# What is Depreciation? What are the Methods of Depreciation?

### Topic Overview

• Depreciation is the allocation of fixed cost over its useful
• Depreciation rate can be changed due to rapid changes in technology
• There are five methods of depreciation.
• Straight line method and Reducing balancing method commonly using
• If cost falls below the salvage value/residual value, depreciation application will be stopped.

### What is Depreciation?

Depreciation is the allocation of the cost of non-current assets (fixed assets) over its useful life. Normally accountants charge depreciation on fixed assets (other than land) in calculating profit & loss of business or profession.

Depreciation can be varied for rapid changes in technology.

### Methods of Depreciation

There are five methods of Depreciation, such as:

• Straight-line method
• Unit of Production Method
• Reducing balancing method
• Double declining balance method
• Sum-of the year’s Digits method

### Straight-Line Method

Straight-line depreciation method is the simplest and most commonly used depreciation method. In this methods, firstly the company estimate its residual value which is also known as salvage value, scrap value etc of the end of the asset’s life. The residual value may be Zero or even negative due to costs required to retire it. But, usually, the residual value never considers below zero. Under this method, the company will charge equal depreciation amount each year over the lifetime of the asset.

The formula of this method are as follows:

Annual Depreciation = Cost of Assets – Residual value/ Useful life of assets (years)

Example:

Western Marine purchased a vehicle at a cost of \$ 40,000. The lifetime of the assets is estimated 5 years with a residual value \$2000. What will be the annual depreciation in this respect?

The company uses Straight-line depreciation method.

Solution:

Annual Depreciation = Cost – Residual value/Asset Life = 40,000-2000/5 = \$7,600 p.a.

Hence, the company will charge annual depreciation @ \$ 7,600 against its revenue to calculate profit.

### Unit of Production Method

This method provides for depreciation by means of a fixed per unit of production. Under this method, firstly cost per unit of production to be determined and multiply it with the total number of units the company produced within an accounting period to determine its depreciation expenses.

The formula of this method

= (Cost-Salvage value/Lifetime produced units) * Number of units produced in the accounting year

Example:

Western Marine purchased a vehicle at a cost of \$ 40,000. The lifetime of the assets is estimated 5 years and estimated lifetime production is 50,000 units with a residual value \$2000.During this year the total produced units are 7,500 units. What will be the annual depreciation in this respect?

The company uses Units of production depreciation method.

Solution:

Depreciation is = (40,000-2,000)/50,000 units * 7,500 = 38,000/50,000 units * 7,500 = \$5,700

Hence, Depreciation expenses for the year are \$5,700/-

### Reducing Balancing Method

Reducing Balancing Method commonly known as Written Down Value method (WDV) where the maximum portion of depreciation charges in earlier years. This is the method where depreciation is not charged equally, rather it is charged on decreasing value of an asset.

Example:

Western Marine purchased a vehicle at a cost of \$ 40,000. The lifetime of the assets is estimated 5 years with a residual value \$2000. The depreciation rate is estimated @ 25%. What will be the annual depreciation in this respect?

The company uses Reducing Balancing depreciation method.

Solution:

Year – 1: Depreciation Expenses = (Cost – Residual value) * 25% = \$(40,000-2,000)*25% = \$9,500

Written down value \$(40,000 – 9,500) = \$30,500

Year – 2: Depreciation Expenses = (WDV – 2,000) * 25% = \$(30,500 – 2,000) * 25% = \$7,125

Written down value \$(30,500 – 7,125) = \$23,3375

Year – 3: Depreciation Expenses = (WDV – 2,000) * 25% = \$(23,375 – 2,000) * 25% = \$5,344

Written down value \$(23,375 – 5,344) = \$18,031

Year – 4: Depreciation Expenses = (WDV – 2,000) * 25% = \$(18,031 – 2,000) * 25% = \$4,008

Written down value \$(18,031 – 4,008) = \$ 14,023

Year – 5: Depreciation Expenses = (WDV – 2,000) * 25% = \$ (14,023-2000) * 25% = \$3,006

Balancing allowance ( as lat year of the assets) = (14,023 – 2,000 -3,006) = \$9,017

### Double Declining Balance method

This method simply doubles the straight line deprecition rate. Say, if Straight line method depreciation rate is 25%, the double declining rate will be (25*2) = 50%.

Example:

Western Marine purchased a vehicle at a cost of \$ 40,000. The lifetime of the assets is estimated 5 years. The salvage value of the asset is \$2,000 at the end of 5 years. What will be the annual depreciation in this respect?

The company uses Double Declining Balance depreciation method.

Solution:

Asset Lifetime is 5 years. Hence, Depreciation rate is 100% / 5years = 20%

Make it double = (20% * 2) = 40%

This 40% is the Depreciation rate.

Year 1:  Depreciable value \$40,000

Annual Depreciation is \$(40,000 * 40%) = \$16,000

Year 2:  Depreciable Value \$(40,000 – 16,000)    = \$ 24,000

Annual Depreciation is \$ 24,000 * 40%  = \$ 9,600

Year 3:  Depreciable value    \$ (24,000 – 9,600)   = \$ 14,400

Annual Depreciation is \$ 14,400 * 40%   = \$ 5,760

Year 4:   Depreciable value   \$ (14,400 – 5,760)    = \$ 8,640

Annual Depreciation \$ 8,640 * 40%       = \$ 3,456

Year 5:  Depreciable value \$ (8,640 – 2,000 – 3,456) = \$3,184

Depreciation is \$ 3,184 * 40% = \$1,274

### Sum of the Digits year Method

Sum of the digits year method is the accelerated method for calculating the depreciation. This method falls the asset’s expected life and adds together the digits for each year.

Example:

Western Marine purchased a vehicle at a cost of \$ 40,000. The lifetime of the assets is estimated 5 years. The salvage value of the asset is \$2,000 at the end of 5 years. What will be the annual depreciation in this respect?

Solution:

As lifetime is 5 years, the sum of digits will be = 5+4+3+2+1 = 15

Year 1: Depreciation Expenses = \$(40,000 – 2,000)/15 * 5 = \$12,667

Year 2: Depreciation Expenses =\$(40,000 – 2,000)/15 * 4 = \$10,133

Year 3: Depreciation Expenses =\$(40,000 – 2,000)/15 * 3 =   \$7,600

Year 4: Depreciation Expenses =\$(40,000 – 2,000)/15 * 2 =    \$5,067

Year 5: Depreciation Expenses =\$(40,000 – 2,000)/15 * 1 =    \$2,533

# Point to be noted that you will stop accumualting depreciation if cost falls below the salvage value.