Under this method, the cost of the asset less salvage value is charged as expenses and debited to profit and loss account in the year in which the asset is retired from the service. Thus, the depreciation is not changed on regular annual basis, but it is changed only in the year of its retirement.
The effect of this method would be that, in the year of retirement the burden of depreciation would be heavy and would deflate the revenue income substantially while in other years the position would be reverse i.e. as depreciation is not charged, the revenue income will get inflated to that extent. This method is applicable to only such assets whose service life is very short, say one or two years.
Under this method, the acquisition cost of an asset is treated capital expenditure and the amount is shown as an asset account in the balance sheet. The cost of the replacement is charged as revenue expenditure in the year of replacement. Thus, in the year of replacement substantial amount will be charged to the profit and loss account deflating the profit of that year phenomenally. The main drawback of this method is that, it assumes that the amount of replacement would be same. If the replacement cost is higher than the original cost, the profit and loss account is charged with the replacement cost deflating the profit. Cost is higher than the replacement cost of the original asset, the excess of replacement cost is considered s an addition to the capital asset, and it is not changed to profit and loss account as revenue expenses.
Like the above method, it will distort the presentation of revenue income substantially. This method is used by the public utilities such as electricity supply water supply transport services etc.
Selection of the Depreciation Method:
The selection of the method of depreciation is an important decision because it involves certain financial and tax implications. Among the different methods of depreciation, the important considerations lie in the selection between the straight line method (SLM) and diminishing balance method (DBM). In India laws regarding the provision of depreciation are governed under the Indian Companies Act , 1956 and the Income Tax Act 1961 Sec 205 (2) of the Indian Companies Act 1956 provides or the selection of either the DBM or the SLM. If the DBM is elected, then according to Sec 350 of the Indian Companies Act 1956 the depreciation on different assets should be provided at the rates of depreciation specified for various types of assets in the Income Tax Act 1961. In case, if the rates are not specified for any asset under Income Tax Act, the Central Government is empowered to specify the general rates or the rates of specific asset. In case of any ambiguity or absence of provision regarding the rate of depreciation, the onus lies on the company to seek clarification from the Central Government in such matters.
If the straight line method (SLM) is selected, the depreciation will be calculated by dividing 95% of the acquisition cost of the asset by the specified period. The specified period is the number of years at the end of which at least 95% of the acquisition cost is written of by way of depreciation as per the provisions of Sec 350 of the Indian Companies Act i.e. if the diminishing balance method is followed.
Change in the Depreciation Method:
Companies are entitled to follow different depreciation methods for different kinds of assets. Out of two depreciations straight line and diminishing balance method, they are permitted to switch over from one method to the other one at alter stage. From the legal point of view and from the financial accounting system, change in the depreciation method is not objected. In USA for tax purpose, the tax payer is permitted to switch over to a residual straight line depreciation method when the straight line depreciation exceeds he amount of depreciation under the accelerated method. In India also such switch over is permitted provided adequate depreciation has been provided on the date of change over.