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Depreciation

 What is depreciation? All most all the assets that company uses will become obsolete at some point of time. Depreciation is the term used to identify the obsolescence. Depreciation is decrease in price value of an asset due to obsolesces or usage. It is a systematic and rational process of distributing cost of tangible assets over the life of assets. Depreciation is usually reported as depreciation expense and since it is a non-cash expense it increase cash flow by reporting a lower net income. There are several components needed to calculate depreciations. Below are the components

-          Original cost   - is the purchase price of an asset

-          Salvage Value  - scrap value of the obsolete asset

-          Useful life  - generally the number of years that asset will be used for

-          Depreciation rate  - the rate at which an asset will be depreciated

-          Estimated Total Product  - estimated output from the asset

-          Actual production  -   specific point of production at which we would like to find out the depreciation expense or accumulated deprecation

There are several depreciation method used in real life to figure out depreciation expenses. Most commonly used methods are straight line method, double declining method, sum of year’s digit method and units-of-production method.  Each of these methods has its advantages and disadvantages which are explain below in detail.

Straight Line depreciation:

Straight line depreciation method is the simplest and most common used depreciation method. This method suggests a flat depreciation expense over the life of an asset. Components here are original cost of the asset, salvage value of the asset and useful life of the asset. Though the straight line method provides a better forecast of accounting measures, it assumes the asset will perform at same level for all its useful life. In reality, that is not the case since a new assets performs better at the beginning.

Straight line depreciations also involve the concept of book value to create deprecation table. “Book value” at the beginning of year 1 is the original cost of the asset. For any other year, the book value is simply the beginning of the year value minus the depreciation expense. Below is an example of straight line depreciation with the table. Use the Depreciation Calculator to calculate different types of depreciations.

Example:

A vehicle that depreciates over six years is purchased for $15,000. It has a salvage value of $3,000. What is the depreciation expense? Create the deprecation table.

Original Cost = $15,000
Salvage Value = $3,000
Useful life = 6

Depreciation expense = (15,000 – 3,000)/6 = 12,000/6 = $2,000.

Depreciation Table:

Double Declining Method:

Double declining method is more of a practical method for depreciation expense than straight line. It assumes assets are at their peak performance when they are new and their performance deteoriate with it. Thus, double declining assumes the largest depreciation expense at the first year. Double declining is a common method of accelerated depreciation. It doesn’t consider the salvage value in the deprecation of each period. However, if the book value drops below the salvage value, the period is adjusted so that it ends at salvage value. Steps to calculate double declining method are below.

Step1:
Calculate the straight line depreciation percentage. This is 100% divide by useful life.

Step 2:
Figure out the double decline deprecation rate. This is calculated by multiplying depreciation percentage by 2.

Step 3:
Sometimes an asset might be bought or sold in middle of a year. We need to figure out the depreciation for period. This is calculated by multiplying deprecation rate by book value of the beginning of year. If first year is not full 12 months than the expense is deprecation for period * (month/12). If the last year is not full 12 month than the expense is deprecation for a period * (month/12).

Below is an example of double declining method which includes all the mentioned steps. However, use the Depreciation Calculator to simply plug in the numbers and calculate depreciation.

Example:

On April 1^st, 2011 a company bought machinery for $1500. The machine is estimated to have 5 years of useful life. At the end of the 5 years the salvage value will be $200. Calculate deprecation in double declining method and create a depreciation table.

Step1:
Find the straight line depreciation percentage.
100%/5 = 20%

Step 2:
Find the double decline percentage
20% * 2 = 40%

Step 3:
Fin Depreciation for Period.
Since the asset was bought in April the depreciation will be for 9 months.
1500 * 40% * (9/12) = $450

The table below shows depreciation expense till year 2015.

Note: $200 salvage value is worked backward to get from beginning value. If we have taken 40% of $227 than the depreciation would have been 90.8 and the salvage value would have been 136.2, which is below book value.

The table below shows the formulas for calculating each column.

Sum-of-years’ end method:

Sum-of-years’ end method provides a cushion between straight line and double declining method. It offers little more accelerated depreciation than straight line and less accelerated than double declining. Below are the steps to calculating sum-of-years’ end method. However, use the Depreciation Calculator to calculate and create depreciation table.

Step 1:
Find the depreciable cost
Depreciable cost = Original Cost – Salvage Value

Step 2:
Find the sum of digits.
Sum of digits = (n²+n)/2
n = useful life

Step 3:
Find the depreciation percentage
Depreciation Percentage = n/Sum of Digits
Here n is the year number for which we are calculating.

Step 4:
Find the depreciation expense
Depreciation expense = Depreciable Cost * Depreciation Percentage

Below is an example of Sum-of-year’s end method.

Example:

An asset has original cost of $2,000 with a useful life of 5 years. It has a salvage value of $200. Calculate the depreciation expense using sum-of-years’ end method and create the table.

Step 1:
Find the depreciable cost
Depreciable cost = Original Cost – Salvage Value
Depreciable Cost = $2,000 - $200 = $1,800

Step 2:
Find the sum of digits
Sum of digits = (n²+n)/2               
Sum of Digits = (5²+5)/2 = 15

Step 3:
Depreciation percentage
Depreciation Percentage = n/Sum of Digits
Year 5 = (5/15) = 40%
Year 4 = (4/15) = 26.67%
Year 3 = (3/15) = 20.00%
Year 2 = (2/15) = 13.33%
Year 1 = (1/15) = 6.67%

Step 4:
Depreciation Expense
Depreciation expense = Depreciable Cost * Depreciation Percentage
Year 5 Expense = 1800 * 40% = 600
Year 4 Expense = 1800 * 26.67% = 480
Year 3 Expense = 1800 * 20% = 360
Year 2 Expense = 1800 * 13.33% = 240
Year 1 Expense = 1800 * 6.67% = 120

Below is the table created to show accumulated depreciation and the book value end of each year.

The table above is created with the assumption that an asset was purchased at the beginning of a year. However, if an asset is purchased in middle of the year then the depreciation percentage changes accordingly. Below is the table created assuming an asset is purchased in April 1^st.

Units of Production depreciation method:

Units of production depreciation method is another realistic method used to calculate depreciation at number of units produced. Units of production method takes into considering useful life in terms of total number of expected units to be produced from an asset. Use the Depreciation Calculator to calculate units of production. However, steps to calculating by hand are below.

Step 1:
Find the Depreciable Cost
Depreciable cost = Original Cost – Salvage Value

Step 2:
Find depreciation per unit
Depreciation per unit = Depreciable cost/Total Units

Step 3:
Find the depreciation for period
Depreciation Expense = Depreciation per Unit * Actual production.

Below is an example of units of production depreciation.

Example:
A sheet metal making unit is purchased for $500,000 and expect to have a salvage value of $20,000 at the end of 5 years. This machine is also expected to produce 600,000 units of sheet metal. In a given period of time the machine produced 300,000 units. What is the depreciation expense for that period?

Step 1:
Find the Depreciable cost
Depreciable cost = Original Cost – Salvage Value
Depreciable cost = $500,000 - $20,000 = $480,000

Step 2:
Find the depreciation per unit
Depreciation per unit = Depreciable cost/Total Units
Depreciation per unit = 480,000/600,000 = $.8

Step 3:
Find the depreciation for period
Depreciation Expense  = Depreciation per Unit * Actual production.
Depreciation expense = .8  * 300,000 = $240,000

Suggested Calculators:

Gross profit margin – Use the gross profit margin calculator to calculate gross profit margin
Earnings per share  - Earnings per share calculation made simple

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