Depreciation Methods – 4 Types of Depreciation, Formula & Calculation

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Company incurs cost related to tangible assets. These assets are called depreciable assets. The cost of tangible asset is not reflected fully in the current year’s income statement. It is reported as depreciation expense in the income statement over the time and simultaneously reported on the balance sheet as a part of accumulated depreciation under fixed assets. Accumulated depreciation is a contra asset account and it offsets the fixed asset line item on the balance sheet. The depreciation entry is a debit to depreciation expense and a credit to accumulated depreciation.

Company depreciates its long-term tangible assets for accounting and tax purpose. “Depreciation” is an accounting method of cost allocation of fixed assets over its useful life in a rational and systematic manner until the value of asset becomes zero or equals to its residual value. Generally, depreciation involves the following four criteria:

  1. Cost of assets or book value: This includes shipping, preparation or set up expense as well as taxes.
  2. Salvage or residual value of the assets: Remaining value of the depreciable asset post useful life.
  3. Estimated useful life of the assets: It is the duration when company considers fixed asset to remain productive.
  4. Methods of allocating the cost over its life span.

Objectives of computing depreciation:

  1. Reduction of book value due to usage or obsolescence or wear and tear.
  2. Spread fixed asset purchase cost proportionately over its useful life.

Conditions for claiming depreciation:

  1. The tangible assets must be wholly or partially owned.
  2. The tangible assets should be used for business purpose. If the assets are used for other purposes and not used exclusively for the business, depreciation allowable would be proportionate to the use of business purpose.

Depreciation is a non-cash expenditure. Cash flows related to the fixed assets are occurred when it is acquired and eventually sold. Example of fixed assets are building, equipment, machinery, furniture etc. (Exception is land which can’t be depreciated as value of land appreciates with the time). Depreciation methods vary for tax and accounting purpose as well as between asset types within the same business. There are mainly four standard methods of depreciation:

  1. Straight-line
  2. Double declining balance
  3. Units of production
  4. Sum of the years digits

1. Straight line depreciation method:

It is the simplest method of depreciation. In this method, depreciation expense is equally distributed throughout the useful life of the asset.

Depreciation Expense: (Cost of tangible asset – Residual value) / Useful life of the asset

Example:  Company XYZ purchases a machinery for Rs 10,000 with useful life of 8 years and residual value of machinery is Rs 1,000

Annual Depreciation expense = (10,000 – 1,000) /8 = Rs 1,125

Depreciation Methods
Pic: Straight-line depreciation schedule

Depreciation Methods

2. Double Declining Balance Depreciation Method:

As name suggested, earlier period shows higher expense compared to the later years of the asset’s useful life. In this method, residual value is not considered while calculating depreciation value although ending book value never goes below residual value.

Rate of Depreciation: 2 / Useful life of the asset

Example:  Company XYZ purchases a machinery for Rs 10,000 with useful life of 8 years and residual value of machinery is Rs 1,000

Depreciation expense for first year = Rate of depreciation multiplied by the beginning book value of the year = 25% * 10,000 = Rs 2,500

Depreciation Methods

3. Units of Production Depreciation Method:

As name suggested, asset is depreciated based on the unit produced over the useful life of the asset.

Depreciation Expense: (Number of unit produced per year / Remaining units to be produced) *(beginning book value – residual value)

Example:  Company XYZ purchases a machinery for Rs 10,000 with useful life of 8 years and residual value of machinery is Rs 1,000. During first year, machinery produced 5 million units out of 100 million units.

Depreciation expense for first year = (5/100)*(10,000 – 1,000) = Rs 450

Depreciation Methods
Pic: Units of production depreciation schedule

Depreciation Methods

4. Sum-of-the-Years-Digits Depreciation Method:

It is one of the most accelerated depreciation methods.

Depreciation Expense: (Remaining life / Sum of the year) *(beginning book value – residual value)

Example:  Company XYZ purchases a machinery for Rs 10,000 with useful life of 8 years and residual value of machinery is Rs 1,000.

Depreciation expense for first year = (8/36)*(10,000 – 1,000) = Rs 2,000

Depreciation Methods
Pic: Sum-of-the-Years-Digits depreciation schedule

Conclusion

Different type of depreciation methods are used for tax and accounting purpose and they have different impact on the net profit of the company. In most of the cases, company uses accelerated depreciation method for tax purpose to reduce taxable income in the initial year of the asset’s life. While company uses straight-line method for accounting purpose and accelerated method for tax purpose, then the difference is reported as deferred tax liability on the company’s balance sheet and it will be eventually paid. Although total depreciation expense over the life of the asset is same for all the depreciation methods, it is the timing of depreciation expense which varies with different methods.

A company may opt to use different depreciation methods over the time and this change is treated as accounting estimate change. In this case, no retrospective changes are required. The accounting estimate change reflects in the current as well as future period.

Author: Gargi D. – Sr. Analyst

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