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 the 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.
Features of Depreciation and the Methods
Every asset has only a timely use. And with that, the value has declined accordingly. So the measure of declination of asset value over the period is calculated with depreciation. And the following methods; straight-line method, written down value method, production unit method, annuity method, sinking fund method have their features making the depreciation process unique.
The major features of depreciation are listed below:
By the usage, obsolescence or time that have passed, there is a loss of value occurred for the assets. And it is included in it.
The booked value of fixed assets that have affected a declination is what depreciation is.
Depreciation is a continuous process until the useful life period of the asset.
We must deduct the cost of expiration, that is depreciation before calculating the taxable profit.
It doesn’t involve cash flow. Hence it can be called a non-cash expense.
The loss measured must be constant and gradual.
In depreciation, maintenance cannot be included.
Depreciation Objectives For Providing
If we have closely checked, the term ‘depreciation’ has two different meanings. As a common term that is generalized, the word depreciation means the decline of the value of property over time. However, in accounting ‘depreciation’ is the expiration cost of the fixed asset. And the assets we mentioned here are physical assets except for land. All other assets do have only a limited period of usefulness.
Assets are used for generating income till their economic value. So that must be allocated and it is done smoothly using the depreciation method. And this is considered the primary objective.
The Need of Providing Depreciation
The amount accumulated as profit during the useful period of the asset can be used for the replacement after its expiration period.
The capital amount should be secured without affecting the period of inflation in the economy. So it must be well planned.
In a way, true profit obtained as a result of this asset is to be taken as the business expenditure. To ascertain that we can use depreciation.
As depreciation is considered a statutory need. It must be calculated accordingly before the profits are shared in dividends.
Just like any other concept, depreciation methods also have got their benefits. As already said, depreciation is the expense of a business. So we can check it with calculated depreciation as they both are matching ones. After calculation of depreciation, we get the tax benefits and also the replacement cost too.
FAQs on Methods of Depreciation
1. What is the difference between straight-line method and diminishing balance method?
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. |
2. What are the factors affecting depreciation value calculation?
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.
3. Which method of depreciation is accurate?
Unfortunately, we cannot say if any of the methods of depreciation we used so far is accurate. As depreciation is calculating the cost of expenditure of the business. The useful period students calculate is an estimation. So an estimation cannot be taken as an accurate one.
It is for getting an equitable basis about periodically charging depreciation for the assets, we use different methods of depreciation. Just like the straight-line method charging the same amount of depreciation every year for the asset is an example. It proves that the equitable basis is a subjective sense.
4. Do you know the depreciation method of double-declining balance?
Double declining balance is a type of accelerated depreciation. In this method, depreciation occurs rapidly decreasing the value of assets in the initial period and slows down by the end of its useful period. In other words, we can say it is using the double of the rate used in the straight-line method. And this method is more commonly used too.
5. How do we select the method of depreciation if it is not specifically mentioned?
The SEC notes have all the prescribed notes to be followed in the US. The voluminous notes to be followed do give details of how to calculate depreciation in each circumstance. However, if it's a student doing an academic project, you can use the straight-line method. And while following so in an academic project, the students will still have to calculate the value of fixed assets. More details on methods of depreciation can be found from the Vedantu site and app.
6. Why do power generating companies use the straight-line method of depreciation?
In the bill passed in 1998 of income tax(amendment) reason is provided in “statement of objects and reasons” for using a straight-line method specifically for power generating companies.
In the section, it says that it is calculated like the same rate for every year using the straight-line method as the amount is reimbursed by the state board every year. And it is mentioned under the state electricity board act.
7. What do you know about the change in the method of depreciation?
It is about adopting an appropriate method and thus forming as a part of accounting policy. In that way, a change in the accounting policy will occur. It is necessitated by a standard or by a statute. And thus resulting in a more appropriate presentation.