Depreciation Methods
It is expressed as the reduction in the value of a tangible or physical asset over time.
What Are The Depreciation Methods?
Depreciation is expressed as the reduction in the value of a tangible or physical asset over time. Assets such as buildings, plants and machinery, and vehicles are known as tangible assets.
It impacts how profits, taxes, and the book value of assets are calculated, making it an essential component of financial reporting and taxation. Therefore, any business owner or investor must comprehend the various types of depreciation and its effects.
Depreciation is a method to discover how much of the asset's total useful life is already used. In addition, it helps the company to find out how much revenue it has earned for the asset used during the financial period.
Depreciation influences a company's financial statements and tax commitments, so it is a vital topic for investors and business owners to apprehend.
By depreciating assets during their reasonable life, firms can properly recall the worth of their assets and the expenditures associated with their usage. This can also help in decision-making about the replacement or upgrade of assets.
The price of the asset comprises all the charges connected with purchasing and preparing the asset for use, such as shipping fees, installation costs, and legal expenses.
The reasonable life of an asset is the duration during which it is projected to show monetary advantages, such as having income or lowering expenses.
The salvage value of an asset is the evaluated value it will have at the end of its functional life, which is used to determine the final depreciation payment.
Because of depreciation, the cost of assets is not entirely expensed during the year it was purchased. Therefore, the cost of ownership can be divided amongst the asset’s useful life.
Companies depreciate assets for tax purposes and also for accounting purposes. Depreciation can also be compared to the amortization of assets. However, the major difference is that amortization is done for intangible assets.
One can use various depreciation methods as per the suitability of the asset and the situation at that time. Different types of depreciation methods are listed below:
- Straight line method (SLM)
- Written down value method (WDV) or Double declining method (DDM)
- Units of production method
- The sum of digits method
Key Takeaways
- Depreciation is crucial for accurately reflecting the reduction in value of tangible assets over time.
- Depreciation is calculated based on the asset's cost, salvage value, and useful life.
- Depreciation can lower taxable income, leading to reduced tax liabilities for businesses.
- Choosing the appropriate depreciation method depends on factors such as asset type, business goals, and tax considerations.
Understanding Depreciation Methods
Businesses can spread out the expense of an asset throughout its useful life by using depreciation, a widely used accounting technique. So, businesses' financial statements more appropriately represent the underlying value of their assets.
Selecting the best depreciation approach finally comes down to several distinctive measures for the company and the assets. By being conscious of the benefits and weaknesses of each technique, the business can choose the one that best fits your requirements.
Now, a host of factors need to be considered to calculate the amount of depreciation to be charged in each accounting period.
Nevertheless, businesses don't consider the service benefit patterns when choosing a depreciation method. Generally, one technique calculates depreciation on the company's depreciable assets.
Depreciation accounting can be done in various ways, each with pros and cons. We shall examine a few instances of these techniques in detail.
Accounting of Depreciation
Depreciation is a non-cash item on a company's financial statements. Therefore, a company does not make a cash outflow when depreciation is recorded. Regardless, it impacts a company's cash flow and profits.
Companies can use any depreciation method to allocate an asset's cost proportionally. The income statement shows the monthly and annual expenses of depreciation. The accumulated depreciation is recorded on the company's balance sheet.
Assume ABC purchased manufacturing equipment for $200,000.00. The company estimates a useful life of ten years. So yearly depreciation would amount to $ 20,000 and be debited to the profit and loss account.
Furthermore, the company employs a straightforward straight-line depreciation method. For simplicity's sake, assume the equipment's salvage value is zero after ten years.
Depreciation helps the company move the assets cost from the balance sheet to the income statement. Which otherwise would be only in the balance sheet because the cash is decreased and assets increase.
Note
As mentioned above, providing depreciation on the asset has tax benefits. It increases the expenses and reduces the taxable income on the income statement. Hence, paying fewer taxes to the government.
There are two parts to the asset side when one records depreciation on an asset.
- Net Block: The netblock is the net amount depicted on the balance sheet after subtracting depreciation.
- Gross Block: The netblock plus the total depreciation is the gross block.
Methods of Depreciation
There are various types and methods of providing depreciation expense in the books of accounts. The most common are listed below:
Units Of Production Method
As the name suggests, the units of production method uses a unique way to apply depreciation to the asset only by the number of units produced over its useful life during the financial year.
The appropriate time to use this method is when the asset's value lies in the number of units produced or hours used rather than its lifespan.
The formula for the Units of Production method can be written as follows:
Depreciation expense = (Asset’s cost - Salvage value) / Estimated number of units the asset can produce over its lifetime X Total units produced
Straight line method (SLM)
The most popular and straightforward way of determining depreciation expense is straight-line depreciation. For the course of the asset's useful life, the expense amount stays constant under straight-line depreciation.
This method's calculated depreciation must be expensed throughout the asset's anticipated useful life.
The formula for using the straight-line method is given below:
Depreciation Expense = (Asset’s Cost - Salvage Value) / Total useful life of the asset
Double Declining Method (DDM)
This method results in the most conservative type of depreciation accounting compared to the other three methods. As a result, this helps maximize tax advantage in the early years of the asset's useful life.
The strategy considers the practical truth that any asset (think of buying a car) loses more of its value in the first few years of use and that assets are normally more productive in their early years than in their later years.
This strategy is frequently applied when an item is anticipated to lose value or be more useful in the early years. Also, it facilitates the realization of a higher gain when the asset is sold.
As the name suggests, the double declining method provides double the depreciation compared to the straight-line method. The formula for the double declining method is given below:
Depreciation Expense = Opening Book Value X Rate of Depreciation X 2
Note
Here, the rate of depreciation is calculated as 1/ useful life of the asset.
Sum Of The Year's Digits Method
One of the techniques for accelerated depreciation is the sum-of-the-years-digits method. Early in the asset's useful life, expenses are higher; later on in the asset's useful life, expenses are lower.
The remaining life of an asset is divided by the total number of years in the sum-of-the-years digits depreciation technique, and the result is multiplied by the depreciating base to produce the depreciation expense.
This method is less aggressive than the double declining method. The formula for the sum of year’s digits method is given below:
Depreciation Expense = (Asset’s Cost – Salvage value) X (Remaining life / Sum of the year's digits)
Note
Here, the sum of digits is referred to as the total sum of the useful life of the asset. For example, if the total useful life of the asset is 6 years, then the sum of the years digit would be equal to 6 + 5 + 4 + 3 + 2 + 1 = 21.
Depreciation Methods Examples
Company XYZ Inc. recently purchased a plastic injection molding machine for $ 500,000. The estimated salvage value of the machine was $ 50,000. The company estimated its useful life to be 20 years.
Let us demonstrate how various depreciation methods will work in the above-given example.
Straight line method (SLM)
The formula for the straight-line method is:
Depreciation Expense = (Asset’s Cost - Salvage Value) / The total useful life of the asset
Depreciation expense = (500,000 - 50,000)/ 20 = $ 22,500
Under the straight-line method, the company would record a yearly depreciation expense of $ 22,500.
Double declining method (DDM)
The formula for the double declining method is:
Depreciation Expense = Opening Book Value X Rate of Depreciation X 2
Let us first calculate the rate of depreciation.
Rate of Depreciation = 1/ Useful life of the asset
= 1/ 20 X 100 = 5%
Now that we have the depreciation rate let us calculate the depreciation expense.
Depreciation Expense = Opening Book Value X Rate of Depreciation
= 500,000 X 5% X 2= $ 50,000
The depreciation expense for the first year under this method is $ 50,000. Subsequently, when one calculates the depreciation expense for the next year, it will be equal to (450,000 X 5% X 2 = $ 45,000) and so on.
Units Of Production Method
For the sake of calculation, let us assume that the machine has a production capacity of 100,000 units during its lifetime and the company is going to produce 15,000 units during this year.
The formula for the units of production method is:
Depreciation expense = (Asset’s cost - Salvage value) / Estimated number of units the asset can produce over its lifetime. X Total units produced.
Depreciation expense = (500,000 - 50,000)/ 100,000 X 15,000 = $ 67,500.
Under the units of production method, XYZ Inc. would record a depreciation expense of $ 67,500 for this year. The depreciation expense would vary on the number of units produced during the year.
Sum Of Years Digits’ Method
The formula for the sum of years digits method is:
Depreciation Expense = (Asset’s Cost – Salvage value) X (Remaining life / Sum of the years)
The sum of the year’s digits(SYD) = total of the useful life of the asset
SYD = 20 + 19 + 18 + 17 + 16 + 15 + 14 + 13 + 12 + 11 + 10 + 9 + 8 + 7 + 6 + 5 + 4 + 3 + 2 + 1 = 210
Depreciation expense = (500,000 - 50,000) X (20/ 210) = $ 42,857.143
As we can see, the depreciation expense for the first year is $ 42,857. This tells us that even though this method is very aggressive in terms of accounting, it is a little less aggressive than the double declining method.
Conclusion
For firms to appropriately reflect the value of tangible assets over time, depreciation methodologies are essential.
Businesses can efficiently spread out the expense of assets and match financial reporting with the underlying worth of their assets by utilising a variety of depreciation methodologies, including straight-line, double declining, units of production, and sum of the digits.
These techniques affect tax responsibilities and financial statements, but they also have an effect on decisions about asset replacement and management.
To effectively analyze financial statements and make judgments, investors, business owners, and financial professionals need to understand the subtleties of depreciation procedures.
All things considered, depreciation methods are an essential instrument for financial management since they guarantee the efficiency, correctness, and transparency of accounting procedures.
Depreciation Methods FAQs
Because it is the simplest to utilize, the straight-line depreciation approach simplifies accounting calculations. On the other hand, the declining balance method frequently offers a more accurate accounting of an asset's value.
DDM stands for double declining method. This method is the most aggressive method for depreciation accounting.
NBV stands for net book value. The asset value after subtracting depreciation is known as the asset's net book value.
The formulas are:
Book value of an asset = Total cost of the asset - Accumulated depreciation.
Book value of a company = Assets - liabilities.
Each year, a portion of the asset is debited to the depreciation expense account and credited to the accumulated depreciation account with the identical amount.
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