Methods of depreciation
There are several methods for calculating depreciation, generally based on
either the passage of time or the level of activity (or use) of the asset.
Straight-line depreciation
Straight-line depreciation is the simplest and most-often-used technique, in
which the company estimates the salvage value of the asset at the end of the
period during which it will be used to generate revenues (useful life) and will
expense a portion of original cost in equal increments over that period. The
salvage value is an estimate of the value of the asset at the time it will be
sold or disposed of; it may be zero or even negative. Salvage value is also
known as scrap value or residual value.
Straight-line method:
For example, a vehicle that depreciates over 5 years, is purchased at a cost of
US$17,000, and will have a salvage value of US$2000, will depreciate at US$3,000
per year: ($17,000 − $2,000)/ 5 years = $3,000 annual straight-line depreciation
expense. In other words, it is the depreciable cost of the asset divided by the
number of years of its useful life.
This table illustrates the straight-line method of depreciation. Book value at
the beginning of the first year of depreciation is the original cost of the
asset. At any time book value equals original cost minus accumulated
depreciation.
book value = original cost − accumulated depreciation Book value at the end of
year becomes book value at the beginning of next year. The asset is depreciated
until the book value equals scrap value.
Book value at
beginning of year Depreciation
expense Accumulated
depreciation Book value at
end of year
$17,000 (original cost) $3,000 $3,000 $14,000
$14,000 $3,000 $6,000 $11,000
$11,000 $3,000 $9,000 $8,000
$8,000 $3,000 $12,000 $5,000
$5,000 $3,000 $15,000 $2,000 (scrap value)
If the vehicle were to be sold and the sales price exceeded the depreciated
value (net book value) then the excess would be considered a gain and subject to
depreciation recapture. In addition, this gain above the depreciated value would
be recognized as ordinary income by the tax office. If the sales price is ever
less than the book value, the resulting capital loss is tax deductible. If the
sale price were ever more than the original book value, then the gain above the
original book value is recognized as a capital gain.
If a company chooses to depreciate an asset at a different rate from that used
by the tax office then this generates a timing difference in the income
statement due to the difference (at a point in time) between the taxation
department's and company's view of the profit.
Declining-balance method (or Reducing balance method)
Depreciation methods that provide for a higher depreciation charge in the first
year of an asset's life and gradually decreasing charges in subsequent years are
called accelerated depreciation methods. This may be a more realistic reflection
of an asset's actual expected benefit from the use of the asset: many assets are
most useful when they are new. One popular accelerated method is the
declining-balance method. Under this method the book value is multiplied by a
fixed rate.
Annual Depreciation = Depreciation Rate * Book Value at Beginning of Year
The most common rate used is double the straight-line rate. For this reason,
this technique is referred to as the double-declining-balance method. To
illustrate, suppose a business has an asset with $1,000 original cost, $100
salvage value, and 5 years useful life. First, calculate straight-line
depreciation rate. Since the asset has 5 years useful life, the straight-line
depreciation rate equals (100% / 5) 20% per year. With double-declining-balance
method, as the name suggests, double that rate, or 40% depreciation rate is
used. The table below illustrates the double-declining-balance method of
depreciation.
Book value at
beginning of year Depreciation
rate Depreciation
expense Accumulated
depreciation Book value at
end of year
$1,000 (original cost) 40% $400 $400 $600
$600 40% $240 $640 $360
$360 40% $144 $784 $216
$216 40% $86.40 $870.40 $129.60
$129.60 $129.60 - $100 $29.60 $900 $100 (scrap value)
When using the double-declining-balance method, the salvage value is not
considered in determining the annual depreciation, but the book value of the
asset being depreciated is never brought below its salvage value, regardless of
the method used. The process continues until the salvage value or the end of the
asset's useful life, is reached. In the last year of depreciation a subtraction
might be needed in order to prevent book value from falling below estimated
Scrap Value.
Since double-declining-balance depreciation does not always depreciate an asset
fully by its end of life, some methods also compute a straight-line depreciation
each year, and apply the greater of the two. This has the effect of converting
from declining-balance depreciation to straight-line depreciation at a midpoint
in the asset's life.