4 Common Depreciation Methods and Applications

What Are the Different Ways to Calculate Depreciation?
  • Depreciation accounts for decreases in the value of a company’s assets over time. …
  • The four depreciation methods include straight-line, declining balance, sum-of-the-years’ digits, and units of production.

Depreciation Methods: Straight Line, Double Declining & Units of Production

What is depreciation?

Once a business chooses a depreciation method, it is typically required to continue using that method moving forward for that specific asset. To change it, previous financial statements that were submitted would need to be revised.

Methods to calculate depreciation

According to the asset and the purpose of the depreciation, the following four common methods are used to calculate depreciation:

1. Straight-line depreciation

The straight-line method is frequently used to determine the average value decline over a time period. The most popular and straightforward method for calculating depreciation is this one. The straight-line method of depreciation targets assets like vehicles, office equipment, computers, and office buildings.

You need to know the asset’s depreciable base (its initial cost) and its salvage value (what the asset will be worth when its useful life is over) in order to calculate the straight-line method. Subtract the salvage value from the initial. Subtract the total from the asset’s estimated useful life. Until the asset is fully depreciated or its salvage value is reached, the sum should remain constant year after year.

As an illustration, a business spends $20,000 to purchase a truck that it expects to use for five years and has no salvage value. Divide the asset’s cost ($20,000) by its estimated life (five years) to get the straight-line depreciation amount ($4,000). Using this method, the asset will be worth $16,000 at the beginning of the following year after the first year’s depreciation of $4,000 has been applied. This keeps happening every year, using $4,000 to reduce the book value to $12,000 This continues through the fifth year or until the asset has depreciated fully.

The fractional period depreciation is a variant of the straight-line calculation. Assets purchased in the middle of the year are depreciated using the fractional period method. In this instance, a portion of the straight-line method is used in the partial period calculation to value the asset.

Example: In April, a construction company spends $20,000 on a piece of equipment. The business chooses to record depreciation for the nine months the tractor was in use because they didn’t use it for the entire year. By dividing the yearly depreciation ($4,000) by nine months to get $2,997 for the partial year, they can figure out the straight-line depreciation method.

2. Declining balance and double-declining balance method

The declining balance method is predicated on the idea that an asset will increase in value initially before declining over time. Depreciation in this instance decreases over time until it reaches salvage value or complete depreciation. This strategy can be used by new businesses or those who anticipate lower first-year revenue to reduce their tax burden by claiming higher depreciation expenses.

Some businesses may employ double-declining balance techniques, which accelerate depreciation. For the depreciation of computers, mobile phones, and other technological products that can quickly become obsolete, the declining balance method is frequently used.

An illustration would be a research firm that spends $100,000 on a powerful microscope and decides to depreciate it using the declining balance method because it may become outdated in five years. They arrive at $200,000 by multiplying the asset’s value ($100,000) by one (the depreciation rate). In order to arrive at $40,000 for the first-year depreciation, they then divide $200,000 by the lifespan of the microscope (five years). The beginning book balance is now $60,000 ($100,000 – $40,000) after repeating the calculation for the second year. Depreciation would be $24,000 in year two, or $60,000 multiplied by 1 and divided by five.

3. Units of production

A company may select this approach in some industries, such as those that employ production machinery, based on how the machine produces In this instance, higher production entails higher costs, so the depreciation method is appropriate given those circumstances. Divide the asset’s value (after deducting its residual value) by its life in units to determine depreciation.

As an illustration, a company that sells bottled water has a bottle-capping machine that costs $100,000, has a residual value of $5,000, and will eventually cap 95,000 bottles. They divide the machine’s lifetime per unit ($95,000 divided by 95,000 = $1 per unit) by the machine’s value less the residual value ($100,000 – $5,000). The machine caps 10,000 bottles or units in the first year at a cost of $1 each, resulting in a first-year depreciation of $10,000.

4. Sum of years digits (SYD)

Depreciation is calculated using the sum of the years at a rate that is quicker than the straight-line method but slower than the declining balance method. Early years see higher depreciation costs, and later years see a decline. When an asset will lose the majority of its value near the start of its useful life, it is most beneficial. Divide the asset’s remaining life by the total number of years it is expected to be useful to calculate the total number of years. Then multiply by the depreciation base to determine the expense.

Example: A photographer has a $10,000 camera that she plans to use for five years and expects it to have no residual value. The years are first added together to determine the depreciation rate: 1 + 2 + 3 + 4 + 5 = 15. She then divides the total number of years (15) by the value of the asset ($10,000) to arrive at the fifth years’ expense ($3,333).

She deducts the depreciation cost from the $10,000 book value, leaving a balance of $6,667. She then calculates year four using the same method, but divides the asset value by four years rather than five, and moves on to year one.

FAQ

What are the 5 depreciation methods?

Several different depreciation techniques are covered in your intermediate accounting textbook. Three are based on time: straight-line, declining-balance, and sum-of-the-years’ digits.

What are the 9 methods of depreciation?

Five methods are used by businesses to calculate asset depreciation: straight-line, declining balance, double-declining balance, units of production, and sum-of-years-digits.

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