Depreciation is an accounting method that considers the initial cost or value of an item, what it may be worth at the end of its life and how its value changes over time. Instead of writing off an asset as a deduction, which can devalue the asset, depreciation recognizes the assets usefulness over time and how the asset changes with use.
Calculating depreciation depends on the asset, its use and expected lifetime. In this article, we detail the main methods to calculate depreciation and determine the value of the asset. Depreciation is the state in which a tangible asset declines in value over time due to the type of use, frequency of use or obsolescence. In order to choose a depreciation method, it's important to consider the asset and how it's used in the industry. Since depreciation methods can affect both the book value as well as revenue, the various methods address different circumstances in order to calculate depreciation favorably.
Related: What Is an Asset? Here are five common methods used to calculate depreciation depending on the asset and the intent of the depreciation:.
The straight-line method is typically used to calculate an average decline in value over a period of time. The straight-line method is commonly used and is considered the simplest method to calculate depreciation. Depreciation targets assets such as vehicles, office furniture, computers and office buildings using the straight-line method.
To calculate the straight-line method, divide the asset's depreciable base its initial cost subtracted by its salvage value the asset's worth at the end of its useful life and divided by its service life usefulness and is the same amount every year until the asset reaches the salvage value or full depreciation. This continues until the asset reaches full depreciation or the fifth year.
Assets acquired in the middle of the year use the fractional period depreciation application. In this case, the partial period calculation uses a fraction of the straight-line method to value the asset.
Under this method, an equal amount is charged for depreciation of every fixed asset in each of the accounting periods. This uniform amount is charged until the asset gets reduced to nil or its salvage value at the end of its estimated useful life. So, this method derives its name from a straight line graph. This graph is deduced after plotting an equal amount of depreciation for each accounting period over the useful life of the asset.
Thus, the amount of depreciation is calculated by simply dividing the difference of original cost or book value of the fixed asset and the salvage value by useful life of the asset. This method is also known as reducing balance method, written down value method or declining balance method.
A fixed percentage of depreciation is charged in each accounting period to the net balance of the fixed asset under this method. This net balance is nothing but the value of asset that remains after deducting accumulated depreciation. Thus, it means that depreciation rate is charged on the reducing balance of the asset.
This asset is the one reflected in the books of accounts at the beginning of an accounting period. So, the book value of the asset is written down so as to to reduce it to its residual value.
Now, as the book value of the asset reduces every year so does the amount of depreciation. Accordingly, higher amount of depreciation is charged during the early years of the asset as compared to the later stages. Thus, the method is based on the assumption that more amount of depreciation should be charged in early years of the asset. This is on account of low repair cost being incurred in such years. As an asset forays into later stages of its useful life, the cost of repairs and maintenance of such an asset increase.
Hence, less amount of depreciation needs to be provided during such years. This method recognizes depreciation at an accelerated rate. Thus, the depreciable amount of an asset is charged to a fraction over different accounting periods under this method. Thus, this fraction indicates that the capital blocked or the benefit derived out of the asset is the highest in the first year. So, as an asset moves towards the end of its useful life, the benefit gained out of such an asset declines.
That is to say, highest amount of depreciation is allocated in the first year since no amount of capital has been recovered till then. Accordingly, least amount of depreciation should be charged in the last year as major portion of capital invested has been recovered.
This method is a mix of straight line and diminishing balance method. Thus, depreciation is charged on the reduced value of the fixed asset in the beginning of the year under this method. This is just like the diminishing balance method. However, a fixed rate of depreciation is applied just as in case of straight line method.
This rate of depreciation is twice the rate charged under straight line method. Thus, this method leads to an over depreciated asset at the end of its useful life as compared to the anticipated salvage value. Therefore, companies adopt various approaches in order to overcome such a challenge.
Firstly, the amount of depreciation charged for the last year is adjusted. The expected economic life of an asset is 5 years. Double Declining Double Declining The Double Declining Balance Method is one of the accelerated methods used for calculating the depreciation amount to be charged in the company's income statement. Please note that in the last year, the asset gets depreciated fully Asset Gets Depreciated Fully Fully depreciated assets are the assets that can no longer be depreciated for accounting or tax purposes.
It implies that the entire depreciation has been provided in the accumulated depreciation account. These assets continue to be a part of the balance sheet unless they are sold or destroyed. In the unit of production method, depreciation is charged according to the actual usage of the asset. This is similar to the straight-line method Straight-line Method Straight Line Depreciation Method is one of the most popular methods of depreciation where the asset uniformly depreciates over its useful life and the cost of the asset is evenly spread over its useful and functional life.
Features of Unit of Production Depreciation Method. Trevor has conducted technical feasibility of the bottling machine and believes that the unit of production method The Unit Of Production Method Unit of production depreciation is an activity method to ascertain asset value through its usage.
It is evaluated as the multiplication of depreciation rate per unit and units produced per year, where depreciation per unit is the asset's cost minus salvage value divided by a particular year's production units. Calculate the amount of depreciation for each of the five years. At the end of year 5, we can see that asset accumulated depreciation Accumulated Depreciation The accumulated depreciation of an asset is the amount of cumulative depreciation charged on the asset from its purchase date until the reporting date.
It is a contra-account, the difference between the asset's purchase price and its carrying value on the balance sheet. It depends on the number of units produced by the machine. We can see that the maximum expense is in year 5 when the machine produces , units, and the lowest is in year 1 when the machine produced , units.
Therefore, greater deductions are allowed in the starting life of the assets than in subsequent years. In this method, most of the depreciation is recognized in the first few years of its useful life. For e. Trevor has conducted technical feasibility of the bottling machine and believes that the sum of the digits method will be most suited.
Calculate the depreciation. This has been a guide to what is Depreciation and its meaning. Here we discuss the top 4 types of depreciation methods along with examples.
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