Depreciation is a non-cash expense that is calculated to allocate the cost of a tangible asset over its useful life. It recognizes that the value of assets decreases over time through wear and tear or obsolescence. There are several methods to calculate depreciation including straight-line, declining balance, and sum-of-years digits. Straight-line depreciation divides the asset cost minus salvage value evenly over its useful life. Declining balance depreciates at a higher percentage in early years. Sum-of-years digits allocates more depreciation in early years based on the sum of remaining useful life years.
1. Depreciation
Definition:-
Depreciation is non-cash expense (also known as non-cash charge) that
provides a source of free cash flow.
Depreciation can’t be count in days it will be count in months. E.g. one
month, two months, one year etc.
Depreciation is a non-cash expense that reduces. When it's stated that
depreciation is "non-cash," it means that depreciation is taken as
an accounting entry, and that the amount of cash held by the business
is not affected. Business assets that can be depreciated include
equipment, machinery, technology and computers, office furniture,
buildings and improvements to buildings, leasehold improvements,
and business vehicles. Land cannot be depreciated because it
appreciates instead of depreciating.
Depreciation is taken on business assets to recognize the change in
value of these assets as they age. Assets depreciate for two reasons:
2. Wear and tear. For example, an auto will decrease in value
because of the mileage, wear on tires, and other factors related to
the use of the vehicle.
Obsolescence. Assets also decrease in value as they are replaced
by newer models. Last year's car model is less valuable because
there is a newer model in the marketplace.
How depreciation is calculated:-
Depreciation is calculated as follows
The original cost of the asset, including costs of acquiring the
asset, transporting it, and setting it up
Less the salvage value (the "scrap" value)
Divided over the years of useful life of the asset. The useful life of
an asset is determined by the IRS based on a schedule set up for
various types of assets. Check with your tax advisor for more
information on "useful life" of different classifications of business
assets.
As an example, office furniture is purchased by a business for $20,000.
The furniture has a useful life of 10 years and a scrap value of $1000.
Using straight-line depreciation (described below), the $19,000 of the
cost of the furniture is divided over the 10 years of life, so $1,900 can
be deducted on the business's tax return for each of the 10 years.
Methods of depreciation:-
3. Depreciation is determined by one of several methods approved by the
IRS.(Internal Revenue Service).
The most common method is straight-line depreciation, in which the
same amount is expensed each year. Other methods are double-
declining balance and sum-of-the years'-digits.
Straight line method:
In straight line method:
Span of year calendar
Number of hours worked
Number of unit produced
In straight line method we use this formula
cost − scrap value
usefull life
Examples of span of year calendar:-
1:-
1-1-2001
Depreciation = 5000
11-1-2001
Depreciation = 5000
4. 21-1-2001
Depreciation = 4576
In above example on 21-1-2001 depreciation is 5000, or on 11-1-2001
depreciation is also 5000, but on 21-1-2001 depreciation is 4576,
because we can’t count depreciation less than 15 days, or half month.
2:-
13-05-2001
Depreciation of one year is 3000
What will be depreciation 8 months..?
Depreciation of 8 months is 2000
23-5-2001
Depreciation will be 1750
Note: - Machine account can’t be touched when depreciation is
recorded. –Depreciation recorded at the end of the year not recorded
during the year.
Examples of remaining two methods of straight line:-
Numbers of hours worked:-
5. Cost = 50,000, Life = 10,000 hours, Year = 2014 2000 hours,
Scrap value = 10,000
50,000−10,000
10,000
= PRs 4 per hour
2000× 4 = PRs = 8000
Numbers of unit produced:-
Cost = 50,000, Life = 20,000, In 2014 5000 unit produced, Scrap Value =
10,000
50,000−10,000
20,000
= 2
5000× 2 = 10,000
Declining or Double Declining balance Method:
Meaning of declining is (Reduction in cost). Only method in which scrap
value is not deducted initially.
The double-declining-balance method provides for a declining periodic
expense over the expected useful life of the asset. This method
applies in three steps.
1. Determine the straight-line percentage using the expected useful
life
2. Determine the double-declining balance rate by multiplying the
straight-line rate from step 1 by two.
6. 3. Compute the depreciation expense by multiplying the double-
declining-balance rate from step 2 times the book value of the
asset.
To illustrate, the equipment purchased in the preceding example is used
to compute double-declining-balance depreciation, for the first year, the
depreciation is $9,600, as shown below.
1. Straight-line percentage =20%(
100%
5
)
2. Double-declining-balance rate = 40% (20% x 2)
3. Depreciation expense = $9,600($24,000 x 40%)
Examples:-
Cost = 25000, Life = 5 years, Scrap value = 10,000
Note: Cost – Accumulated depreciation called book value.
Years Book-V
cost at
beginning
Depreciation
rate
Amount of
depreciation
Accumulated
depreciation
Book-
V at
the
end
1 25000 20% 5000 5000 20000
2 20000 20% 4000 9000 16000
3 16000 20% 3200 12200 12800
4 12800 20% 2560 14760 10240
5 10240 20% 240 15000 10000
7. Sum of year digit method:
Explanation
Sum of the years' digits depreciation method, like reducing balance
method, is a type of accelerated depreciation technique that allocates
higher depreciation expense in the earlier years of an asset's useful life.
Calculation of depreciation under this method can be summarized in the
following 4 steps:
Step 1: Calculate the sum of the years' digits in an asset's useful life
For an asset having a useful life of 4 years, the sum of the years' digits
will be calculated as follows:
Sum of years' digits = 4 + 3 + 2 + 1 = 10
Step 2: Calculate the depreciable amount
Depreciable amount, as with all depreciation methods, is equal to:
Asset's cost of acquisition or construction including any
subsequent capital expenditure
Less: Estimated residual value or scrap value at the end of the
asset's useful life
Step 3: Calculate the un-depreciated useful life
Un-depreciated useful life is equal to the number of years in the asset's
useful life that have not yet been subjected to depreciation.
8. Hence, for an asset that has a useful life of 4 years, the un-depreciated
useful life to be used in calculating depreciation shall be 4 years in the
first year of depreciation, 3 years in the second year and so on.
Step 4: Calculate depreciation using the sum of years' digits & un-
depreciated useful life
Depreciation using the sum of the years' digits method can be
calculated using the following formula:
Depreciation
Expense
=
Un-depreciated useful life
(Step 3)
x
Depreciable Amount
(Step 2)Sum of the years' digits
(Step 1)
Example
Following information relates to a fixed asset:
Cost $100,000
Residual Value $10,000
Useful Life 3 Years
Calculate depreciation over the useful life of the asset using the sum of
the years' digits method.
Step 1: Calculate the sum of the years digits
Sum of the years' digits = 3 + 2 + 1 = 6
9. Step 2: Calculate the depreciable amount
Depreciable amount = $100,000 - $10,000 = $90,000
Step 3: Calculate the un-depreciated useful life
Year 1Year 2Year 3
Un- depreciated useful life (years) 3 2 1
Step 4: Calculate depreciation expense
Year 1: Depreciation expense =
3 (Step 3)
x $90,000 (Step 2) = $45,000
6 (Step 1)
Year 2: Depreciation expense =
2 (Step 3)
x $90,000 (Step 2) = $30,000
6 (Step 1)
Year 3: Depreciation expense =
1 (Step 3)
x $90,000 (Step 2) = $15,000
6 (Step 1)
Note: Over the life of the asset, the total depreciation charge equals to
the depreciable amount, i.e. $90,000 (Step 2). Also note that the amount
of annual depreciation progressively declines as the asset ages. This
method of depreciation is therefore appropriate for assets whose utility
and productiveness is greater in the earlier years of their life (e.g.
computer equipment).
Sum of year digit method:
Example:-
Year 10,
10. SYD =
𝐍+𝟏
𝟐
× 10
𝟏𝟎+𝟏
𝟐
× 10
55
Years Amount of
depreciation
Depreciation life
1 15000x5/15 5000
2 15000x04/15 4000
3 15000x3/15 3000
4 15000x2/15 2000
5 15000x1/15 10000
Example:
Cost = 1, 00,000, Life = 6 years, Scrap value = 10,000
In straight line
4-9-2013
𝟏𝟎𝟎𝟎𝟎𝟎−𝟏𝟎𝟎𝟎𝟎
𝟎𝟔
𝟓
𝟏𝟐
× 15000
5000
In Declining method:-