## What is Depreciation Methods?

### Table of contents Depreciation is a historical cost. Depreciation is the systematic and gradual reduction in the value of the fixed asset (as recorded in the books of accounts) due to the continuous wear and tear or obsolescence over a period of time. Depreciation is a method of allocating cost of capital assets throughout its useful period of life. As a requirement of the matching principle, depreciation is the expense or cost of the fixed asset is associated with the revenue it generates during the given reporting year. The overall effect of this is reflected as the declined value of the fixed assets as shown in the Balance sheet.

Accounting entry for depreciation:

DEBIT depreciation expense account and

CREDIT accumulated depreciation account.

## Related Terms • Group Assets: Groups assets are assets similar in function to each other which are pooled together and they have nearly the same useful lives.

• Composite Assets: ≠ Composite assets are those assets which are not similar to each other but their functions are such that they can be clubbed into a specific category. Examples are the office stationary items.

## Methods of Depreciation

The calculation of depreciation for assets can be done in many different ways.

### Straight Line Method Straight Line method is a method in which each accounting year will be allocated an equal part of the assets cost as the depreciation amount after reducing its salvage value from its original cost and by dividing it by its useful life.

For more information, click here ⟹ Straight Line Depreciation Method

### Written Down Value Method In written down value method also known as Reducing Balance Method, the value of the asset is depreciated more during its initial years of putting it to use and the amount of depreciation reduces with every passing year. The asset is depreciated at a higher amount in its earlier years as compared to its later years as seen in the chart above. It is applicable for assets with greater utilities in its initial years.

Depreciation Per Annum = (Cost of Asset - Residual Value) x Rate of Depreciation (%)

Example: A computer costing \$ 600 has a useful life of 5 years. Its residual value is \$ 50 and the rate of depreciation is 60%. The depreciation is calculated as follows:

 Year Cost in the beginning of the year (\$) Rate (%) Depreciation amount (\$) Cost at the end of the year. (\$) Year 1 600- 50(residual value) = 550 60 330 220 Year 2 220 60 132 88 Year 3 88 60 58.8 35.2 Year 4 35.2 60 21.1 14.1 Year 5 14.1 60 14.1* -

The depreciation in the last year is taken as the cost at the beginning of the last year as the residual value is already deducted from the original cost of the asset and hence there should be no residue.

This method is useful when the assets productivity is more during the early stages of it being put to use.

### Unit of Production Depreciation This method also known as units of usage or units of activity is based on the expected usage or output level of the asset. It measures the current achieved level of output to its expected level of output or capacity in future. In this method the useful life of the asset is calculated in terms of output of production and not on its year of service. It needs that the total estimated output or usage of the asset during its useful life is known in advance.

Depreciation Expense = Actual production x (Cost- Residual Value)

Total Expected Production or Usage

Example: A factory installed a packaging plant costing \$ 20 million and it is expected capacity is 80 million packages over its period of life. Its residual value is \$2 million. The packaging in the first year is expected to be 10 million packages. Thus the depreciation for the first year is calculated as below: ### Sum of the Years Digits Method

This is a type of accelerated depreciation and is similar to reducing to balance method which apportions higher depreciation in the initial useful years of the asset. Depreciation is charged on the sum of the years of the useful life of an asset. It is charged on the fractional element of the total of sum of the years.

Example: If the life of asset is 3 years, then the sum of the assets is 1 + 2 + 3 = 6.

The fractional part is the year under consideration to calculate depreciation and it is the non depreciated useful life of the asset.

For year 1= depreciation is 3/6 * depreciable cost

For year 2= depreciation is 2/6 * depreciable cost

For year 3= depreciation is 1/6 * depreciable cost

For more information, click here ⟹ Composite Depreciation Method

## Causes of Depreciation

• Regular use of assets causes the wear and tear.

• Whether the asset is out to use or not, with the passage of time there is deterioration in the asset.

• Some assets come with usage rights and thus depreciation must be provided within the period of permitted usage.

• Unforeseeable incidences such as fire, natural calamities, accidents, etc.

• Mishandling of the asset.

• Obsolescence, as the technology is very dynamic and ever changing.

• Depletion due to the extraction of its essential materials composing the asset.

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