What Are the Different Ways to Calculate Depreciation?
Depreciation is an orderly process in which the cost of a fixed asset is expensed out to the income statement; the amount used to purchase an asset is initially marked as a tangible asset on the balance sheet and charged to the income statement over the functional life of an asset. Therefore, the depreciation method must reciprocate how a fixed asset is expected to produce revenue or cost savings.
The ways to calculate depreciation is classified into two types, (A) the time-factor ways and (B) the usage-factor ways. Here’s a list of both the ways to calculate depreciation.
- Straight-line depreciation method:
Calculating depreciation is essential for writing off the cost of lavish purchases and for taking out the tax depreciation properly.
The straight-line method is a common method for calculating how much a certain fixed asset loses its value over time. The method presumes a continual rate of depreciation. It calculates the depreciation of an asset in one year and then depreciates the asset by the same amount every year after that.
The formula for the straight-line method:
Depreciation cost = (Cost-scrap value)/ Useful life of asset
- Reducing balance depreciation method:
The reducing balance method is also known as “declining balance method” In this method, the depreciation cost decreases with the asset’s usage. In other words, more depreciation gets charged at the starting point, while less gets charged towards the end. Depreciating assets include machinery, buildings, furniture, vehicles, and equipment.
Many firms may also use the double-reducing balance method, which is an even more aggressive method for early cost management.
The formula for Reducing balance method:
Depreciation cost= Net book value x depreciation price
- Sum of the Year’s Digit Depreciation:
This method is the best for a full-time investor because it offers a depreciation rate that precipitates more than the Straight-line method but less than the declining balance method. Yearly depreciation is divided into fractions using the number of years of the fixed asset’s functional life.
This method allows for larger depreciation expense reduction in the primary years of an asset’s life. Firms usually use this method to minimize their taxable income. It could also be a more accurate method, as they presume that an asset loses a majority of its worth in the first few years of its use.
The formula for the Sum-of-the-year’s-digit method:
Depreciation cost= remaining functional life of an asset/ sum-of-years-digits (asset price- residual value)
- The unit of production method:
This method calculates the depreciation of the value of an asset over time. It’s become functional when a fixed asset’s value is closely related to the number of units it generates rather than the number of years it is in use. This method results in larger subtractions for depreciation in years when the asset is used, which can then equalizes the period when the equipment experiences less use.
The formula for unit production method:
Depreciation cost= (Original value-scrap value/ estimated production capacity) x units per year.