for the same year.

Where in a filing is the method a business uses stated?

In two places, and both of them are in the notes rather than on the face of any statement. The method and the useful lives are written in the significant accounting policies note, usually as a single sentence naming the method, and they appear again inside the property, plant and equipment note where the lives are often set out class by class. Read both. The policies note gives the method and the property note gives the lives the method is applied to.

The gross block, the additions, the disposals and the accumulated depreciation sit in the fixed asset scheduleThe table inside the notes that reconciles an asset class from its opening cost to its closing net figure, showing additions, disposals and the depreciation charged along the way., a table inside the notes and not a line on the balance sheet. The balance sheet carries only the net figure, so Anjani Stationers' Rs 36,00,000 appears there while the Rs 64,00,000 of gross block and the Rs 28,00,000 of accumulated depreciation behind it appear only in the schedule.

The charge for the year has its own line in the statement of profit and loss, and the identical figure appears again as the first add-back in the operating section of the cash flow statement. Anjani Stationers reports Rs 12,00,000 there, being Rs 11,00,000 of depreciation and Rs 1,00,000 of amortisation. Last year's figures for every one of these sit in the prior-year column of the same schedule, beside this year's.

Who reads the method line, and what do they do with it?

Three people open the same policies note in the same week and none of them is reading it for pleasure.

A lender reads the method to work out whether the charge it is subtracting will still be there in three years, an analyst reads it to decide whether this year's margin can be carried forward, and Vaidehi Rao, sitting inside Anjani Stationers as its finance controller, reads it to know which of next year's numbers are already fixed. Watch each of them work. The lender is testing whether the business can service a loan out of what it earns, and depreciation is the largest expense on the income statement that will not be paid in cash. If the business is on reducing balance, the charge on everything it already has will fall each year on its own, and future profit is flattered without anything improving. The lender wants to know that before it builds a covenant on a profit measure.

The analyst's use is narrower and sharper. A margin computed after depreciation is only comparable across two businesses if the two are depreciating on similar bases over similar lives, and they very often are not. Two identical sheds, one on straight line over eight years and one on reducing balance, will report different margins in year one and different margins in year six, in opposite directions, with nothing different happening in either shed. So the analyst reads the method and the lives first and the margin second, and where the bases differ, compares a measure taken before depreciation as well as one taken after it.

Vaidehi Rao is not inferring anything, so she has the easiest job of the three. She knows the method, the lives and the additions, so she can state next year's depreciation on the existing block before the year begins: the Rs 7,00,000 on the opening assets continues, the Rs 2,25,000 on the year two additions continues, the Rs 1,75,000 on the right-of-use asset continues, and anything bought next year is added to that. Depreciation is the one large cost in a business that can be forecast almost exactly, and it can be forecast exactly only by someone who knows the method.

Anjani Stationers Private Limited, Chitra Binding Works Private Limited and Vaidehi Rao are invented.
Educational material. Not advice on any investment, tax, budget or market position.