What is Depreciation?

The word "depreciation" is defined as an accounting method wherein the cost of tangible assets is spread over its useful life and it usually denotes how much of the assets value has been used up. The depreciation is usually considered as an operating expense. The main reason behind depreciation includes wear and tear of the assets, obsolescence etc.

What Are the Different Methods of Depreciation?

According to the generally accepted accounting principles (GAAP), there are four methods of calculating depreciation.

i. Straight-Line method of depreciation.

ii. Declining Balance depreciation.

iii. Sum of the years' Digits depreciation.

iv. Units of production depreciation.

A. Straight- Line Depreciation

Straight-line method of depreciation is used when the loss that an asset has borne over the period is to be calculated and it is considered to be the simplest of the methods for calculating depreciation. The straight line is a method that calculates depreciation by dividing the difference between the cost of an asset and the expected salvage value* of that asset by the total number of years for which the asset is expected to be used. The straight-line depreciation is generally used for assets that experience a steady downfall in their value over the useful life.

B. Declining balance Depreciation

This depreciation method is a quicker and enhanced way of calculating depreciation wherein the larger depreciation expenses are usually recorded at the earliest part of assets useful life while the smaller depreciation expenses are recorded at a later stage. The declining balance method of calculating depreciation is generally used for those assets which lose their book value too quickly and eventually become obsolete.

This depreciation method is used for assets like computer equipment, cell phones, and other electronic gadgets.

The "double declining balance" method of depreciation is a type of declining balance method which depreciates asset at double the normal depreciation rate under the straight-line method.

C. Sum of the years' digits Depreciation

This depreciation method is an accelerated way of calculating depreciation and is based on the assumption that an asset will lose its book value over the period if put to regular use throughout its useful life. In this method, the expected life of an asset is taken and the total of the digits of the expected life is added, then each digit is divided by the total sum of the digits to arrive at a depreciation rate for each year with Year 1 giving the highest rate of depreciation

Eg: If the expected life of an asset is 6 years, so the sum of the years digit would be (6+5+4+3+2+1)= 21, now by dividing each digit by the total sum we will get the depreciation rate for each year.

Year 1 : 6/21*100 = 29%

Year 2 : 5/21*100 = 24%

Year 3 : 4/21*100 =19%

Year 4 : 3/21*100 = 14%

Year 5 : 2/21*100 = 9%

Year 6 : 1/21 *100 = 5%

The sum of years' digits methods accordingly as seen above results in higher depreciation in the initial years as compared to later years. This depreciation method also results in increasing the economic usefulness of the asset over the years as the rate of depreciation in more in the earlier years when the economic value of the asset is higher and as the useful life of the assets starts diminishing the depreciation charges also diminishes.

One of the disadvantages of using the sum of years' digits depreciation method is that it is harder to calculate and more confusing than the other methods of depreciation.

D. Units of production Depreciation

The units of production depreciation method takes into consideration the practical use of the asset rather than the time of its usage. This particular method is put to use where the value of the asset is determined by keeping into consideration the number of units produced by the asset instead of the number of years for which it was put to use. Under the units of production depreciation method, the depreciation usually begins when the units are being produced by the asset and it ends when (either the asset has produced all the required number of units within its production capacity or where the cost of the asset is recovered fully) whichever is earlier. The depreciation expense under this method proportionately varies with the usage of the asset.

The depreciation expense under this method is calculated by deducting the salvage value of the asset by the original value and dividing the same by the number of units the asset is expected to produce during its useful life. The resultant is then multiplied by the number of units that were put to use in the year.

Which Depreciation Method Is Widely Used Under the GAAP and Why?

The Straight - Line Depreciation method is the most commonly used method of depreciation adopted by companies to depreciate their assets because of its simple and easy calculations. The straight-line method can also be applied to long-term assets which is one of its biggest advantages.

Which Method of Depreciation Produces the Highest Amount of Depreciation Expense?

The double-declining depreciation method depreciates the assets at double the normal rate as this balancing method of depreciation works on the presumption that the value of an asset diminishes with the period if put to regular use and since the depreciation is at the double rate, it eventually leads to the highest amount of depreciation expense.

Are There Any Other Methods of Calculating Depreciation?

There are in total eight different methods of calculating depreciation as per the GAAP, however, only methods are widely put to use, namely ;

• Straight Line Depreciation.
• Declining Balance Depreciation.
• Sum of the digits' Depreciation.
• Units of Production Depreciation.

Apart from the above-mentioned depreciation methods, there are methods of calculating: Sinking fund method, Annuity method, Insurance policy method, and Discounted Cash Flow method.

What is the Impact of Depreciation Methods?

The depreciation method adopted by the businesses around having fixed assets can largely impact their income statements and assets column in the balance sheet.

Formulas

• Straight Line method of calculating depreciation = ( Cost of an asset - Salvage value) / Useful life of an asset.

* Salvage Value: It is usually the book value of an asset after it has been depreciated for its expected useful life. The salvage value is usually the amount that the company expects to receive if the asset is sold in the market after exhausting its useful life.

Example of straight lines basis depreciation: If a company buys a piece of equipment for $10,000 for 10 years as useful life and carrying a salvage value of $1000. The depreciation for the piece of equipment under straight-line basis for each year would be ($10,000-$1000) / 10 = $900.

So, under the straight-line method of depreciation, the company needs to incur an expense of $900 each year, instead of writing off the entire cost in the current year.

• Declining Balance method of calculating depreciation = *Current Book Value (CBV) of an asset × Rate of Depreciation.

* Current Book Value: It is the net value of an asset as shown at the beginning of the year which is arrived at by subtracting the accumulated depreciation of an asset for the year from the cost of an asset.

Units of Production Depreciation method = [(Original Value - Salvage Value) ÷ Number of units produced during the useful life of the asset ] × U.

• U = Number of units used during the year.

Common Mistakes

The care must be taken while putting depreciation methods to use. It must be evaluated that the method which is being used complies with the GAAP guidelines. Moreover, the rate of depreciation and the tenure should be populated correctly when using a particular method of depreciation , otherwise it might lead to unrealistic and incorrect depreciation amount.

Context and Applications

This topic is significant in the professional exams for both undergraduate and post-graduate courses, especially for:

• B.com (Honors)
• M.com
• Chartered Accountants (CA)
• Company Secretary (CS)
• MBA (Finance)

Related Concepts

• Scrap or Salvage Value.
• Accelerated Depreciation.
• Affect of proration on asset depreciation.