Depreciation is the process of allocating the depreciable cost of fixed assets over their estimated useful lives in a systematic and rational manner. It matches the depreciable cost of the asset with revenues generated from its use. Depreciation recognizes the asset’s declining service due to wear and tear, deterioration, and decay in addition to functional factors such as obsolescence and inadequacy.
Various methods are used to determine the expense or manufacturing overhead during the period. A critical question is: what method of cost apportionment is best for this asset? Based on that assessment, the accountant determines the best method.
The salvage value considers an estimate of the amount at the time the asset is sold or removed from service. It is the amount to which the asset must be written down or depreciated during its useful life. For example, an asset’s original cost is $100,000 and a salvage value of $10,000 has a depreciation base of $90,000.
Methods of depreciation are also called methods of cost apportionment. The following methods are used for depreciation purposes:
1) Activity method (units of use or production
2) Straight-line method
3) Decreasing-charge methods (accelerated):
b) Declining-balance method.
4) Special depreciation methods:
a) Group and composite methods
b) Hybrid or combination methods.
Straight-Line Depreciation (SL)
The straight-line depreciation method charges a fixed amount of depreciable cost to each period. The amount is calculated by dividing the result of the asset historical cost minus salvage value by its estimated useful life. Assets are recoded at their acquisition cost, the cash price of its equivalent.
For example, equipment purchased for $250,000 with a 5-year estimated useful life and $10,000 salvage value, the yearly depreciation expense is $48,000.
[($250,000 - $10,000)]/5 years = $48,000/year]
SYD ( Sum-of-the-Years’-Digits) Depreciation
A decreasing fraction is applied each year to the depreciable base (cost minus salvage value). The fraction is established by adding the number of years of estimated useful life at the beginning of the asset’s life. For a 5-year estimated useful life, the denonimator would be: (5+4+3+2+1=15). The numerator is the remaining number of years as of the beginning of the tax year, as follows:
Year 1 Remaining life in years 5 Depreciation Fraction: 5/15
Year 2 Remaining life in years 4 Depreciation Fraction: 4/15
Year 3 Remaining life in years 3 Depreciation Fraction: 3/15
Year 4 Remaining life in years 2 Depreciation Fraction: 2/15
Year 5 Remaining life in years 1 Depreciation Fraction: 1/15
If a depreciation base is $450,000, the depreciation expense for the year 1 would be:
$450,000 x 5/15 = $150,000 and so on.
Declining Balance Method
This method utilizes a depreciation rate expressed as a percentage that is some multiple of the Straight-Line method. For example, a Double-Declining –Balance (DDB) utilizes a rate of depreciation twice the Straight-Line rate is applied to the book value. This method does not take into consideration the salvage value. The constant declining balance rate is applied to a successively lower book value, which results in lower depreciation charges each year. The process continues until the book value of the asset is reduced to its estimated salvage value, at which time depreciation is discontinued.