Depreciation Methods
Depreciation
The monetary value of an asset decreases over time due to use,
wear and tear or obsolescence. This decrease is measured as
depreciation.
Depreciable Assets
You can depreciate most types of tangible property (property you can see and
touch), including:
Buildings
Machinery
Vehicles
Furniture and fixtures
Computers
Equipment.
Depreciable Assets
You can also depreciate most intangible property, (property that has no form) including
Patents
Copyrights
Computer software.
Non Depreciable Assets
What Assets Cannot Be Depreciated?
Land - Land can't be depreciated because it isn't used up or worn out. It doesn't lose its
value. But you can depreciate some land preparation costs.
Current assets - You can't depreciate assets that are purchased and disposed of in the
same year. Current assets include supplies, prepaid insurance and other pre-paids
(amounts you pay for ahead of time, like insurance), and accounts receivable (amounts
owed to your business).
Cash - Cash is the amount in your business checking account. Its value stays the same
and it is not a long-term asset, so it can't be depreciated.
Factors that cause depreciation
Factors that cause depreciation are as under :–
(a) Wear and tear due to actual use.
(b) Efflux of time; where passage of time makes machinery old and fit for replacement.
(c) Obsolescence; if a new and more efficient machine comes into the market, old one
has to be replaced.
(d) Accident, and
(e) Fall in market value.
Common Terms Used in Depreciation
Initial cost is the total cost of acquiring the asset.
Salvage value represents estimated market value of the asset at the end of its useful life. It
is the expected cash inflow that the owner of the asset will receive by disposing it at the
end of useful life.
Book value is the value of asset recorded on the accounting books of the firm at a given
time period. It is generally calculated at the end of each year. Book value at the end of a
given year equals the initial cost less the total depreciation amount till that year.
Useful life represents the expected number of years the asset is useful in terms of
generating revenue. The asset may still be in working condition after the useful life but it
may not be economical. Useful life is also known as depreciable life. The asset is
depreciated over its useful life.
Main Types of Depreciation
There are several types of depreciation expense and different formulas for determining the
book value of an asset. The most common depreciation methods include:
1. Straight-line Method
2. Double declining balance Method
3. Units of production Method
4. Sum of years digits Method
Straight Line Depreciation Method
Straight-line depreciation is a very common and simple method of
calculating the expense. In straight-line depreciation, the expense
amount is the same every year over the useful life of the asset.
Depreciation Formula for the Straight Line Method:
Depreciation Expense = (Cost – Salvage value) / Useful life
Straight Line Depreciation Method
Example
Consider a piece of equipment that costs $25,000 with an estimated useful life of 8 years and
a $0 salvage value. The depreciation expense per year for this equipment would be as
follows:
Depreciation Expense = ($25,000 – $0) / 8 = $3,125 per year
Straight Line Depreciation Method
Depreciation Expense = ($25,000 – $0) / 8 = $3,125 per year
Straight Line Depreciation Method
Sum-of-the-Years-Digits Depreciation
Method
Sum-of-the-years-digits method is one of the accelerated
depreciation methods. A higher expense is incurred in the early years
while lower expense is incurred in the latter years of the asset.
In sum-of-the-years digits depreciation method, the remaining life of
an asset is divided by the sum of the years and then multiplied by the
depreciating base to determine the expense.
The depreciation formula for the sum-of-the-years-digits method:
Depreciation Expense = (Remaining life / Sum of the years digits) x
(Cost – Salvage value)
Sum-of-the-Years-Digits
Depreciation Method
Example
Consider a piece of equipment that costs $25,000 with an estimated useful life of 8 years and
a $0 salvage value.
Explanation
1. The depreciation base is constant throughout the years and is calculated as follows:
Depreciation Base = Cost – Salvage value
Depreciation Base = $25,000 – $0 = $25,000
2. The remaining life is simply the remaining life of the asset. For example, at the beginning of the year, the asset
has a remaining life of 8 years. The following year, the asset has a remaining life of 7 years, etc.
3. RL / SYD is “remaining life divided by sum of the years.” In this example, the asset has a useful life of 8 years.
Therefore, the sum of the years would be 1 + 2 + 3 + 4 + 5 + 6 + 7 + 8 = 36 years. The remaining life in the
beginning of year 1 is 8. Therefore, the RM / SYD = 8 / 36 = 0.2222.
4. The RL / SYD number is multiplied by the depreciating base to determine the expense for that year.
5. The same is done for the following years. In the beginning of year 2, RL / SYD would be 7 / 36 = 0.1944. 0.1944 x
$25,000 = $4,861 expense for year 2.
Sum-of-the-Years-
Digits Depreciation Method
Units of Production Method of
Depreciation
In units of production method of depreciation, depreciation is charged
according to the actual usage of the asset.
In units of production method, higher depreciation is charged when their is higher
activity and less is charged when there is low level of operation.
Zero depreciation is charged when the asset is idle for the whole period.
This method is similar to straight-line method except that life of the asset is
estimated in terms of number of operations or number of machine hours etc.
Such a method is useful where a company has many fixed assets with varying
usage.
Units of Production Method
of Depreciation
Formula
The following formula is used to calculate depreciation under this method:
Depreciation =
Number of Units Produced × (Cost − Salvage Value)/Life in Number of Units
Units of Production Method of
Depreciation
Example 1: A plant costing $110 million was purchased on April 1, 2010. The salvage value was
estimated to be $10 million. The expected production was 150 million units. The plant was used
to produce 15 million units till the year ended December 31, 2010. Calculate the depreciation
on the plant for the year ended December 31, 2011.
Solution:
Depreciation = (15/150) × ($110 million - $10 million) = $10 million
Example 2: A coal mine was purchased by X Corporation for $16 million. It was estimated that
the mine has capacity to produce 200,000 tones of coal. The company extracted 46,000 tones
during its first year of operation. Calculated the depreciation.
Solution:
Depreciation = (46,000/200,000) × $16 million - = $3.68 million
Double Declining Balance Depreciation
Method
Compared to other depreciation methods, double-declining-balance results in larger
expense in the earlier years as opposed to the later years of an asset’s useful life.
The method reflects the fact that assets are more productive in its early years than in its later
years.
With the double-declining-balance method, the depreciation factor is 2x that of a straight
line expense method.
Depreciation formula for the double declining balance method:
Periodic Depreciation Expense = Beginning book value x Rate of depreciation
Double Declining Balance Method
Example
Consider a piece of equipment that costs $250,000 with an estimated useful life of 8 years
and a $2,500 salvage value. To calculate the double declining balance depreciation, set
up a schedule:
The information on the schedule is explained below:
1. The beginning book v alue of the asset is filled in at the beginning of year 1 and the salv age v alue is filled in at the
end of year 8.
2. The rate of depreciation (Rate) is calculated as follows:
3. Expense = (100% / Useful life of asset) x 2
4. Expense = (100% / 8) x 2 = 25%
5. Note: Since this is a double declining method, we multiply the rate of depreciation by 2.
6. 3. Multiply the rate of depreciation by the beginning book v alue to determine the expense for that year. For
example, $25,000 x 25% = $6,250 depreciation expense.
7. 4. Subtract the expense from the beginning book v alue to arriv e at the ending book v alue. For example, $25,000 –
$6,250 = $18,750 ending book v alue.
8. 5. The ending book v alue for that year is the beginning book v alue for the following year. For example, the year 1
ending book v alue of $18,750 would be the year 2 beginning book v alue. Repeat this until the last year of useful life.
Double Declining Balance Method
