Fixed installment method

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Definition

As the name of the method implies, under fixed installment method of depreciation the amount of depreciation each year is fixed and equal. At the end of each year, a fixed amount is removed from the book value of the asset concerned and charged to profit and loss account (or income statement).

Explanation

This is the oldest and most commonly used method of depreciation. Here a fixed amount of depreciation is charged every year during the lifetime of the machine. There at the end of its useful life, the value of the asset will be zero. This is also known as straight-line method or original cost. method.

There are certain assets that give more or less the same service over their entire life, and when their useful life is over, they are of no value to the owners. A good example is a leasehold property. If a businessman acquires a property on a 100 years lease, the property would be of no value to him after 100 years as it would return to the original owner. For such a fixed asset, depreciation per year is arrived at by dividing its cost over the number of years it is expected to have a useful life of.

Advantages/Merits of Fixed Installment Method


(i) Simple Method: This is a very simple method to understand and its application is very simple.

(ii) Zero Value: Under this method, the value of the asset during its effective working life will be zero.

(iii) Suitable for Assets having Expiry Period: This method is suitable to such asset which gets depreciation more on account of expiry of time the examples are: Lease-hold properties, patents, etc.

Disadvantages/Demerits of Fixed Installment Method

The following are the demerits of this method:

(i) Concept of Zero Value. Under this method the value of asset after its working life will be zero, it is wrong to believe. No such asset whose value will be zero any time.

(ii) Equal Amount of Depreciation. In this method amount of depreciation remains equal throughout the working life of machine which is not logical. The amount of depreciation should be more in the initial years and lesser in the later part of its life.

(iii) No Thought to Interest. In this method, only the original cost of asset is depreciated no thought is given to this fact that the same investment is made at a different place it would fetch interest which is completely ignored in this method.

(iv) Difficulty in Additional Purchase of Fixed Asset. The method creates complications in respect of depreciation on additions to assets which have a different life span.

Formula

fixed-installment-method-formula

Example 1

ABC company acquired a plot on a 100 years lease for $125,000. Calculate the plot’s depreciation per year.

Depreciation per year = $125,000/100 years
= $1,250

Scrap or residual value

Most fixed assets, however, have some value left even after their useful life is over. For example, if a trader buys a machine which is expected to have a useful life of 10 years, it is likely that after 10 years, even though the machine may not be active and useful it will still be worth a few dollars as scrap. This amount is called asset’s scrap or residual value. For assets that are likely to leave a scrap value, depreciation per year is calculated by using the following formula:

fixed-installment-method-formula1

Example 2

The ABC company purchased a machine for $124,000. It is expected to last for 6 years and leave a scrap value of $4,000. Calculate its depreciation per year.

Depreciation per year = ($124,000 – $4,000)/6 years
=$20,000

Trade in value

Some businessmen prefer not to keep their fixed assets till the end of their useful life but to sell them off when they are still in working order. The price fetched then is called resale value, or if the asset is traded in for a new one, trade-in value. For such assets, depreciation per year is calculated as follows:

fixed-installment-method-formula2

Example 3

The XYZ company bought a machine for $124,000. It expects to use it for 5 years and sell it for $34,000. Calculate its depreciation per year.

Depreciation per year = ($124,000 – $34,000)/5 years
= $18,000

The fixed installment method is also known as the straight-line method. It is particularly suitable for such assets that give more or less the same service over their entire useful life and whose useful life and whose useful life can be ascertained to a fair degree of accuracy. Examples of such assets are leasehold property, large machinery and plants, mines, etc.

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