How to calculate Depreciation?
In the last unit, we briefly discussed the concept of depreciation as part of expenses in the income statement. Here we will learn not only to calculate depreciation expenses but also its different methods.
I.Straight line Method of depreciation- This method is the simplest and commonly used method of depreciation. It is calculated by taking the purchase or acquisition price of an asset, subtracting the salvage value and then dividing by the total productive years for which the asset is expected to benefit the company.
Depreciation = (Cost of an Asset- Salvage Value) / Useful life
- Cost of the asset is purchase price or historical cost
- Salvage value is value of the asset remaining after its useful life
- Useful life of the asset is the number of years for which an asset is expected to be used by the business
Example: - Consider an asset that costs ₹30,000 with an estimated useful life of 8 years and has a salvage value of ₹5,000. Under the straight-line method, the depreciation expense per year will be
Depreciation expense = (30,000-5,000)/8 = ₹3,125 per year
II.Accelerating Method of Depreciation- This method allows the companies to write off a larger part of assets in the earlier years than the later years. It recognizes higher depreciation expenses during the earlier years as compared to the straight-line method of depreciation. The major benefit is to provide a tax shield. In the initial years, the depreciation is higher as a result of which tax charged on the profit is less compared to the later years. This results in deferment of tax liability since income in earlier years are lower.
There are two most popular methods of Accelerated Depreciation Methods-
A)Double Declining Method – In this method, a fixed rate of depreciation is charged on the net value of the fixed asset at the beginning of the year. The rate of depreciation charged under this method is twice the rate that is charged under the straight-line method. The method reflects that assets are more productive in the earlier years as compared to their later years.
Depreciation Expense = 2 x Straight-line depreciation rate x Book value at the beginning of the year.
Example: - Consider a piece of property, plant, and equipment (PP&E) that costs ₹25,000, with an estimated useful life of 8 years and a ₹2,500 salvage value. To calculate the double-declining balance depreciation, set up a schedule:
B)Sum of the Years’ Digits Method – In this method, the remaining useful life of the asset in a particular period is divided by the sum of the years’ digits. This fraction is then multiplied by Depreciable Cost. It recognizes depreciation at an accelerated rate.
Depreciation Expense = Depreciable Cost x (Remaining useful life of an asset/Sum of Years’ Digits)
Depreciable Cost = Cost of asset – Salvage Value
Sum of Years’ Digit = n x (n+1) / 2
where n = useful life of asset
Example: - Consider a piece of equipment that costs ₹25,000 and has an estimated useful life of 8 years and a ₹0 salvage value. To calculate the sum-of-the-years-digits depreciation, set up a schedule:
III.Unit of production Method of Depreciation- This method provides for depreciation by means of a fixed rate per unit of production. The units-of production depreciation method depreciates assets based on the total number of units to be produced by using the asset, over its useful life.
Depreciation Expense = (Number of units produced / Life in number of units) X (Total Acquisition Cost - Salvage Value)
Example: - Consider a machine that costs ₹50,000, with an estimated total unit production of ₹100 million and ₹10,000 salvage value. During the first quarter, the machine produced 5 million units.
Depreciation Expense = (5/100) x (50,000-10,000) = ₹2,000