Methods of Depreciation in Accounting

Depreciation plays a key role in accounting, and it is the process of wearing out an asset over a period of time. This decline is due to factors such as wear and tear, obsolescence or usage. It saves cost since companies spread the expense of an asset over the period that the asset was expected to become useless; making financial statements provides a true picture of the value of assets of the company. In this blog, I will ensure that I explain to you different methods of depreciation in accounting that we have, how each works, and when you can apply it.

What is Depreciation in Accounting?

Depreciation is another way of writing off the cost of a tangible asset over the useful life of that asset. This allocation is put in the statement of the company’s profit and loss account as an expense. Also, by spreading out an asset’s cost over time, depreciation is beneficial to a business in the sense that it allows the cost of the said asset to be more closely aligned with its earnings in the form of revenues.

Why Is Depreciation Important?

1. Accurate Financial Reporting: Depreciation helps standard-setters to arrive at a realistic value for the assets.
2. Tax Deductions: There is a tax advantage from depreciation because depreciation lowers the level of taxable income.
3. Cost Allocation: It directs the costs of an asset regarding the benefits of the asset by spreading the expense of the total cost of an asset over the useful life of the asset.

Common Methods of Depreciation

In fact, there are several prompts on how to schedule depreciation, and each one has its benefits and drawbacks. The most commonly used methods include:

1. Straight-Line Depreciation

The straight-line depreciation method is likely to be the most traditional one since it reflects the more or less simultaneous write-off of the asset. The formula for straight-line depreciation is:

Straight-Line Depreciation Formula:

Depreciation Expenses = Cost of Asset- Salvage Value /Useful Life

• Cost of Asset: The cost at which an organization first acquires an asset for use in its business operations.
• Salvage Value: The value of the asset after deterioration to the point where it is no longer useful by whoever is making the estimate.
• Useful Life: This is the projected time that the asset will be in use, say the number of years before it deprecates.

Advantages:

1. To calculate and easy to comprehend.
2. One of the advantages is that it gives a constant depreciation expense for each of the years.

Disadvantages:

1. No consideration is given to the state of depreciation of the item or its usage frequency.
2. May not be appropriate where the assets deteriorate faster during the earlier periods.

2. Declining Balance Depreciation

The declining balance method increases depreciation rates because more of the asset value is expensed in the first couple of years of an asset’s useful life. Within this method, a certain proportion of book value, once the sum arrived at is adjusted for depreciation to date, is written off each year.

Declining Balance Depreciation Formula:

Depreciation Expenses = Current book value * Depreciation Rate (%)

• Depreciation Expense is the Book Value at the beginning of the Year multiplied by the prescribed depreciation rate.
• Book Value: The cost of the asset is less than the total amount of depreciation that has been expended on the asset up to the date of the balance sheet.
• Depreciation Rate: A fixed percentage of the book value was taken and used as the amount of a letter of credit based on the fact that the value of the book is very constant.

Advantages:

1. Exemplifies the sharp deterioration in the value of items that are considered to be of a depreciation nature because they have short useful lives.
2. Consequently, this results in higher depreciation in the savings from the earlier years when taxation is attained.

Disadvantages:

1. More complex to calculate.
2. It may not reflect the actual use of the asset as it puts forward an expectation that the asset is going to deteriorate much faster.

3. Units of Production Depreciation

The units of production method is most effective when applied to fixed assets whose value is or can be directly related to the number of units the firm produces or the number of hours the fixed assets are used in production. Depreciation is charged on the actual usage of the particular asset, and therefore, it is more appropriate when equipment undergoes different usage rates.

Units of Production Depreciation Formula:

Depreciation Expenses = (cost of asset – salvage value / Total units of production) * Units Produced During the year

• Total Estimated Units: The anticipated total quantity of goods or services that the asset will generate over its useful life.
• Units Produced During the Year: The total number of units that were manufactured and brought into the market in the period.

Advantages:

1. Better applied to assets that turn over with utilization as opposed to chronological depreciation.
2. Depreciation expense should, therefore, be matched with the actual productivity of the asset.

Disadvantages:

1. This will also necessitate monitoring of the usage of assets, a task that may take some time.
2. Least suited for utilization of assets that cannot generate output that can easily be quantified.

4. Sum-of-the-Years’-Digits (SYD) Depreciation

Another accelerated method of depreciation is known as the sum-of-the-years’-digits method, which, although it resembles the declining balance method in a way, is quite different in its application of a special formula. The concept is that depreciation expenses are greater in the first few years and are lesser in subsequent periods.

SYD Depreciation Formula:

Depreciation Expense = Remaining Life/sum of the year’s Digit* (cost of the asset- salvage value)

The sum of the Years’ Digits: This is obtained by summing the digits of each year of the asset’s useful life, which for the case of 5 years would be 1+2+3+4+5 = 15.

Advantages:

1. Indicates higher wear and tear rates and better responses.
2. This is most appropriate for those assets that depreciate more at the beginning of their useful life.

Disadvantages:

1. Happens to be much more complex than the straight-line method of depreciation.
2. Thus, an estimate of actual usage still.

Choosing the Right Depreciation Method

1. Straight-Line: It is most suitable for those assets that experience a definite, repetitive rate of utilization.
2. Declining Balance: Suitable for such assets that depreciate heavily in the initial years of their usage.
3. Units of Production: Applied to machinery and equipment whose utilization varies depending on total production.
4. Sum-of-the-Years’-Digits: Most suitable where the rate of use is high in the initial years of the useful life of the asset.

Conclusion

It is important for firms and other organizations to study the several accounting methods of depreciation with a view to identifying the best method to adopt for effective cost distribution of equipment and for the right financial reporting. Every method has its strength depending on the type of asset being used and the pattern in which it is being used. It is significant to choose the right depreciation method to get better tax benefits and a better picture of the value of the company.

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