Explain various methods of calculating depreciation in details
Depreciation is the systematic allocation of the cost of a tangible fixed asset over its useful life. There are several methods to calculate depreciation, each with different implications for how expense is recognized over time. Here’s a detailed explanation of the most commonly used methods:
### 1. Straight-Line Depreciation
**Description**: This method allocates an equal amount of depreciation expense each year over the asset's useful life.
**Formula**:
\[ \text{Annual Depreciation Expense} = \frac{\text{Cost of the Asset} - \text{Residual Value}}{\text{Useful Life}} \]
**Example**:
- Cost of Asset: $10,000
- Residual Value: $1,000
- Useful Life: 5 years
\[ \text{Annual Depreciation Expense} = \frac{10,000 - 1,000}{5} =
### 1. Straight-Line Depreciation
**Description**: This method allocates an equal amount of depreciation expense each year over the asset's useful life.
**Formula**:
\[ \text{Annual Depreciation Expense} = \frac{\text{Cost of the Asset} - \text{Residual Value}}{\text{Useful Life}} \]
**Example**:
- Cost of Asset: $10,000
- Residual Value: $1,000
- Useful Life: 5 years
\[ \text{Annual Depreciation Expense} = \frac{10,000 - 1,000}{5} = 1,800 \text{ per year} \]
### 2. Declining Balance Method
**Description**: This method applies a constant rate of depreciation to the declining book value of the asset each year. The most common form is the double declining balance method.
**Formula** (Double Declining Balance):
\[ \text{Annual Depreciation Expense} = \text{Book Value at Beginning of Year} \times \left( \frac{2}{\text{Useful Life}} \right) \]
**Example**:
- Cost of Asset: $10,000
- Useful Life: 5 years
First year:
\[ \text{Depreciation Expense} = 10,000 \times \left( \frac{2}{5} \right) = 4,000 \]
Second year:
\[ \text{Book Value} = 10,000 - 4,000 = 6,000 \]
\[ \text{Depreciation Expense} = 6,000 \times \left( \frac{2}{5} \right) = 2,400 \]
### 3. Sum-of-the-Years'-Digits (SYD) Method
**Description**: This method results in a higher depreciation expense in the earlier years of an asset’s useful life and lower expense in the later years.
**Formula**:
\[ \text{SYD} = \frac{n(n+1)}{2} \]
Where \( n \) is the useful life of the asset.
Annual Depreciation Expense:
\[ \text{Depreciation Expense} = (\text{Cost of Asset} - \text{Residual Value}) \times \left( \frac{\text{Remaining Life}}{\text{SYD}} \right) \]
**Example**:
- Cost of Asset: $10,000
- Residual Value: $1,000
- Useful Life: 5 years
\[ \text{SYD} = \frac{5(5+1)}{2} = 15 \]
First year:
\[ \text{Depreciation Expense} = (10,000 - 1,000) \times \left( \frac{5}{15} \right) = 3,000 \]
Second year:
\[ \text{Depreciation Expense} = (10,000 - 1,000) \times \left( \frac{4}{15} \right) = 2,400 \]
### 4. Units of Production Method
**Description**: This method bases depreciation on the actual usage of the asset, making it suitable for manufacturing equipment and machinery.
**Formula**:
\[ \text{Depreciation Expense} = \left( \frac{\text{Cost of Asset} - \text{Residual Value}}{\text{Total Expected Production}} \right) \times \text{Actual Production} \]
**Example**:
- Cost of Asset: $10,000
- Residual Value: $1,000
- Total Expected Production: 100,000 units
- Actual Production (Year 1): 20,000 units
\[ \text{Depreciation Expense} = \left( \frac{10,000 - 1,000}{100,000} \right) \times 20,000 = 1,800 \]
### 5. MACRS (Modified Accelerated Cost Recovery System)
**Description**: This is the depreciation method used for tax purposes in the United States. It allows for greater depreciation expense in the early years of the asset's life.
**Method**: MACRS provides a set of predefined depreciation rates for different classes of assets over specified periods. It combines the declining balance method with the straight-line method at a later stage.
**Example**:
For an asset with a 5-year recovery period, the IRS provides specific rates to apply each year.
Each method of depreciation serves different financial reporting and tax purposes, and the choice of method can significantly affect a company’s financial statements and tax liabilities.
