Depreciation Methods: Check Formula, Factors & Types

Depreciation Methods: Check Formula, Factors & Types

Depreciation, according to the Oxford Dictionary, denotes a decrease in an asset's value over time, particularly due to wear.

This phrase refers to an accounting technique used to determine the cost of a physical asset, such as machinery such as lathes, mills, grinders, etc., during the course of its useful life in industry. 

It demonstrates the extent to which an asset's value has been utilized—paying for a specific amount of time enables businesses to get more from their assets.

The income statement for practically every firm includes depreciation. Since it is recorded as an expense, it should be considered anytime an item is computed for year-end tax purposes or to assess whether it is still viable for liquidation.

When a fixed asset is employed in the course of routine company activities, depreciation signifies the periodic, planned conversion of the asset into a cost. 

Depreciation is viewed as an operational expenditure since the asset is a necessary component of daily business activities.

TYPES OF DEPRECIATION

As this is a major factor for revenue, the company should have great control over depreciation, and it must be calculated in a very skilful manner. 

These depreciation methods directly affect the company's finances. There are generally four methods of depreciation calculation, and they should be chosen wisely.

  1. Straight-line depreciation
  2. Units of production depreciation
  3. Double declining balance depreciation
  4. Sum of the year’s depreciation
  5. Year-to-date totals

1. DEPRECIATION OF STRAIGHT LINES

The simplest and most popular approach is straight-line depreciation. By dividing the difference between the asset's cost and estimated salvage value by the number of years remaining in the asset's anticipated usable life, one may compute the straight-line depreciation. 

(The salvage value may be zero or even negative due to costs associated with retiring it; nevertheless, the salvage value is often not estimated below zero for depreciation reasons.)

Once the asset's worth has dropped from its initial cost to its salvage value, the corporation will deduct the same amount from it annually over that period.

The formula for Depreciation Costs is

DEPRICIATION EXPENSE=COST OF ASSET-SCRAP VALUEOF ASSETUSEFUL LIFE OF ASSET

It is most commonly used for equipment that depreciates slowly over time. 

For instance, a lathe machine in a certain industry slowly loses value due to characteristics like accuracy, product quality, and precision.

Benefits: It equally distributes the cost throughout each accounting period. Most accounting software makes it simple to automate the adjusting entry for straight-line depreciation.

Cons: Estimating the asset's useful life takes speculation. A mathematical error might cause the asset to be overpriced for several years.

2. INDUSTRIAL FACILITY DEPRECIATION

Depreciation deductions are calculated to be greater in years when the asset is heavily used. 

Another consideration is the amount that a piece of machinery or equipment can generate.

This approach is widely used to manufacture machines such as lathes and milling machines, which are anticipated to produce a fixed number of products before becoming outdated.

DEPRICIATION EXPENSE=no.of units produced life of asset in units(cost of asset-scrap value of asset)

3. THE SINKING BALANCE'S DEPRECIATION DOUBLED.

The process of deteriorating balance is another name for it. An asset's accelerated rate of depreciation compared to its non-depreciated balance during the asset's early years of useful life is calculated using the double-declining-balance technique. 

When using the double-declining-balance methodology, the salvage value is not considered when predicting yearly depreciation. 

Still, regardless of the method chosen, the book value of the item being depreciated is never reduced below its salvage value. 

Depreciation comes to an end when the asset's useful life or salvage value is reached.

Because double-declining-balance depreciation does not always fully depreciate an object by the end of its useful life, some methods compute a straight-line depreciation each year and utilize the greater of the two. 

This leads to a midpoint shift from a declining balance to straight-line depreciation for the asset. 

The double-declining-balance approach also more accurately portrays how automobiles deteriorate and may match cost with asset utilization gain. 

In the future, the company may want to use as little depreciation as possible to offset new expenses.

FORMULA

(100% / Life of asset = Depreciation rate) x 2

Vehicles and other assets that depreciate rapidly are frequently employed. It is the easiest way to depreciate a thing.

Pros: More exactly represents the loss of value of some assets than straight-line depreciation.

The computations are more challenging than with the other approaches. Most accelerated processes users will create a depreciation schedule - a table that depicts the depreciation expense for each year of the asset's life — so they only have to complete the calculations once.

4. THE TOTAL OF THE YEAR'S DEPRECIATION

Sum-of-years-digits is a spent depreciation technique that produces a faster write-off than the straight-line approach and, in most cases, a faster write-off than the decreasing balance method. 

The yearly depreciation is calculated by multiplying the depreciable cost by a fractional schedule.

One of the accelerated depreciation approaches is the sum of the years' digits method, which is based on the idea that assets are typically more productive while they are new, and their productivity falls as they age.

FORMULA

DEPRECIATION EXPENSE=REMAINING LIFE OF THE ASSETSUM OF THE YEAR'SDIGITS (COST OF THE ASSET-SCRAP VALUE OF THE ASSET)

Used most frequently for: Obsolete assets, sometimes referred to as assets that may soon become obsolete. 

Inventory that has reached the end of its useful life is referred to as obsolete inventory. 

It has been a while since this inventory was used or sold, and it is doubtful that it will be shortly. 

This kind of inventory has to be written down or written off, which can cause a corporation to incur significant losses.

Benefits: Based on an item's useful life, you may determine the number of years you wish to depreciate it. You can manage your monthly depreciation expenditures thanks to this.

6. YEAR-TO-DATE TOTALS

Depreciation happens at a higher pace than the straight-line technique, but at a slower rate than the decreasing balance approach, according to the sum of years. 

Depreciation expenditure is higher in the early years and decreases later. The value of an asset decreases as it approaches the end of its useful life. 

To account for this, you assign maximum depreciation in the first year because you have not yet recovered your investment in the asset. 

With the growth in years, the asset frequently recovers most of its original investment; therefore, it does not depreciate as much.

FORMULA

Depreciation expenditure = depreciable cost x (asset's remaining useful life/sum of years' digits)

Depreciable cost = asset cost less salvage value

The sum of the digits of the years equals (n(n +1))/2, where n is the usable life of an item.

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Factors affecting Depreciation

Numerous factors influence the rate of depreciation. We'll look at a few of them now. 

The following are the four primary criteria to take into account while determining depreciation expense:

The asset's price.

The asset's projected salvage value. Salvage value, often referred to as residual value, is the sum of money that a corporation anticipates making when an asset is sold, traded in, or destroyed, less the costs associated with disposal.

Estimated asset's usable life The period that a business intends to employ an asset is referred to as the useful life. 

In terms of years, months, working hours, or generated units, useful life can be stated.

When estimating an asset's useful life, obsolescence should be taken into account since it will change how depreciation is calculated. 

For instance, a machine that can produce units for 20 years could become outdated after six years; in this scenario, the asset's useful life is six years.

Frequently Asked Questions

  • What is depreciation?

A tangible or physical item's cost can be distributed over the course of its useful life using the accounting concept of depreciation. The amount of value that has been depleted from an asset is measured by depreciation. It enables companies to purchase and generate income from assets over time.

  • What are methods of depreciation?
  1. Straight-line depreciation
  2. Units of production depreciation
  3. Double declining balance depreciation
  4. Sum of the year’s depreciation
  5. Year-to-date totals
  • What is a formula for depreciation?

DEPRICIATION EXPENSE=COST OF ASSET-SCRAP VALUEOF ASSETUSEFUL LIFE OF ASSET

  • What are the factors of depreciation?

The cost of the asset, Life of the asset, and Maturity are the factors of depreciation.

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