Business entities own different assets that are used for operations and revenue generations. Some assets are consumed within one accounting period, while others last for more than one accounting period. The short-term assets used within one year are not recorded in the company’s balance sheet.
Instead, they are recorded as the expense of the company. However, the assets that last for more than one year are recorded in the company’s assets.
The portion of such assets that are consumed in one accounting period is deducted from the asset’s value. The consumed portion is recorded as the depreciation expense in the profit & loss statement.
The accounting bodies developed different depreciation methods to calculate and record the depreciation expense against different assets.
Some methods are more popular and commonly used, while others are less frequently used. This article will explain all depreciation methods and identify which depreciation method is the most frequently used in business entities.
What Is Depreciation?
Depreciation can be defined as,
“systematic allocation of the costs over the useful life of a fixed asset.”
There are more than one definitions of depreciation that comprehends the concept of depreciation. Let’s quote some of the most common depreciation definitions:
“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 of depreciation states:
“ 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 periodically allocate the asset’s costs over its useful life. This is known as depreciation.”
From the definitions, the following characteristics of depreciation are highlighted:
- It’s a cost allocation method
- Continues until the useful life of assets
- A permanent and gradual decrease in asset’s value
- Applicable on assets whose economic benefits are expanded over two or more financial years
Which Assets Are Depreciable?
The company’s non-current assets that are useful for more than one financial year are depreciable and written off for a portion of book value in every period. However, it’s important to note that not all non-current assets are depreciable.
Non-current assets are categorized as tangible assets and intangible 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.
Since intangible assets are non-physical, they’re not depreciated. However, the cost of intangible assets is allocated to expense by an accounting method known as amortization.
Different Depreciation Methods With Examples
Let’s discuss different depreciation methods that are used by business entities in different cases.
Straight Line Method
The straight-line method is a depreciation method where the assets of the company are depreciated at a fixed rate of the asset’s value. The straight-line-method can be described as,
A depreciation method in which an asset’s cost is divided into equal parts over the asset’s useful life.
The asset’s cost is calculated by subtracting the salvage value from the purchasing/acquisition price of the asset. The remaining amount is divided over the number of years the asset is expected to stay useful.
The companies and business entities do not define the straight-line rate to calculate depreciation. Instead, the rate is calculated after the appropriation of depreciation for every accounting period.
The formula of depreciation is as follows:
Depreciation = (Cost -Residual or Salvage Value)/Years of Useful Life
For instance, if a company has purchased an asset for USD15,000 with a salvage value of USD3,000. The useful life of the asset is estimated to be 4 years. The depreciation for every accounting period will be calculated as follows:
Depreciation expense = (15,000 – 3,000)/4
Depreciation expense = USD 3,000
Declining Balance Method
Declining balance is an accelerated deprecation method. The accelerated depreciation methods are more commonly used depreciation techniques by business entities. The declining balance method is explained as follows,
The declining balance method, also known as the fixed-percentage-of-declining balance depreciation method, is calculated at a fixed percentage of the straight-line rate.
For instance, the company uses 150% of the straight-line method as a declining balance rate. The straight-line-method rate is 10%. The declining balance method rate will be 150% of 10%, which will be equal to 15%.
The depreciation expense for every financial year against a fixed asset is calculated as:
Depreciation Expense = Remaining book value X accelerated depreciation rate.
The depreciation expense is higher in the early depreciation periods and declines in the later periods. This method of depreciation is most commonly used for tax purposes by business entities.
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 answer is multiplied by (the cost-residual value) of the asset. The number of years across which asset is utilized adds up. The remaining years are divided by the total useful life.”
The depreciation expense under the SYM can be calculated as:
Depreciation Expense =(Cost – Residual Value)X[(number of years left in asset life)/the sum of the years in asset life]
Cost = initial acquisition cost of the asset
Residual value = end value of the asset after its useful life
The sum-of-the-years digit method is an allowed depreciation method under GAAP and IFRS. The method is commonly used by companies for assets that have a risk of becoming obsolete quickly due to a technological or industrial breakthrough.
Unit Production Method
The unit of production method is calculated by the number of units produced by machinery over its useful life. The time factor is not relevant in the unit production method. The companies enjoy higher tax deductions in the years when an asset is working more efficiently and giving higher output.
The salvage value is subtracted from the cost of acquisition for an asset. It’s divided by the estimated production capacity and multiplied by units produced in each year. The formula of the depreciation expense under the unit of production method looks like this:
Depreciation Expense = (Cost – Residual Value) X (Units Per Year/Estimated Production Capability)
Double Declining Method
The double-declining method is also an accelerated depreciation method and is very similar to the declining balance method.
However, the difference is that the percentage of the straight-line rate used in the double-declining method is 200% as compared to a variable rate in the declining balance method.
For instance, the straight-line rate calculated by a company for depreciation of assets is 10%. The depreciation rate in the double-declining method will be 200% of 10%, which will become 20%. The asset will be depreciated on the remaining balance every year by 20%.
The formula for depreciation expense is:
Depreciation Expense = Remaining book value X accelerated depreciation rate.
Most Frequently Used Depreciation Method
Businesses do not use a single depreciation method for all types of assets. Besides, the method of depreciation varies from purpose to purpose as well. The different depreciation methods are commonly used for accounting and tax purposes.
For Accounting Purposes
The most frequently used depreciation method for the companies’ accounting purposes is the straight-line method. The cost of the asset is divided into equal parts over the useful life of the assets. However, some companies also use the unit-of-production method for cost allocation.
For Tax Purposes
The accounting method for tax purposes is usually the declining balance method. Tax depreciation is the depreciation that the entities shown in the statement submitted for tax returns.
Business entities use this method because the larger expense is recorded in, the earlier years of operation when the company is getting most of the profits from the asset. As a result, higher tax deductions are made in the earlier years.
We have discussed different methods of depreciation and how each method is used by business entities for different purposes. The most commonly used method for accounting purposes is the straight-line method. Whereas the business entities usually use the declining balance method for tax purposes.