Depreciation Methods (With Definitions and Examples)
Updated July 9, 2022
Depreciation is the process of determining the value of a material item over a long period. The process begins with calculating the item's initial purchasing price and then determining its decrease in value through frequent usage. Learning about and using methods of depreciation can help you accurately calculate the value of your employer's assets. In this article, we discuss the different techniques you can use to calculate depreciation.
Why use depreciation methods?
An organization can use several depreciation methods to determine the real-time value of an asset. An asset is an item or article of property acquired by a company through a monetary purchase. It's essential for a company to know the value of its assets. Companies use depreciation to determine if an asset is worth investing money in, how long its value can last, and if it can sell for a profit at the end of its useful life. Assets that require depreciation calculations include real estate property, company vehicles, company equipment, and machinery.
Companies may also depreciate office furnishings, such as desks, computers, or large office equipment like commercial printers. Another common name for these fixed assets is capital expenditures. A company's financial controller, chief financial officer, or accountant may choose to use a particular method of depreciation depending on the situation. Some practices offer a consistent decline of value over the asset's life. In contrast, other forms depreciate most of the asset's value at the beginning or end of its useful life. Each method depends on the circumstance, the resulting tax benefits or implications, and the purpose of depreciation.
5 common depreciation methods
Your position may require you to record the decreasing value of your employer's assets. There are several methods you can use to calculate depreciation. You can determine the depreciation schedule of the company's assets or expenditures by following one of the five methods for depreciation listed. Consider using a handheld calculator or online calculator for using one of these methods:
1. The straight-line method
The straight-line method of depreciation is the most commonly used method for determining the value of an asset. It follows a simple formula: the purchase cost minus the asset's salvage value divided by years of the asset's usefulness. The simplicity of this formula makes it an ideal method for small business owners who complete their own accounting.
For example, you purchase an advanced stereo system and other music equipment at the initial cost of $3,000. You plan to use this equipment for ten years. The estimated salvage value for the equipment is $200. This is what you expect to sell the equipment for when it's no longer usable. You can follow the formula:
Straight-line depreciation = (initial cost of the asset - salvage value) / asset's useful life
Straight-line depreciation = ($3,000 - $200) / 10 years
Straight-line depreciation = $2,800 / 10 years
Straight-line depreciation = $280
You can deduct $280 from the stereo's value every year for ten years on your financial statement. When the ten years are over, the value of the stereo system as a usable asset for your company is $0.
2. The fractional period method
This method is a variation of the straight-line method. The fractional period's method of depreciation calculates an asset's worth over a shorter period, such as eight or nine months. A company may purchase the asset in the middle of the working year rather than at the beginning. As a result, they may not include this asset in the same schedule as assets acquired at the beginning of the year. The formula for the fractional period method is:
Fractional period depreciation = (initial cost - salvage value) / estimated working years x (the asset's span in months / months of one working year)
For example, a music company buys a temporarily used vehicle to transport your music equipment. This used vehicle costs $15,000, and its salvage value is $1,000. The company purchases the used vehicle in May rather than in January and plans to use the asset only eight months out of the year. They estimate the vehicle's lifespan as 10 years. The calculation is:
Fractional period depreciation = ($15,000 - $1,000) / 10 years x (8 / 12)
Fractional period depreciation = $14,000 / 10 years x 0.667
Fractional period depreciation = $933.33
3. The double-declining depreciation method
The double-declining depreciation method helps determine an asset's value in its earliest working years. This method deducts the asset's value twice as quickly as the straight-line method. It can lead to the asset's depreciation total being larger in its earlier years than in later years. The double-declining process follows this formula:
Double-declining depreciation = straight-line depreciation percentage x asset's book value at the beginning of the period
Using the same example as in the straight-line method, you know that the initial depreciation is 10% every year based on an initial purchase price of $3,000. Again, this is because the equipment's expected lifespan is 10 years.
Double-declining depreciation = 2 x 10% x $3,000
Double-declining depreciation = $600
You can deduct $600 from the stereo system and equipment's value during its first year of usage. During that first working year, its overall value, or book value, is $2,400. When you complete the calculation for the second operational year, you use $2,400 in the equation. Now you can use the formula again to arrive at $480. Finally, you deduct a further $480 from the asset's value. This makes the asset's book value $1,920 at the beginning of its third working year.
4. The units of production method
The units of production method calculates the value of an asset based on the frequency of use in the workplace. This method helps estimate how many products an investment may produce or how many hours of service the asset may generate. You can also determine how much it costs for the asset to create one product or provide one hour of service. The formula for the units of production method is:
Unit of production depreciation = (initial cost of the asset - salvage value) / profitable units produced during an asset's working year
For example, the stereo system and music equipment cost an initial $3,000, and the salvage value is $200. The company estimates that they can use the equipment for 80,000 hours before it's no longer usable. Now you can use the formula:
Unit of production depreciation = ($3,000 - $200) / 80,000 hours
Unit of production depreciation = $0.035 / hour
During the music equipment's first year of use, the number of hours totals 8,000 hours. Now you can multiply the number of hours the equipment usage in the year by the unit of production depreciation to determine the asset's depreciation amount. This totals $280, and as a result, you can deduct that amount from the asset's value that year.
5. The sum of years method
Also known as the SYD method, this method determines the value of an asset that begins its first set of working years with a higher expense than its later working years. This method can help determine the asset's value in its early years. You can use this method as an alternative to the double-declining method. The formula for this method is:
Sum of years depreciation = (lifespan of the asset / total sum of the asset's years) x (initial cost - salvage value)
Using the music equipment example, the equipment costs $3,000 and has a salvage value of $200. It's established that the equipment's estimated lifespan is ten years. You can add the individual digits of the asset's lifespan, such as 1 + 2 + 3 + 4 + 5 + 6 + 7 + 8 + 9 + 10. This leads to a total sum of 55. Now you can use the formula:
Sum of years depreciation = (10 years / 55) x ($3,000 - $200)
Sum of years depreciation = 0.1818 x $2,800
Sum of years depreciation = $509.09
You can write off this amount from the asset's first working year. Then, in the asset's second active year, you can use the same formula, but use nine years as the lifespan instead of 10.
Related: What Is a Financial Controller?
What tools and services can you use to calculate depreciation?
There are many tools and services available to help you with calculating depreciation for your workplace's assets. Consider using an online spreadsheet or an online depreciation generator. You can ask your workplace to provide specialized software to help with the process. You can also attend classes and workshops at a local school or community centre. Some courses can teach you how to calculate depreciation manually. It may be beneficial to learn how to calculate depreciation manually, as online tools may not always be accurate.
You can purchase instructional books on finance from your local bookshop or borrow them from your local library. Instructional books can help improve your financial education and increase the quality of your calculations. You can also ask an accountant or a friend with financial knowledge for guidance. Consider seeking a professional accountant's advice at the end of every business year. Review the accuracy of the depreciation calculations with them. If you enlist a second educated or experienced party to review and revise the calculations, you can avoid errors.
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