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What are the different types of depreciation methods?
Running a business

What are the different types of depreciation methods?

Depreciation is the accounting process of allocating the original costs of fixed assets such as plant and machinery and equipment over the course of their useful life. It refers to the decline in the value of fixed assets due to their usage or obsolescence or the passage of time. Furthermore, depreciation is a non-cash expense, as it does not involve any outflow of cash. Hence, depreciation as an expense is different from all the other conventional expenses.


However, there are different factors a company must consider in order to calculate depreciation. One such factor is the depreciation method. Companies use different methods in order to calculate depreciation. 

Let’s discuss the different types of depreciation methods and then look at a depreciation example.



The various depreciation methods

Various methods are used by the companies to calculate depreciation. These are as follows:

Types of depreciation methods

  • Straight line (prime cost) depreciation method
  • Diminishing value method
  • Sum of years’ digits method
  • Double declining balance method
  • Sinking fund method
  • Annuity method
  • Insurance policy method
  • Discounted cash flow method
  • Use-based method
  • Output method
  • Working hours method
  • Mileage method
  • Depletion method
  • Revaluation method
  • Group or composite method.
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1. Straight line depreciation method

This is the most commonly used method to calculate depreciation. It is also known as the fixed instalment method. Under this method, an equal amount is charged for depreciation of every fixed asset in each accounting period. This uniform amount is charged until the asset value is reduced to nil or to its salvage value at the end of its estimated useful life.


This method derives its name from a straight line graph. This graph is created from plotting an equal amount of depreciation for each accounting period over the useful life of the asset.

Thus, the amount of depreciation is calculated by dividing the difference between the original cost or book value of the fixed asset and its salvage value by the useful life of the asset.

Straight-line depreciation formula

The formula for annual depreciation under the straight line method is as follows:

Annual depreciation expense = (cost of an asset – salvage value) / useful life of an asset


Where,

  • The cost of the asset is the purchase price or historical cost.
  • The salvage value is value of the asset remaining after its useful life
  • The useful life of the asset is the number of years for which an asset is expected to be used by the business.

2. Diminishing value method

This method is also known as the reducing balance method, the written-down value method or the declining balance method. A fixed percentage of depreciation is charged in each accounting period to the net balance of the fixed asset under this method. This net balance is the value of the asset that remains after deducting the accumulated depreciation.


This means that the depreciation rate is charged to the diminishing value of the asset. This asset is reflected in the books of accounts at the beginning of an accounting period. So, the book value of the asset is written down so as to reduce it to its residual value.

As the book value of the asset reduces every year, so does the amount of depreciation, so a higher amount of depreciation is charged during the early years of the asset as compared to the later stages.

Thus, the method is based on the assumption that more depreciation should be charged in the early years of the asset. This is on account of the low repair cost being incurred in these years. As an asset moves into the later stages of its useful life, the cost of repairs and maintenance of the asset increase. Hence, a smaller amount of depreciation needs to be provided for during these years.

Diminishing value method formula

Depreciation expense = (book value of the asset at the beginning of the year x rate of depreciation) / 100



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3. Sum of years’ digits method

Another accelerated depreciation method is the sum of years’ digits method. This method recognises depreciation at an accelerated rate. Thus, the depreciable amount of an asset is charged to a fraction over different accounting periods under this method.


This fraction is the ratio between the remaining useful life of an asset in a particular period and sum of the years’ digits. Thus, this fraction indicates that the capital blocked or the benefit derived out of the asset is the highest in the first year.

As an asset moves towards the end of its useful life, the benefit gained from the asset declines. That is to say, the highest amount of depreciation is allocated in the first year since no capital has been recovered at that point. The least amount of depreciation should be charged in the last year, as the major portion of capital invested has been recovered.

Sum of years’ digits depreciation formula

The formula for the sum of years’ digits method is as follows:



Depreciation expense = depreciable cost x (remaining useful life of the asset / sum of the years’ digits)

Where depreciable cost = cost of asset – salvage value

Sum of the years’ digits = (n(n +1)) / 2 (where n = useful life of an asset)



4. Double declining balance method

This method is a mix of the straight line and diminishing value methods. Under this method, depreciation is charged on the reduced value of the fixed asset at the beginning of the year. This is just like the diminishing value method, except a fixed rate of depreciation is applied just as in the case of the straight line method. This rate of depreciation is twice the rate charged under the straight line method. Thus, this method leads to an over-depreciated asset at the end of its useful life as compared to the anticipated salvage value.


Companies adopt various approaches in order to overcome challenges like this. For one, the amount of depreciation charged for the last year is adjusted. This is done to make the salvage value equal to the anticipated salvage value. For another, many companies choose to use the straight line depreciation method in the last year to adjust the over-depreciated salvage value.

Double declining balance formula

Annual depreciation expense = 2 x (cost of an asset – salvage value) / useful life of an asset.


Or

Depreciation expense = 2 x cost of the asset x depreciation rate.



Depreciation calculation example

Kapoor Pty Ltd purchased machinery worth $100,000 on 31 March 31 2018. However, in 2018 a new variant of the same machinery comes onto the market due to innovation in technology. As a consequence, the machinery purchased by Kapoor Pty Ltd becomes outdated. This technological innovation causes the value of the old machinery to decline. Say the profit before depreciation and tax for Kapoor Pty. Ltd for the year ended December 2018 is $50,000, and depreciation for the same accounting period is $10,000. The depreciation for plant and machinery is shown as:

Profit before depreciation and tax: $50,000.

(-) Depreciation: $10,000.

Profit before tax: $40,000.

Also Read: A small business owner’s guide to tax depreciation


Factors for estimating depreciation

There are various factors that need to be considered in order to calculate the amount of depreciation to be charged in each accounting period. These include:

Cost of the asset

The cost of the asset is also known as the historical cost. It comprises the purchase price of the fixed asset and the other costs incurred to put the asset into working condition. These costs include freight and transportation, installation cost, commission, insurance, etc.

Salvage value

The salvage value is also known as the net residual value or scrap value. It is the estimated net realisable value of an asset at the end of its useful life. This value is determined as a result of the difference between the sale price and the expenses necessary to dispose of an asset.

Estimated useful life

The commercial or economic life of an asset is called the useful life of an asset. When the useful life of an asset is estimated, its physical life is not taken into consideration. This is because an asset might be in good physical condition after a few years but it may not be useful for production purposes.

Method of depreciation

You need to determine a suitable way to allocate the cost of the asset over the periods during which the asset is used. Generally, the method of depreciation to be used depends upon the patterns of expected benefits obtainable from a given asset. This means that different methods will apply to different types of assets in a company.

However, in reality, companies do not think about the service benefit patterns when selecting a depreciation method. In general, only a single method is applied to all of the company’s depreciable assets.




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