A business entity has many assets that are used for revenue generation. Some assets are acquired and consumed during the regular business year. Such consumable assets are not recorded in the balance sheet at the year-end. Instead, they are debited to the expense account of the company. Then comes the current assets.
These assets are liquid assets of a business entity that can be easily converted into cash. Cash, cash equivalents, short-term securities, inventory, and account receivable are some examples.
The third type of asset is fixed assets or non-current assets. These assets are the company’s owned resources that provide economic benefit for several years.
Since the economic benefit from fixed assets is extended for several financial years, they are not debited to the expense account at once. Instead, the company makes estimates of the annual usage of the asset. The estimated amount is deducted from the book value of the asset every year.
The estimated amount is deducted from the asset’s value over its useful life. Afterward, the asset is disposed of at capital gain or loss. The estimates made for writing down the asset’s value are known as depreciation. There are several methods of depreciation. We will briefly look over the depreciation and its types.
However, the main focus is one depreciation method: the sum-of-the-years’ digits method. The article will talk about the step-by-step process of the sum-of-the-years’ digits method and its implications.
What Types Of Assets Are Depreciable?
In general, we talked about the depreciation and assets that are not debited to the expense account when acquired. Obviously, the non-current assets are depreciable and written off for a certain part of book value in every financial year. However, the non-current assets are further segregated into two types: tangible and non-tangible assets.
The tangible assets are the physical assets that can be touched and seen. Plant, machinery, furniture, office equipment, factory, buildings, etc., are common examples of the tangible assets owned by any business entity.
On the other hand, intangible assets are non-physical assets that cannot be touched or seen. Examples are patents, copyrights, goodwill, trademarks, etc.
The question is: which assets are depreciable?
The answer is tangible assets.
Another question might be asked: why intangible assets not depreciated?
The intangible assets are not depreciated. Instead, a similar phenomenon known as amortization has been put into place for catering the intangible assets. Therefore, the intangible assets are amortized and not depreciated.
What Is Depreciation?
The simplest definition of depreciation is ‘systematic allocation of the costs over the useful life of a fixed asset.’
However, many definitions for depreciation can collectively elaborate the concept of depreciation in simple terms. Here are some of the definitions of depreciation that are all true and similar.
The monetary value of a fixed asset decreases over time due to usage, obsolescence, and wear and tear. This reduction in value is recorded as annual depreciation for the asset. Depreciation is a non-cash expense for any entity.
Another definition says,
Depreciation’s concept can be explained as a continuous, gradual, and permanent decline in the book value of a fixed asset. However, the word permanent implies the useful life of the asset.
Similarly, the depreciation can also be defined as,
The business entities do not debit the purchase of a fixed asset to an expense account as the asset gives economic benefit for several years. Therefore, the business entities allocate the asset’s costs over its useful life periodically. This is known as depreciation.
From the definitions, depreciation can be explained as:
- An accounting method
- A continuous, permanent, and gradual decrease of asset’s value
- Continues over the useful life of an assets
- Systematic allocation of an asset’s cost over the useful life
- Depreciation is calculated on assets that deliver economic benefits for more than one financial year.
Different Depreciation Method
There are different methods of calculating depreciation. Business entities use different methods for different purposes. For instance, the depreciation method for accounting is different from the one used for tax purposes by most business entities. The most broader sub-divisions of depreciation method are as follow:
- Straight-line depreciation method
- Accelerated depreciation methods
- Unit of production method
Straight Line Depreciation Method
In this method, the cost of an asset’s residual value is subtracted from the original cost of acquisition. The balance is divided by the number of useful years. The answer is the periodic depreciation that will be deducted from book value in every financial year. It is the most popular method.
Accelerated Depreciation Method
As the name suggests, the accelerated depreciation method is a category that depreciates assets at a higher rate in the initial years and at a lower rate in the later years. The reason behind this is an assumption that assets generate higher revenue when they are new. Therefore, the greater expense should be recorded as per the matching principle of accounting.
Unit of production method
In the unit of production method, time is not a relevant factor, unlike the first two categories. The unit of production method focuses on the activity or output of the asset in the initial and later years. The depreciation charged in the initial years is greater than that of the later years.
Accelerated Depreciation Methods
Business entities most commonly use the accelerated depreciation method for tax purposes. It is further sub-divided into the following types:
- Declining balance method
- Double declining balance method
- Sum-of-the-years’ digits method
We will focus on the SYD method and its whole process. So let’s get into it.
The Sum-Of-The-Years’ Digit Method
The sum-of-the-years’ digit method is an accelerated depreciation method. We can define the method as,
‘The depreciation expense in the initial years is higher than that of the later years. The number of years across which asset is utilized adds up. The remaining years are divided by the total useful life. The answer is multiplied by (cost-residual value) of the asset.
Formula For Calculation:
Under the SYD method, the depreciation’s formula can be summarized as follow:
Cost = initial acquisition cost of the asset
Residual value = end value of the asset after its useful life
Excel Function For SYD Method
The sum-of-the-years’ digit method can also be solved in the excel sheet. By using the SYD function, you can quickly calculate the depreciation without any hassle. The function for excel is as follow:
Per = period for which you want to calculate the depreciation.
The step-by-step calculation method for calculating the sum-of-the-years’ digits method is as follow:
- The first step is to calculate the cost of an asset. It is usually the cost of the asset plus the expenses incurred for making the asset operational.
However, if the company has acquired a used asset, the acquisition cost plus costs of operationalizing the asset is recorded as the asset’s cost.
- The second step is a calculation of the depreciable amount of the asset. It will be calculated by subtracting the residual or salvage value of the asset from the total cost.
- Now you have to estimate the useful life of the asset and add the useful years.
- Multiply the depreciable amount with the depreciation factor. The depreciation factor for every year is different.
The formula for the depreciation factor is the remaining useful life/sum of useful years.
Let’s comprehend the process of calculating depreciation with the help of an example.
A manufacturing company Delta Inc. has purchased machinery for USD 4 million. The useful life of the machinery is seven years, and its residual value is 300,000 USD. The company has incurred the transportation-in expense of USD 100,000.
Now we will start from step 1 as mentioned above.
- Calculation Of Asset’s Cost
Total cost of the asset = purchase cost + transportation
Total cost of the asset = USD 4,000,000 + USD 100,000
= USD 4,100,000
- Calculation Of Depreciable Amount
Depreciable value = total cost of the asset – Residual value
= USD 4,100,000 – USD 300,000
= USD 3,800,000
- Sum Of Useful Years
Sum of useful years = 5+4+3+2+1
- Yearly Factor
The yearly factor will be as follow for each year:
Now the depreciation for year one can be calculated as follow:
The depreciation expense for year one = USD 3,800,000 X 5/15
= USD 1,266,667
Similarly, the depreciation expense for each subsequent year will be calculated.
There are many advantages of the approach, but there are certain disadvantages of the approach too.
- The approach does not create large tax deductions. The earlier years will have a tax advantage as higher deductions will be made. However, the later years will have lower deductions and higher income tax.
- In the accelerated depreciation methods, if an asset is sold at a higher price than book value, the capital gain is recognized as a taxable income. Therefore, it raises the risk of recaptured depreciation.
We have discussed the process of the SYD method and its limitations. The approach is realistic, and it is allowed under all the accounting standards like GAAP and IFRS. Additionally, the method is useful for the assets that are subject to obsolescence due to new technology or industrial breakthrough.