The four main types
The four main types
There are several types of depreciation expense and different formulas for determining the book value of an asset. The most common depreciation methods include:
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 of value in an asset over time due to usage, wear and tear, obsolescence. The four main depreciation methods mentioned will be explained in detail below.
Straight-line depreciation is a very common and simple method of calculating the expense. In straight-line depreciation, the expense amount is the same every year over the useful life of the asset.
Depreciation Formula for the Straight Line Method:
Depreciation Expense = (Cost – Salvage value) / Useful life
Consider a piece of equipment that costs $25,000 with an estimated useful life of 8 years and a $0 salvage value. The depreciation expense per year for this equipment would be as follows:
Depreciation Expense = ($25,000 – $0) / 8 = $3,125 per year
Compared to other depreciation methods, double-declining-balance results in larger expense in the earlier years as opposed to the later years of an asset’s useful life. The method reflects the fact that assets are more productive in its early years than in its later years. With the double-declining-balance method, the depreciation factor is 2x that of a straight line expense method.
Depreciation formula for double declining balance method:
Periodic Depreciation Expense = Beginning book value x Rate of depreciation
Consider a piece of equipment that costs $250,000 with an estimated useful life of 8 years and a $2,500 salvage value. To calculate the double declining balance depreciation, set up a schedule:
The information on the schedule is explained below:
Expense = (100% / Useful life of asset) x 2
Expense = (100% / 8) x 2 = 25%
Note: Since this is a double declining method, we multiply the rate of depreciation by 2.
3. Multiply the rate of depreciation by the beginning book value to determine the expense for that year. For example, $25,000 x 25% = $6,250 depreciation expense.
4. Subtract the expense from the beginning book value to arrive at the ending book value. For example, $25,000 – $6,250 = $18,750 ending book value.
5. The ending book value for that year is the beginning book value for the following year. For example, the year 1 ending book value of $18,750 would be the year 2 beginning book value. Repeat this until the last year of useful life.
Units-of-production depreciation method depreciates based on the total number of hours used or the total number of units to be produced over its useful life.
The formula for units-of-production method:
Depreciation Expense = (Number of units produced / Life in number of units) x (Cost – Salvage value)
Consider a machine that costs $25,000 with an estimated total unit production of 100 million and a $0 salvage value. During the first quarter of activity, the machine produced 4 million units.
To calculate the depreciation expense using the formula above:
Depreciation Expense = (4 million / 100 million) x ($25,000 – $0) = $1,000
Sum-of-the-years-digits method is one of the accelerated depreciation methods. A higher expense is incurred in the early years while lower expense is incurred in the latter years of the asset.
In sum-of-the-years digits depreciation method, the remaining life of an asset is divided by the sum of the years and then multiplied by the depreciating base to determine the expense.
The depreciation formula for sum-of-the-years-digits method:
Depreciation Expense = (Remaining life / Sum of the years digits) x (Cost – Salvage value)
Consider the following example to more easily understand the concept of the sum-of-the-years-digits depreciation method.
Consider a piece of equipment that costs $25,000 with an estimated useful life of 8 years and a $0 salvage value. To calculate the sum-of-the-years-digits depreciation method, set up a schedule:
The information in the schedule is explained below:
Depreciation Base = Cost – Salvage value
Depreciation Base = $25,000 – $0 = $25,000
2. The remaining life is simply the remaining life of the asset. For example, in the beginning of the year, the asset has a remaining life of 8 years. The following year, the asset has a remaining life of 7 years, etc.
3. RL / SYD is “remaining life divided by sum of the years.” In this example, the asset has a useful life of 8 years. Therefore, the sum of the years would be 1 + 2 + 3 + 4 + 5 + 6 + 7 + 8 = 36 years. The remaining life in the beginning of year 1 is 8. Therefore, the RM / SYD = 8 / 36 = 0.2222.
4. The RL / SYD number is multiplied by the depreciating base to determine the expense for that year.
5. The same is done for the following years. In the beginning of year 2, RL / SYD would be 7 / 36 = 0.1944. 0.1944 x $19,444 = $4,861 expense for year 2.
Below is the summary of all four depreciation methods from the examples above.
Here is a graph of the book value of an asset over time with each method.
Here is a summary of the expense over time for each of the 4 types of depreciation expense.
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