Depreciation is the accounting process of converting the original costs of fixed assets such as plant and machinery, equipment etc into expense. It refers to the decline in the value of fixed assets due to their usage, passage of time or obsolescence.
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 considered by a company in order to calculate depreciation. One such factor is the depreciation method. Thus, companies use different depreciation methods in order to calculate depreciation. So, let’s consider a depreciation example before discussing the different types of depreciation methods.
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Depreciation Calculation Example
Kapoor Pvt Ltd. purchased a machinery worth Rs. 1,00,000 on March 31st, 2018. However, in 2018 a new variant of the same machinery comes into the market due to innovation in technology. As a consequence, the machinery purchased by Kapoor Pvt. Ltd. becomes outdated. This technological innovation causes the value of the old machinery to decline. Say, the profit before depreciation and tax for Kapoor Pvt. Ltd for the year ended December 2018 is Rs.50,000. And depreciation for the same accounting period is Rs. 10,000. Hence, depreciation for plant and machinery is shown as under:
Profit before depreciation and tax Rs. 50,000
(-) Depreciation Rs. 10,000
Profit Before Tax Rs. 40,000
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Factors for Estimating Depreciation
Now, there are a host of 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 of 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 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 result of the difference between sale price and the expenses necessary to dispose off an asset.
Estimated Useful Life
The commercial or economic life of an asset is termed as the useful life of an asset. Now, for estimating useful life of an asset, its physical life is not taken into consideration. This is because an asset might be in a good physical condition after few years but it may not be used for production purposes.
Method of Depreciation
You need to determine a suitable way to allocate 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, different methods would 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 for all of the company’s depreciable assets.
Various Depreciation Methods
Various methods are used by the companies to calculate depreciation. These are as follows:
Various Depreciation Methods
- Straight Line Depreciation Method
- Diminishing Balance 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
- Other Methods
- Depletion Method
- Revaluation Method
- Group or Composite Method
1. Straight Line Depreciation Method
This is the most commonly used method to calculate depreciation. It is also known as fixed instalment method. Under this method, an equal amount is charged for depreciation of every fixed asset in each of the accounting periods. This uniform amount is charged until the asset gets reduced to nil or its salvage value at the end of its estimated useful life.
So, this method derives its name from a straight line graph. This graph is deduced after 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 simply dividing the difference of original cost or book value of the fixed asset and the salvage value by useful life of the asset.
Straight Line Depreciation Formula
The formula for annual depreciation under straight line method is as follows:
Annual Depreciation Expense = (Cost of an asset – Salvage Value)/Useful life of an asset
- Cost of the asset is purchase price or historical cost
- Salvage value is value of the asset remaining after its useful life
- Useful life of the asset is the number of years for which an asset is expected to be used by the business
2. Diminishing Balance Method
This method is also known as reducing balance method, written down value method or 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 nothing but the value of asset that remains after deducting accumulated depreciation.
Thus, it means that depreciation rate is charged on the reducing balance of the asset. This asset is the one 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 to reduce it to its residual value.
Now, as the book value of the asset reduces every year so does the amount of depreciation. Accordingly, 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 amount of depreciation should be charged in early years of the asset. This is on account of low repair cost being incurred in such years. As an asset forays into later stages of its useful life, the cost of repairs and maintenance of such an asset increase. Hence, less amount of depreciation needs to be provided during such years.
Diminishing Balance Method Formula
Depreciation Expense = (Book value of asset at beginning of the year x Rate of Depreciation)/100
3. Sum of Years’ Digits Method
Another accelerated depreciation method is the Sum of Years’ Digits Method. This method recognizes 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.
So, as an asset moves towards the end of its useful life, the benefit gained out of such an asset declines. That is to say, highest amount of depreciation is allocated in the first year since no amount of capital has been recovered till then. Accordingly, least amount of depreciation should be charged in the last year as major portion of capital invested has been recovered.
Sum of Years’ Digits Depreciation Formula
Following is the formula for sum of years’ digits method.
Depreciation Expense = Depreciable Cost x (Remaining useful life of the asset/Sum of Years’ Digits
Where depreciable cost = Cost of asset – Salvage Value
Sum of years’ digits = (n(n +1))/2 (where n = useful life of an asset)
4. Double Declining Balance Method
This method is a mix of straight line and diminishing balance method. Thus, depreciation is charged on the reduced value of the fixed asset in the beginning of the year under this method. This is just like the diminishing balance method. However, a fixed rate of depreciation is applied just as in case of straight line method. This rate of depreciation is twice the rate charged under 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.
Therefore, companies adopt various approaches in order to overcome such a challenge. Firstly, the amount of depreciation charged for the last year is adjusted. This is done to make salvage value equal to the anticipated salvage value. Secondly, many companies choose to use 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
Depreciation Expense = 2 x Cost of the asset x depreciation rate
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