Methods of Depreciation and Their Uses

Depreciation is an accounting method used for allocating the cost of a physical asset over its life expectancy. It represents the used value of an asset and it helps companies to earn revenue from the asset’s remaining value.

Through depreciation methods, companies can write off the value of an asset over time to spread out the cost of the asset and generate revenue from it. Companies can use this method instead of realizing the entire cost of the asset in a year. This article will explain the methods of depreciation and what their uses are. 

Table of Contents

• Methods of Depreciation in Accounting
• Uses
• Factors

Depreciation expense is used in accounting to allocate the cost of a tangible asset over its useful life. In other words, it is the reduction in the value of an asset that occurs over time due to usage, wear and tear, or obsolescence.  The above four main methods are in detail below.

Depreciation Methods in Accounting

There are different types of methods to determine the book value of an asset. The following are the most common methods:

1. Straight-line Depreciation Method
2. Double Declining Balance Method of Depreciation
3. Units of Production Method of Depreciation
4. Sum of Years Digits
5. Written Down Value (WDV) Depreciation Method

1. Straight-Line Method of Depreciation

Straight-line method of depreciation is the simplest method for calculating depreciation expense. In this method, the expense amount remains the same every year over the useful life of an asset.

Straight Line Method:

Depreciation Expense = (Cost – Salvage value) / Useful life

Consider a piece of equipment that costs $25,000. It has an estimated useful life of 8 years and $0 salvage value. The depreciation expense per year:

Depreciation Expense = ($25,000 – $0) /8 = $3125 annually

2. Double Declining Balance Deprication Method

This method results in a larger amount expensed in earlier years as opposed to later years of an asset’s useful life. According to this method, assets are more productive in their early years. 

An asset loses more of its value in the early years of its use. In this method, the depreciation factor is 2 times more of the straight-line expense method.

Double-declining balance method:

Periodic Depreciation Expense = Beginning book value x Rate of depreciation

Consider a piece of land, plant, and equipment (PP&E). It costs $45,000 and has an estimated useful life of 10 years. It has $2,500 as its salvage value. 

3. Units of Production Method of Depreciation

This method of depreciation depreciates assets on the basis of the total number of hours used or the total number of units to be produced by using assets over their useful life.

The formula for the units-of-production method:

Depreciation Expense = (Number of units produced / Life in the number of units) x (Cost – Salvage value)

Consider a piece of equipment that costs you $25,000. It has an estimated total unit production of 100 million and the salvage value is $0. During the first quarter of its use, the machine had produced 4 million units.

Depreciation Expense = (4/100 million) x ($25,000 – $0) = $1,000

4. Sum-of-the-Years-Digits Depreciation Method

This is one of the accelerated depreciation methods. Higher expenses are incurred in the early years and lower expenses in later years of an asset’s useful life.

Divide the remaining life of an asset is by the sum of years. You will multiply it by the depreciating base for determining the depreciation expense.

Depreciation Expense = (Remaining life / Sum of the years’ digits) x (Cost – Salvage value)

The depreciation base remains constant throughout the year 

Depreciation Base = Cost – Salvage value

= $25,000 – $0 = $25,000

2. Initially, the asset has 8 years as its remaining life. The following year, its remaining life is 7 years and so on.

3. RL / SYD is “remaining of life divided by sum of years.” Over here the useful life of asset is 8 years. The sum of years is 1 + 2 + 3 + 4 + 5 + 6 + 7 + 8 = 36 years. The remaining life (rm) at  the year beginning is 8 years. Therefore, the RM / SYD = 8/36 = 0.2222.

4. You will multiply RL / SYD by the depreciating base for determining the expense of that year.

5. This will be done for the following years. At the beginning of 2nd year, RL / SYD= 7/36 = 0.1944. Expense for 2nd year = 0.1944 x $25,000 = $4,861.

5. Written Down Value (WDV) Depreciation Method

Written Down Value (WDV) method of depreciation helps in calculating how the value of an asset decreases over time. 

1. Imagine you have a computer that costs $1,000, and it loses value each year.
2. Instead of subtracting the same amount every year, with WDV, we calculate depreciation based on the remaining value.
3. In the first year, if we say the depreciation rate is 20%, the computer's value decreases by $200 (20% of $1,000).
4. So, after the first year, the computer's value is $800.
5. Now, for the next year, we calculate depreciation on this reduced value, not on the original $1,000.
6. This means in the second year, depreciation is $160 (20% of $800), making the computer's value $640.
7. This continues each year, with depreciation based on the current value. WDV helps show a more accurate picture of how assets lose value over time.

Uses of Depreciation Method

Depreciation methods are important since an asset will definitely undergo wear and tear over a period of time. This leads to a reduction in working capacity and effectiveness of assets. Therefore it should reflect the asset value which it is carried in books of accounts. Each asset becomes obsolete over time when the new technology takes over. The asset value will decrease over time and it must be accounted for.

Factors Affecting Amount of Depreciation

Several factors affect depreciation. The following are the four main affecting factors while calculating depreciation expense:

1. Asset cost.
2. Estimated salvage value of the asset. 
3. Estimated useful life of an asset. 
4. Obsolescence while determining the useful life of an asset. An equipment that can produce units for more than 10 years can become obsolete in six years. In this case, the useful life of an asset is six years.

A company can choose any of the above-mentioned methods depending on its business operations. As per the accounting theory, companies should use a method that is in sync with the company’s economic health. They can choose a method that allocates the asset cost to accounting periods. This should be in accordance with benefits from the asset use.