The Fixed Instalment Method of Depreciation Explained

The fixed instalment method of depreciation is one of the most straightforward and widely used approaches for allocating the cost of an asset over its useful life. Also known as the straight-line method, this technique charges a constant annual depreciation amount, making it predictable and easy to calculate. This method ensures that businesses can systematically spread the cost of their fixed assets across multiple accounting periods, providing a clear picture of how asset values decline over time.

What is the fixed instalment method? 🔗

The fixed instalment method is a depreciation technique that allocates an equal amount of an asset’s cost as an expense each year throughout its useful life. Think of it like paying off a loan in equal monthly instalments – except here, you’re “paying off” the asset’s value through consistent annual depreciation charges.

This method operates on a simple principle: since the asset provides equal service potential each year, it should bear an equal share of the cost each year. For example, if you purchase a delivery truck for your business that costs ₹5,00,000 and expect it to last 5 years, the fixed instalment method would charge ₹1,00,000 as depreciation expense each year.

How to calculate depreciation using the fixed instalment method 🔗

The calculation for the fixed instalment method is refreshingly simple. The basic formula is:

Annual Depreciation = (Cost of Asset – Residual Value) ÷ Useful Life

Let’s break down each component:

Cost of asset 🔗

This includes the original purchase price plus any additional costs necessary to bring the asset to its working condition. For instance, if you buy machinery for ₹2,00,000 and spend ₹20,000 on installation and transportation, the total cost would be ₹2,20,000.

Residual value 🔗

Also called salvage value, this is the estimated amount you expect to receive when you dispose of the asset at the end of its useful life. Many assets have minimal residual value, but some, like vehicles, might retain significant value even after years of use.

Useful life 🔗

This represents the number of years the asset is expected to provide economic benefits to the business. Different assets have different useful lives – computers might last 3-5 years, while buildings could serve for 50+ years.

Practical example of the fixed instalment method 🔗

Let’s work through a comprehensive example to see how this method works in practice. Suppose ABC Manufacturing purchases a new printing machine with the following details:

• Purchase price: ₹8,00,000
• Installation costs: ₹50,000
• Transportation costs: ₹25,000
• Expected useful life: 10 years
• Estimated residual value: ₹75,000

First, we calculate the total cost of the asset:

Total Cost = ₹8,00,000 + ₹50,000 + ₹25,000 = ₹8,75,000

Next, we determine the depreciable amount:

Depreciable Amount = ₹8,75,000 – ₹75,000 = ₹8,00,000

Finally, we calculate the annual depreciation:

Annual Depreciation = ₹8,00,000 ÷ 10 years = ₹80,000

This means ABC Manufacturing will record ₹80,000 as depreciation expense each year for 10 years, regardless of how much the machine is actually used in any given year.

Journal entries for the fixed instalment method 🔗

Recording depreciation requires specific journal entries that affect both the income statement and balance sheet. Here’s how the entries work:

At the time of purchase 🔗

When ABC Manufacturing buys the printing machine:

• Debit: Machinery Account ₹8,75,000
• Credit: Bank/Cash Account ₹8,75,000

Annual depreciation entry 🔗

Each year, the company records:

• Debit: Depreciation Expense ₹80,000
• Credit: Accumulated Depreciation – Machinery ₹80,000

The accumulated depreciation account is a contra-asset account that reduces the book value of the machinery on the balance sheet. After three years, the machinery would appear on the balance sheet at ₹8,75,000 – ₹2,40,000 = ₹6,35,000.

Advantages of the fixed instalment method 🔗

The fixed instalment method offers several compelling benefits that make it attractive for businesses:

Simplicity and ease of calculation 🔗

Unlike more complex depreciation methods, the fixed instalment method requires minimal calculations. Once you determine the annual depreciation amount, it remains constant throughout the asset’s life. This simplicity reduces the chances of errors and makes it easy for accounting staff to understand and apply.

Predictable expense allocation 🔗

Since the depreciation amount is fixed, businesses can easily predict their annual depreciation expenses. This predictability helps in budgeting and financial planning, allowing companies to forecast their profits more accurately.

Suitable for assets with consistent usage 🔗

For assets that provide relatively uniform service throughout their lives – like buildings, furniture, or fixtures – the fixed instalment method provides a logical allocation of costs. These assets don’t typically experience significantly different usage patterns from year to year.

Compliance with accounting standards 🔗

The method is widely accepted under various accounting frameworks, including Indian Accounting Standards (Ind AS) and International Financial Reporting Standards (IFRS), making it a safe choice for regulatory compliance.

Disadvantages and limitations 🔗

Despite its advantages, the fixed instalment method has some limitations that businesses should consider:

Ignores actual usage patterns 🔗

The method assumes equal usage each year, which may not reflect reality. A delivery truck might be used heavily in the first few years but sparingly later, yet the depreciation remains constant. This can lead to a mismatch between the asset’s actual contribution to revenue and its recorded expense.

Maintenance costs not considered 🔗

As assets age, they typically require more maintenance and repairs. The fixed instalment method doesn’t account for this reality – it charges the same depreciation amount even when the asset becomes less efficient and more costly to maintain.

May not reflect economic reality 🔗

Some assets lose value more rapidly in their early years (like technology equipment) or maintain their value better initially (like real estate). The straight-line approach may not capture these economic realities accurately.

When to use the fixed instalment method 🔗

The fixed instalment method works best in specific situations:

• Buildings and structures: These assets typically provide consistent service over their long lives
• Furniture and fixtures: Office furniture, shelving, and similar items usually have steady usage patterns
• Assets with uncertain usage patterns: When you can’t reliably predict how intensively an asset will be used
• Regulatory requirements: Some industries or jurisdictions may require or prefer this method
• Simplicity preference: When businesses prioritize ease of calculation and record-keeping

Comparison with other depreciation methods 🔗

Understanding how the fixed instalment method compares to alternatives helps in making informed decisions:

Reducing balance method 🔗

While the fixed instalment method charges equal amounts annually, the reducing balance method charges higher depreciation in early years and lower amounts later. This might better reflect the reality for assets like vehicles or technology equipment.

Units of production method 🔗

This method links depreciation to actual usage, making it more suitable for manufacturing equipment or vehicles where usage varies significantly from year to year.

The choice between methods depends on the nature of the asset, business requirements, and regulatory considerations. Many businesses use the fixed instalment method for most assets due to its simplicity while applying other methods for specific asset categories.

Impact on financial statements 🔗

The fixed instalment method affects both the income statement and balance sheet consistently:

Income statement impact 🔗

Depreciation expense appears as an operating expense, reducing net income by the same amount each year. This creates predictable profit patterns, which can be beneficial for businesses seeking stable earnings reports.

Balance sheet impact 🔗

The asset’s book value decreases linearly over time as accumulated depreciation increases. This creates a smooth, predictable decline in asset values, which can be easier for stakeholders to understand and analyze.

What do you think? How might the choice of depreciation method affect a company’s financial ratios and investment decisions? Would you prefer the predictability of the fixed instalment method or the economic accuracy of usage-based methods for your business?