Computation of Depreciation

Although depreciation may appear to be a bad concept, it can really be quite useful to your organisation if you know how to utilise it and leverage it to the greatest extent possible. The depreciation value has an impact on your company’s balance sheets and might also have an impact on net profits. Knowing the fundamentals of the word depreciation, as well as how to apply it wisely, can allow you to save money on your taxes. So, to understand how depreciation works, let us go over some fundamentals of depreciation, such as what the term truly means and how different forms of depreciation are computed.

What is Depreciation?

It is an accounting method that is used for allocating tangible or physical asset cost over its useful life. In simple words, it is the measure of how much of an asset’s value has been depreciated. It enables businesses to generate money from the assets they possess by paying for them over time. The initial cost of ownership is greatly lowered since corporations do not have to account for them totally in the year the assets are bought. Accounting for depreciation incorrectly may have a significant impact on a company’s earnings.

Computation of Depreciation Method

Straight-line

The straight-line approach is the most fundamental way to record depreciation. It records an identical depreciation expenditure each year for the asset’s entire useful life, until the asset is depreciated to its salvage value.

Assume a $5,000 machine is purchased by a business. The corporation determines that the salvage value is $1,000 and that the usable life is five years. The depreciable amount is $4,000 based on these estimates ($5,000 cost – $1,000 salvage value).

The straight-line technique calculates yearly depreciation by dividing the depreciable value by the total number of years. In this scenario, the annual cost is $800 ($4,000 / 5). This leads to a 20% depreciation rate ($800 / $4,000).

How it works: It works like this: you divide the cost of an object, less its salvage value, by its usable life. This impacts the amount of depreciation you may deduct each year.

Straight-line depreciation is calculated as follows:

Annual Depreciation Expense = (Asset Cost – Residual Value) / Asset Useful Life

Unit of Production

Unlike the straight-line approach, this is a two-step process. In this case, each unit produced is allocated an identical expenditure rate. Because of this assignment, the approach is highly beneficial in assembly for manufacturing lines. As a result, the computation is focused on the asset’s output capabilities rather than the number of years.

The steps are as follows:

Step 1: Determine the depreciation per unit:

Priced per unit Depreciation = (Asset cost – Residual value) / Useful life in producing units

Step 2: Determine the total depreciation of real units manufactured:

Total Depreciation Expense = Depreciation Per Unit Units Produced

How it works: Using the following formula, you calculate the dollar value of depreciation for each unit generated. The amount to write off is calculated by aggregating all of the units generated in one year. Once all of the units have been written off, the asset’s depreciation is complete–its useful life is officially finished, and no more units may be written off.

Double-declining balance (DDB)

Another approach for accelerated depreciation is the double-declining balance (DDB). After twice the reciprocal of the asset’s usable life, this rate is applied to the depreciable base (its book value) for the balance of the asset’s projected life.

Let us consider an example, an asset has a reciprocal value of one-fifth that comes with a useful life of five years. For depreciation, double the rate, or 40%, is applied to the asset’s current book value. Although the rate remains constant, the dollar value decreases over time due to the rate being multiplied by a decreasing depreciable base for each cycle.

The formula is:

Depreciation = 2 depreciation percent of Straight line book value (at beginning of the accounting period)

Value of book = cost of asset – accumulated depreciation

How it works: With this method, you depreciate an asset twice as much in the first year as you would with the straight-line method. In succeeding years, you will apply the depreciation rate to the asset’s residual book value rather than its initial cost. The book value of an asset is the asset’s cost less the amount you’ve previously written off. The salvage value is not considered in the double-declining balance technique.

Understanding the Digits of the Year’s Sum (SYD Method)

Depreciation is a mechanism of allocating an asset’s cost to expenses for each period in which the item is expected to provide a benefit. Depreciation charges can be variable, straight-lined, or accelerated over the useful life of an asset, depending on the cost apportionment or depreciation rate chosen.

Accelerated depreciation employs declining charge methodologies, such as the sum-of-the-years’ digits (SYD), to provide higher depreciation expenses in the early years and reduced depreciation charges in the later years. The depreciation rate percentage for each year is determined using the SYD technique, which divides the number of years in remaining asset life for the current year by the sum of remaining asset life for each year during the asset’s life. The depreciation fee falls as the depreciation rate drops.

When an item loses the majority of its value near the beginning of its useful life, such as autos, it makes sense to employ an accelerated depreciation technique like the SYD method. The SYD approach would produce the following depreciation schedule in the five-year example above:

Year 1: 5/15 = 33%

Year 2: 4/15 = 27%

Year 3: 3/15 = 20%

Year 4: 2/15 = 13%

Year 5: 1/15 = 7%

All of these years’ percentages should total up to 100 percent.

Conclusion 

Depreciation is an accounting method that is used for allocating tangible or physical asset cost over its useful life. In simple words, it is the measure of how much of an asset’s value has been depreciated. The initial cost of ownership is greatly lowered since corporations do not have to account for them totally in the year the assets are bought. The straight-line approach is the most fundamental way to record depreciation. It records an identical depreciation expenditure each year for the asset’s entire useful life, until the asset is depreciated to its salvage value. The straight-line technique calculates yearly depreciation by dividing the depreciable value by the total number of years.