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| Corporate Practice bd |
What-is-depreciation? Methods-With Practical Examples
Depreciation is the systematic allocation of the cost of a tangible asset over its useful life. It reflects the consumption, wear and tear, or obsolescence of the asset as it is used in the business operations. Depreciation is a non-cash expense, meaning it does not involve an outflow of cash but rather reduces the asset's carrying value on the balance sheet.
Methods of Depreciation:
1.Straight-Line Depreciation:
Definition:
Allocates an equal amount of depreciation expense to each year of the asset's useful life.
Formula: Depreciation Expense = (Cost - Residual Value) / Useful Life
Example:
A machine with a cost of $10,000, a residual value of $1,000, and a useful life of 5 years would have an annual depreciation expense of ($10,000 - $1,000) / 5 = $1,800 per year.
2.Declining Balance Method:
Definition:
Applies a fixed rate of depreciation to the asset's book value (cost less accumulated depreciation) each year.
Formula: Depreciation Expense = Book Value at Beginning of Year × Declining Balance Rate
Example:
Using a 20% declining balance rate, an asset with a book value of $10,000 would have depreciation of $2,000 in the first year ($10,000 × 20%).
3.Units of Production Method:
Definition:
Depreciation is based on the asset's usage or output rather than the passage of time.
Formula: Depreciation Expense per Unit = (Cost - Residual Value) / Total Units of Production
Example:
A machine expected to produce 100,000 units with a cost of $50,000 and a residual value of $5,000 would have a depreciation expense of $0.45 per unit ($50,000 - $5,000) / 100,000 units.
4.Sum-of-the-Years'-Digits Method:
Definition:
Allocates more depreciation expense to earlier years of an asset's life and less in later years.
Formula: Depreciation Expense = (Remaining Useful Life / Sum of the Years' Digits) × (Cost - Residual Value)
Example:
For a 5-year asset, the sum of the years' digits is 15 (1 + 2 + 3 + 4 + 5). In year 3, depreciation would be (3 / 15) × (Cost - Residual Value).
5.Double Declining Balance Method:
Definition:
Applies a depreciation rate that is double the straight-line rate to the asset's book value each year.
Formula: Depreciation Expense = Book Value at Beginning of Year × Double the Straight-Line Rate
Example:
Using a double declining balance rate of 40% for an asset with a cost of $10,000 would result in a depreciation expense of $4,000 in the first year ($10,000 × 40%).
These methods provide flexibility in how depreciation is allocated over an asset's useful life, allowing businesses to match depreciation expense with the revenue generated by using the asset. The choice of method depends on factors such as the nature of the asset, its expected usage, and regulatory requirements.