Depreciation Methods

Depreciation is a terminology commonly used in accounting, economics and finance to distribute the cost of tangible assets over the life of assets. In simple terms, it is a method of attributing the historical or purchase cost of an asset across its useful life, including parameters like usage, passage of time, wear and tear, technological outdating or obsolescence, depletion, inadequacy, etc. The use of depreciation to calculate the current value of an asset affects the financial statements as well as taxes of companies and people. The recording of depreciation causes an expense to get identified, which results in reducing stated profits on the income statement, as well as decline in the net value of the assets on the balanced sheet. However, depreciation reported for accounting and tax purposes may differ considerably.

Methods of Depreciation

Though there are different methods for calculating depreciation which are generally based on either the passage of time or the level of activity (or use) of the asset, below are the three most popular ones, explained with examples.

Straight-Line Method
It is the most commonly used technique, estimated by taking the purchase or acquisition price of an asset deducted by the salvage value and then divided by the total productive years or useful life wherein the asset can be fairly expected to benefit the company. The salvage value is basically an estimate of the value of the asset at the time it will be sold or disposed of. Also known as scrap value or residual value, salvage value arrived at using straight line depreciation method, can be zero or negative also.

Annual depreciation expense = (Cost of fixed asset - Salvage value) / Number of useful years

Example: On April 1, 2010, Company X purchased an instrument at the cost of $200,000. This equipment is estimated to have 5 year reproductive or useful life. By the end of the 5th year, the salvage value (residual value) will be $50,000. Company X recognizes depreciation to the nearest whole month. Calculate the depreciation expenses for the first three years of use of the asset i.e. 2010, 2011 and 2012 using straight line depreciation method.

Depreciation (2010) = ($200,000 - $50,000) x 1/5 x 9/12 = $22,500
Depreciation (2012) = ($200,000 - $50,000) x 1/5 x 12/12 = $30,000
Depreciation (2013) = ($200,000 - $50,000) x 1/5 x 12/12 = $30,000

Declining Balance Depreciation Method
Decline balance is another method of depreciation that allows for larger depreciation amounts during the early life of the asset. The method is beneficial when the asset is expected to generate larger revenues in the early life of the asset, hence causing greater tax deduction to offset the larger income that the asset produces. In this method, the book value is multiplied by a fixed depreciation rate. Book value at the beginning of the depreciation year is the cost of the asset, and later it is equal to the original value minus accumulated depreciation. The most common depreciation rate is double the straight line rate, hence this method is also termed as double declining balance rate.

Example: On April 1, 2010, Company X purchased an equipment at the cost of $200,000. This equipment is estimated to have 5 year reproductive or useful life. At the end of the 5th year, the salvage value (residual value) will be $50,000. Company X recognizes depreciation to the nearest whole month. Calculate the depreciation expenses for the first three years of use of the asset i.e. 2010, 2011 and 2012 using double declining balance depreciation method.

Since the useful life is 5 years, the straight line depreciation rate is 1/5, i.e. 20% per year.

Depreciation rate for double declining balance method
= 20% x 200% = 20% x 2 = 40% per year

Year	Book Value at the Beginning	Depreciation Rate	Depreciation Expense	Book Value at the Year-End
2010	$200,000	40%	$60,000	$140,000
2011	$140,0000	40%	$54,000	$86,000
2012	$86,000	40%	$34,400	$51,600
2013	$51,600	40%	$20,640	$20,960
2014	$20,960	40%	$8,384	$12,578

Sum of the Year's Digits (SYD) Method
The SYD is calculated by evaluating an asset's useful life in years, assigning consecutive numbers to each year, and totaling these numbers. For 'n' years, the simple formula for totaling these numbers is SYD = n(n + 1)/2. The yearly depreciation is then estimated by multiplying the total depreciable amount for the asset's useful life by a fraction having numerator as the remaining useful life and denominator as the SYD.

Annual depreciation = ((Original cost - Salvage value) * Remaining useful life) / SYD

Example: Company X purchased the following asset on January 1, 2011. What is the amount of depreciation expense for the year ended December 31, 2015?

Acquisition cost of the asset = $100,000
Useful life of the asset = 5 years
Residual value or salvage value at the end of useful life = $10,000
Sum of the years' digits = 5(5+1)/2 = 15
Depreciation for 2011 = ($100,000 - $10,000) x 5/15 = $30,000
Depreciation for 2012 = ($100,000 - $10,000) x 4/15 = $24,000
Depreciation for 2013 = ($100,000 - $10,000) x 3/15 = $18,000
Depreciation for 2014 = ($100,000 - $10,000) x 2/15 = $12,000
Depreciation for 2015 = ($100,000 - $10,000) x 1/15 = $6,000

The depreciation method that you employ for any particular asset is fixed at the time you first place it into service. Hence, whatever rules or tables are effective for that particular year must be followed as long as an individual owns the property.