Depreciation is generally computed using one of the following methods:
- 1. Straight-line
- 2. Units-of-activity
- 3. Declining-balance
The appropriate depreciation method helps the accountant to measure the role of asset to generate revenue over its useful life. Each method for computing depreciation is approved by Generally Accepted Accounting Principles.
Company selects the method based on the suitability that matches with the nature of the business. After selection of method it will remain consistent for computing depreciation over the useful life of the asset which increases the comparability of financial statements.
Depreciation basically affects the balance sheet through accumulated depreciation and the income statement through depreciation expense.
Here a comparison among the three depreciation methods are described for delivery van by using the following data on January 1, 2012.
- Cost $12,000
- Expected salvage value $ 2,000
- Estimated useful life in years 5
- Estimated useful life in miles 1, 00,000
STRAIGHT-LINE
Straight-line method leads the company to expense the same amount of depreciation for each year of the asset™s useful life which is computed only by the passage of time. Under the straight-line method company have to specify depreciable cost (the cost of asset less its salvage value) for measuring depreciation expense.
Depreciable cost is beneficial to determine the total amount that is to depreciation. To measure annual depreciation expense, a company divides depreciable cost by the asset™s useful life which is given below by using an example:
| Cost’ ‘ ‘ ‘ ‘ ‘ ‘ ‘ ‘ – | Salvage value’ ‘ ‘ ‘ ‘ ‘ ‘ ‘ ‘ ‘ = | Depreciable cost |
| 10,000 | 2,000 | 8,000 |
| Depreciable Cost’ ‘ ‘ / | Useful Life in years’ = | Annual Depreciation Expense |
| 8,000 | 5 | 1,600 |
When an asset is used by a company for only part of a year, the annual depreciation will be prorated. For example, the previous equipment was purchased and placed for service on July 1. Then the depreciation for the year ending December 31 will be computed as follows:
First-Year Partial Depreciation = 1,600*6/12=800
The annual rate of depreciation could be determined (100% / 5 years) = 20%. If a company uses an annual straight-line rate then percentage rate will be applied to the depreciable cost of the asset. For example:
| ‘ ‘ ‘ ‘ ‘ ‘ ‘ ‘ Computation | = | ‘ ‘ ‘ ‘ ‘ ‘ ‘ ‘ ‘ ‘ ‘ ‘ ‘ ‘ End of year | ||||
| Year | Depreciable’ cost’ ‘ ‘ * | Depreciation rate | Annual depreciation expense | Accumulated depreciation | Book value | |
| 2012 | 8,000 | 20% | 1,600 | 1,600 | 8,400 | |
| 2013 | 8,000 | 20% | 1,600 | 3,200 | 6,800 | |
| 2014 | 8,000 | 20% | 1,600 | 4,800 | 5,200 | |
| 2015 | 8,000 | 20% | 1,600 | 6,400 | 3,600 | |
| 2016 | 8,000 | 20% | 1,600 | 8,000 | 2,000 | |
Book value = Cost-Accumulated depreciation
The depreciation expense (1,600) remains same each year. The book value (cost minus accumulated depreciation) at the end of the useful life is equal to the expected $2,000 salvage value. Most of the large companies use the straight-line method due to its easy application and ability to matches expenses with revenues
UNITS-OF-ACTIVITY
When the company uses units-of-activity method the useful life is stated in terms of the total units of production or use expected from the asset, not as a time period.
To determine the depreciation of factory machinery the units-of-activity method is perfectly appropriate. Manufacturing companies apply this depreciation method to compute production (in units of output or in machine hours). This method is also applicable for delivery equipment (miles driven), airplanes (hours in use) etc. but not for buildings or furniture as these assets is more a function of time period than of use.
Under units-of-activity method, the total units of activity are assessed for the total useful life, and these units are divided into depreciable cost which shows the depreciation cost per unit.
To determine the annual depreciation expense, the depreciation cost per unit is applied to the units of activity throughout the year. The computation process for units-of-activity method is illustrated below with appropriate example:
Suppose usage mile for the first year is 30,000
| Depreciable cost’ / | Total units-of-activity’ ‘ ‘ ‘ ‘ ‘ = | Depreciable cost’ per unit |
| 8,000 | 200,000 | 0.08 |
| Depreciable cost’ per unit * | units-of-activity’ ‘ ‘ ‘ ‘ ‘ during the year’ = | Annual Depreciation Expense |
| 0.08 | 10,000 | 1,200 |
The units of activity depreciation schedule are described by using the assume mileage (units of activity):
| ‘ ‘ ‘ ‘ ‘ ‘ ‘ ‘ Computation | = | ‘ ‘ ‘ ‘ ‘ ‘ ‘ ‘ ‘ ‘ ‘ ‘ ‘ ‘ End of year | ||||
| Year | The units of activity * | Depreciation cost/unit | Annual depreciation expense | Accumulated depreciation | Book value | |
| 2012 | 30,000 | 0.08 | 2,400 | 2,400 | 7,600 | |
| 2013 | 15,000 | 0.08 | 1,200 | 3,600 | 6,400 | |
| 2014 | 20,000 | 0.08 | 1,600 | 5,200 | 4,800 | |
| 2015 | 30,000 | 0.08 | 1,600 | 6,800 | 3,200 | |
| 2016 | 15,000 | 0.08 | 1,200 | 8,000 | 2,000 | |
Book value = Cost-Accumulated depreciation
The book value (cost minus accumulated depreciation) at the end of the useful life is equal to the expected $2,000 salvage value.
The units-of-production method is best suited when the productivity (service time or use) of a fixed asset™s differs from year to year and effectively matches the depreciation expense with the asset™s revenues.
However this method is not as popular as the straight-line method due to difficulty in estimating total activity.
DECLINING-BALANCE
Under declining-balance method a decreasing annual depreciation expense over the asset™s useful life is produced. As periodic depreciation is based on a declining book value (cost less accumulated depreciation) of the asset therefore the method is named as declining balance method.
If a company chooses this method for computing depreciation then annual depreciation expense is determined by multiplying the book value at the beginning of the year by the declining-balance depreciation rate. Though the depreciation rate remains same from one accounting period to another, but the book value to which the rate is applied declines each year.
At the first year of asset™s useful life the book value is the cost of the asset as the beginning balance in accumulated depreciation is zero. But in the following years, the amount of book value is determined from the difference between cost and accumulated depreciation to date.
The declining-balance method does not use depreciable cost as the other depreciation methods do. With this method salvage value does not have any role in determining the amount to which the declining-balance rate is applied.
Depreciation could not be measured if the asset™s book value will equal the estimated salvage value and the asset should not be depreciated below its estimated salvage value. A common approach for declining-balance rate is double the straight-line rate which is called as double-declining-balance method.
For example, XYZ Company use double-declining-balance method and uses a depreciation rate of 40% (2*the straight-line rate of 20%).
The declining-balance formula and the computation of the first year™s depreciation for a delivery van are given below with suitable example:
| Book value at beginning of year | Declining balance rate = | Annual depreciation expense |
| 10,000 | 40% | 4,000 |
The declining-balance depreciation schedule is as follows:
| ‘ ‘ ‘ ‘ ‘ ‘ ‘ ‘ Computation | = | ‘ ‘ ‘ ‘ ‘ ‘ ‘ ‘ ‘ ‘ ‘ ‘ ‘ ‘ End of year | ||||
| Year | Book value at beginning of year * | Depreciation rate | Accumulated depreciation expense | Accumulated depreciation | Book value | |
| 2012 | 10,000 | 40% | 4,000 | 4,000 | 6,000 | |
| 2013 | 6,000 | 40% | 2,400 | 6,400 | 3,600 | |
| 2014 | 3,600 | 40% | 1,440 | 7,840 | 2,160 | |
| 2015 | 2,160 | 40% | 864 | 7,481 | 2,519 | |
| 2016 | 1,296 | 40% | 519 | 8,000 | 2,000 | |
Book value = Cost-Accumulated depreciation
**** Computation of 4thyear accumulated depreciation is adjusted in order to make salvage value to equal the book value
If an asset is used for only part of a year then the annual depreciation is prorated. Such as, earlier asset was purchased and placed for service on July 1. Then the depreciation for the year ending December 31 will be computed as follows:
- First-Year Partial Depreciation= (10,000*40%*6/12)= 2,000
- And the book value at beginning of year is = (10,000-2,000) = 8,000
- And the depreciation for the second year will be computed as follows:
- Second-Year Partial Depreciation = (8,000*40%) =3,200
- Other subsequent computations would follow from those amounts.
The double-declining-balance method delivers a higher rate of depreciation in the first year of the asset™s use, followed by declining depreciation amounts which. Therefore, the double-declining-balance method is referred as an accelerated depreciation method.
Asset produce greater revenue in the early years of its use than in later years which lead the double-declining-balance method to produce a good matching of depreciation expense with the asset™s revenues. Moreover the declining-balance method also provides the most appropriate depreciation amount in case of obsolescence of an asset.
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