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October 03, 2019

The 4 Methods of Depreciation with Examples

October 03, 2019


Depreciation is an allocation of fixed asset. The fixed asset may be furniture, equipment, building, machinery, vehicle and land that are purchased for long term use. The land is only the fixed asset which is not depreciated as value of the land increases with passage of time.  The fixed assets are appeared on the balance sheet. Given below are some technical terms which should be learnt before going to the methods of depreciation.


Methods of depreciation

Cost of fixed asset: The cost of fixed asset includes purchase price, taxes, transportation, installation, testing and other costs incurred for putting the fixed asset in use. 

Estimated life: It is an estimate number of years for the asset to remain in service. The useful life of the asset is used to determine depreciation.

Salvage Value: It is the estimated resale value of an asset after its useful life. The salvage value is used to calculate depreciation. It is also known as scrap value or residual value.

Allowance for depreciation:  It is the total amount of depreciation that has been recorded for an asset since its date of purchase.  The allowance for depreciation is also known as accumulated depreciation. 

Book Value:  The book value is calculated by extracting allowance for depreciation from the original cost of fixed asset.

Methods of Depreciation


There are four main methods of depreciation that are listed below.

1. Straight Line Method
2. Diminishing Balance Method
3. Sum of Years’ Digits Method
4. Units Production Method

1. Straight Line Method


The straight line is the simplest and commonly used depreciation method.  The straight line method provides same amount of depreciation each year. Given below is the formula of straight line method:

Formula:
Depreciation expense = Cost - salvage value /   Useful life

Example:
Suppose, a manufacturing firm acquires a plant for Rs. 1000,000 in January 01, 2020. The estimated life of the plant is ten years and the scrap value is Rs. 80,000. So the depreciation expense would be calculated as:

Depreciation expense =  1000,000  -  80,000  /  10  =  Rs. 92000    

Thus manufacturing firm will take Rs. 92,000 depreciation expense each year as shown below.

Method of depreciation: Straight line method

2.  Diminishing Balance Method



Under diminishing balance method, depreciation is charged at a fixed percentage on the book value of the asset. In this method the amount of depreciation reduces every year. This method is also known as written down value method. Given below is the formula of diminishing balance method:

Formula:
Depreciation expense = Book value x Rate%

Example:
Suppose, a manufacturing company purchases a machinery for Rs. 1400,000 in January 01, 2020. The estimated life of the machinery is ten years. The company uses diminishing balance method in order to determine depreciation expense with the rate of 20%.  The depreciation expense for 10 years would be calculated as shown below:

Method of depreciation: Diminishing balance method


3. Sum of Years’ Digits Method


Sum of the years’ digits method is the accelerated depreciation technique which is based on the assumption that productivity of the assets decreases as they become old. In simple words, this method attempts to charge a higher depreciation expense in early years of the asset because the asset is more productive when it is new. Given below is the formula of sum of the years’ digits method:

Formula:
Depreciation expense = Depreciable cost    x    Remaining Life    /    Digits

Depreciable cost =  Cost  -  Salvage Value

Digits = (n + 1)  x  n/2

n = estimated life

Example:
Suppose, a manufacturing firm acquires a machinery for Rs. 600,000 in January 01, 2020. The estimated life of the machinery is ten years and the salvage value is Rs. 50,000. The company uses sum of the years’ digits method for determination of depreciation. The depreciation expense for 10 years would be calculated as shown below:


Method of depreciation: Sum of years' digits method


4. Units Production Method


Units production method depreciates asset’s value based on the total number of units expected to produce over its useful life. Thus, the depreciation will expense will be high, if the asset is heavily used. The useful life of the asset is estimated in terms of number of units that is expected to produce or working hours rather than numbers of years. This method is also known as units of activity method. Given below is the formula of it:

Formula:
Depreciation expense =    Per unit depreciable cost    x    Units produced

Per unit depreciable cost = Cost - Salvage Value    /    Life in units

Example:
ABC company purchase a machinery for Rs. 500000 with a useful life of 400000 units and salvage value is Rs. 50000. It produces 20000 units. The depreciation expense would be:

Step 1:
Per unit depreciable cost  =  500000  -  50000   /   400000

Per unit depreciable cost  =  1.125

Step 2:
Depreciation expense  =  1.125  x  20000

Depreciation expense  =  22500

It is not restricted by GAAP or the IFRS to use a specified depreciation method for the assets of the organization. It depends on the organization to use the method of its own choice. It is also not necessary to use only one method for all of the assets. However, it is required to use a method that will depreciate the value of the asset.

While applying any of the method including straight line, diminishing balance, or sum of years’ digits method, the period of usage should be considered. If the asset is used only for three months in a year, the depreciation will be calculated only for three months. It so because these three depreciation methods provides yearly depreciation.  
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