Methods of Depreciation

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What is Depreciation?

In Accounts, Depreciation can be defined as the method of allocating the cost of a physical asset over its useful life or the time period it is to be used for. In simple words, depreciation is the reduction in the value of an asset due to the passage of time, normal wear and tear and obsolescence. Depreciation is generally regarded as a non-cash expenditure and helps companies to reduce their taxable income. Here, we will study methods of depreciation and how to calculate depreciation.

Methods of Depreciation and How to Calculate Depreciation

In Accounting, there are various methods for calculating depreciation. A company can adopt any of these methods of calculating depreciation depending on its needs. Some of the methods for calculating depreciation are:

  • Straight-line method

  • Written down Value method

  • Annuity method

  • Sinking Fund method

  • Production Unit method

So let us study the methods of calculating depreciation in detail.

Straight-line Method

The straight-line method of depreciation is the most simple and easy to use depreciation method. It is the most commonly used method of depreciation. It is also called the Original cost method, Fixed Installment method or Equal Installment method. Under this method, the depreciation calculation is done by deducting the residual value from the Cost of the asset and then the amount is divided by the number of years the asset was used for or its useful life. The same amount of depreciation is charged every year on the original cost of the asset. The amount of depreciation is charged to the Profit and Loss Account every year. For better understanding, we have given the straight-line depreciation formula.

Straight-line Method Formula is:

Depreciation Formula: \[\frac{\text{Cost of Asset - Residual Value}}{\text{Useful life of the asset}}\] 

Depreciation rate formula: \[\frac{\text{Amount of Depreciation}}{\text{Original Cost of the Asset}}\] X 100

Written Down Value Method

The written down value method also known as diminishing balance method or reducing balance method is a method of calculating depreciation in which a fixed percentage of depreciation is charged on the reducing value of the asset every year. While calculating depreciation in diminishing balance method, the salvage value of the asset is not taken into consideration. The amount of depreciation decreases every year under this method. The diminishing depreciation method is calculated by the formula:

Depreciation, reducing balance method: \[\frac{\text{Rate of Depreciation}}{\text{100}}\] X Book Value

Calculation of depreciation rate under diminishing balance method:  1- (s/c)\[^{\frac{1}{n}}\] X 100

Where s is the scrap value of the asset

c is the cost of the asset and n is the useful life of the asset.

Some companies or organizations also use the double-declining balance method, which results in a large amount of depreciation expense. Double declining balance method is a type of diminishing balance method in which the depreciation factor is 2X than the straight-line method.

Double Declining Balance method formula:

Depreciation = 2 X SLDP X BV

Where SLDP is Straight-line Depreciation Percentage

BV is Book Value

Annuity Method

The annuity method of depreciation calculates depreciation on the asset by calculating its rate of return. This method considers the asset as an investment. It takes into consideration the internal rate of returns on the cash outflows and inflows of the asset.   

Depreciation cost formula under the annuity method is:

Depreciation = (Cost of the Asset - Residual Value) X Annuity factor

Sinking Fund Method

The Sinking fund method of depreciation is a method of calculating depreciation where enough amount is accumulated at the end to replace the asset at the end of its useful life. Here the amount of depreciation is charged to a sinking fund account which is invested in various government bonds and securities. The interest earned from these securities is used to replace the asset.

Sinking fund depreciation method formula:

Depreciation value formula: (Cost of the asset - Residual value) X Present value of Rs. 1 at sinking fund tables for a given rate of interest

Production Unit Method

The Production unit method takes into consideration the number of units that the machine has produced in a year. The depreciation cost depends on how much the machine or asset has been used over a year. The amount of depreciation formula under this method is: 

Depreciation = \[\frac{\text{Estimated Total Cost - Residual Value}}{\text{Estimated Total Output}}\] X Actual Output during the year.

FAQ (Frequently Asked Questions)

Q1. What is the Difference Between Straight-line Method and Diminishing Balance Method?

Ans. The difference between Straight-line Method and Diminishing Balance Method is given in the table below:

Straight-Line Method

Diminishing Balance Method

The depreciation is charged at a fixed rate on the original cost of the asset.

The depreciation is charged at a fixed rate on the written down value or diminishing value of the asset.

The straight-line method of depreciation formula: Cost of the Asset - Residual Value / Useful life of the Asset

Written down value method formula: Rate of [Depreciation / 100] X Book Value

The amount of depreciation in the straight-line method remains the same every year.

The amount of depreciation in the diminishing balance method decreases every year.

The book value in the Straight-line method becomes zero.

The book value in diminishing value depreciation method never becomes zero.

Q2. What are the Factors Affecting Depreciation Value Calculation?

Ans. The different factors that affect the depreciation calculation in accounts are as follows:

  • The Cost of the Asset: The cost of the asset is the amount paid in acquiring the asset. It is the most important factor affecting the determination of the cost of depreciation.

  • The Salvage Value of the Asset: The salvage value or residual value is the amount that the company expects to recover from the asset at the end of its useful life.

  • Estimated Life of the Asset: It is the time period for which the asset is to be used. It can be expressed in years, months or even hours.