Depreciation is reduction in the cost of an asset, used during a certain period of time. In this article, we discuss the different accounting methods devoted to calculate it.
Depreciation is a terminology commonly used in accounting, economics, and finance to distribute the cost of tangible assets over their life. In simple terms, it is a method of attributing the historical or purchase cost of an asset across its useful life, including parameters like usage, passage of time, wear and tear, technological outdating or obsolescence, depletion, inadequacy, etc. The use of depreciation to calculate the current value of an asset affects financial statements, as well as taxes imposed on companies and personal incomes. The recording of depreciation causes an expense to get identified, which results in reducing stated profits on the income statement, as well as decline in the net value of the assets on the balance sheet. However, depreciation reported for accounting and tax purposes may differ considerably.
Methods of Depreciation
Though there are different methods for calculating depreciation, which are generally based on either the passage of time or the level of activity (or use) of the asset, below are the three most popular ones, explained with examples.
It is the most commonly used technique, estimated by taking the purchase or acquisition price of an asset deducted by the salvage value, and then divided by the total productive years or useful life, wherein the asset can be fairly expected to benefit the company. The salvage value is an estimate of the value of the asset at the time it will be sold or disposed off. Also known as scrap value or residual value, salvage value, arrived at using straight line method, can be zero or negative also.
Annual depreciation expense = (Cost of fixed asset – Salvage value)/Number of useful years
Example: On April 1, 2010, Company X purchased an instrument at the cost of $200,000. This equipment is estimated to have 5 year of reproductive or useful life. By the end of the fifth year, the salvage value (residual value) will be $50,000. Company X recognizes depreciation to the nearest whole month. Calculate the depreciation expenses for the first three years of asset use i.e. 2010, 2011, and 2012, using straight line depreciation method.
Depreciation (2010) = ($200,000 – $50,000) x 1/5 x 9/12 = $22,500
Depreciation (2012) = ($200,000 – $50,000) x 1/5 x 12/12 = $30,000
Depreciation (2013) = ($200,000 – $50,000) x 1/5 x 12/12 = $30,000
Declining Balance Depreciation Method
Declining balance is another method of calculation that allows for larger depreciation amounts during the early life of the asset. The method is precise when the asset is expected to generate larger revenues in its early life, hence causing greater tax deduction to offset the larger income that the asset produces. In this method, the book value is multiplied by a fixed depreciation rate. Book value at the beginning of the depreciation year is the cost of the asset, and later it is equal to the original value minus accumulated depreciation. The most commonly used depreciation rate is double the straight line rate. Hence this method is also termed as double declining balance rate.
Example: On April 1, 2010, Company X purchased an equipment at the cost of $200,000. This equipment is estimated to have 5 year reproductive or useful life. At the end of the fifth year, the salvage value (residual value) will be $50,000. Company X recognizes depreciation to the nearest whole month. Calculate the depreciation expenses for the first three years of use of the asset i.e. 2010, 2011 and 2012, using double declining balance depreciation method.
Since the useful life is 5 years, the straight line depreciation rate is 1/5, i.e. 20% per year.
Depreciation rate for double declining balance method
= 20% x 200% = 20% x 2 = 40% per year
|Year||Book Value at the Beginning||Depreciation Rate||Depreciation Expense||Book Value at the Year-End|
Sum of the Year’s Digits (SYD) Method
The SYD is calculated by evaluating an asset’s useful life in years, assigning consecutive numbers to each year, and totaling these numbers. For ‘n’ years, the simple formula for totaling these numbers is SYD = n(n + 1)/2. The yearly depreciation is then estimated by multiplying the total depreciable amount for the asset’s useful life by a fraction having numerator as the remaining useful life and denominator as the SYD.
Annual depreciation = ((Original cost – Salvage value) * Remaining useful life) / SYD
Example: Company X purchased the following asset on January 1, 2011. What is the amount of depreciation expense for the year ended December 31, 2015?
Acquisition cost of the asset = $100,000
Useful life of the asset = 5 years
Residual value or salvage value at the end of useful life = $10,000
Sum of the years’ digits = 5(5+1)/2 = 15
Depreciation for 2011 = ($100,000 – $10,000) x 5/15 = $30,000
Depreciation for 2012 = ($100,000 – $10,000) x 4/15 = $24,000
Depreciation for 2013 = ($100,000 – $10,000) x 3/15 = $18,000
Depreciation for 2014 = ($100,000 – $10,000) x 2/15 = $12,000
Depreciation for 2015 = ($100,000 – $10,000) x 1/15 = $6,000
The depreciation method that you employ for any particular asset is fixed at the time you first place it into service. Hence, whatever rules or tables are effective for that particular year must be followed, as long as an individual owns the property.