Introduction:
An office building is a fixed asset because it has a useful life of more than one year and meets both the criteria of an asset. A tangible good is classified as an asset if its cost can be reliably measured and future economic benefits are expected from it.
When a fixed asset is acquired or constructed, it is recorded as a Non-current asset on the balance sheet instead of expensing it out in one-go.
The cost is then allocated systematically throughout its useful life as a depreciation expense in the income statement. Depreciation expense is charged due to usage, wear and tear or obsolescence.
An office building can be depreciated through any of the three following methods of depreciation:
I’ll show you a solved example of how to calculate the depreciation of an office building through all the three methods.
Question:
Hazza and Co. commenced a business in January 2019. It acquired an office building for $150,000 having an estimated useful life and residual value of 6 years and $30,000 respectively. Calculate depreciation through:
- Straight-line method
- Double declining method
- Sum of year’s digits method
Calculation of depreciation using SLM:
The formula for calculation of a fixed asset through this method is:
= (Cost – Scrap Value) / Estimate Useful LIfe
Hence, the annual depreciation expense for the year using straight-line method would be $20,000. The depreciable amount will be equally allocated to each accounting period from 2019 till 2024 i.e. $20,000.
At the end of its useful life the office building would be disposed of having a scrap value of $30,000 left after years of depreciation.
Calculation of depreciation expense through double declining method:
Through this method depreciation expense is higher in the early years of the asset’s useful life. It is one of the accelerated method of depreciation.
Double declining method is also known as a reducing balance method, meaning that depreciation rate is applied at the Net Book Value (cost less accumulated depreciation) of the asset instead of the initial cost.
In order to calculate the depreciation expense for each accounting period we must know the depreciation rate first which can be determined through the following formula:
= (Annual Depreciation / Cost of Assets) * 100
The annual depreciation is the depreciable cost divided by the asset’s useful life.
In the Hazza and Co. example, the annual depreciation would be ($150,000 – $30,000)/6 = $20,000.
Hence, the applicable depreciation rate would be:
(20,000 / 150,000) * 100 = 13.33%
The net book value (NBV) for 2011 would be $150,000 and the depreciation expense would be $20,000 ($150000 x 13.33%). The closing NBV would be $13,000 while the accumulated depreciation balance would be $20,000.
Hence, for the year 2012 the depreciable amount or net book value of the asset would be $130,000 (cost less accumulated depreciation) and the depreciation expense would be $17329 ($130,000 x 13.33%).
The closing NBV would be $11,2671 while the accumulated depreciation expense would be $37,329.
This process would continue until the end of the useful life of the asset i.e. 2024.
How to calculate depreciation through sum of year’s digits?
SYD method is similar to the double declining method since it is also an accelerated method of depreciation.
We charge higher depreciation expense in the early years of the asset instead of equal depreciation throughout like the straight-line method.
However, in this method the applicable depreciation for each accounting period is different. The applicable depreciation rate is calculated through the following formula:
(Remaining Useful Life at the Beginning of Accounting Period / Sum of year’s digits of estimate useful life) * 100
The applicable depreciation rate for the year 2019 used in preparation of financial statements of Hazza and CO. would be [6/(5+4+3+2+1)]*100 = 28.57%
Similarly, the applicable depreciation rate for the year 2020 would be [ 5/(6+5+4+3+2+1)] *100 = 23.81%
Now this depreciation rate would be multiplied with the depreciable amount (cost less scrap value) of the asset in order to calculate the depreciation expense. In the given example, the depreciation expense for:
a) 2019 would be 28.57% x ($150,000 – $30,000) = $34,284
b) 2020 would be 23.81% x ($150,000 – $30,000) = $28,571
