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Depreciation
Depreciation is a systematic and rational process of distributing the cost of tangible assets over the life of assets.
Depreciation is a process of allocation.
Cost to be allocated = acquisition cot - salvage value
Allocated over the estimated useful life of assets.
Allocation method should be systematic and rational.
Depreciation methods based on time
Straight line method
Depreciation = (Cost - Residual value) / Useful life
Example
Company A purchased an equipment at the cost of 140,000 in 2015. This equipment is estimated to have 5 year useful life. At the end of the 5th year, the salvage value (residual value) will be 20,000. Calculate the depreciation expenses for 2015, 2016 and 2017 using straight line depreciation method.
Depreciation for 2015
= (140,000 - 20,000) x 1/5 = 24,000
Depreciation for 2016
= (140,000 - 20,000) x 1/5 = 24,000
Depreciation for 2017
= (140,000 - 20,000) x 1/5 = 24,000
Declining balance method or Reducing Balance or Diminishing Balance Method
Depreciation = Book value x Depreciation rate
Book value = Cost - Accumulated depreciation
The value of asset goes on diminishing year after year, the amount of depreciation charged every year also goes on declining. Every year a fixed percentage of the net book value of the asset is reduced.
For example 20% depreciation is charged. If the asset has a value of 10000, the depreciation for the first year will be 20% of 10000 i.e. 2000. The book value for the next year will be now 8000. This year the depreciation will be again 20% of the remaining value i.e. 20% of 8000=1600. So the remaining value of the asset is now 8000-1600=6400.
Depreciation rate for double declining balance method
= Straight line depreciation rate x 200%
Sum-of-the-years'-digits method
Depreciation expense = (Cost - Salvage value) x Fraction
Fraction for the first year = n / (1+2+3+...+ n)
Fraction for the second year = (n-1) / (1+2+3+...+ n)
Fraction for the third year = (n-2) / (1+2+3+...+ n)
...
Fraction for the last year = 1 / (1+2+3+...+ n)
n represents the number of years for useful life.
Example
Company A purchased the following asset on January 1, 2015.
What is the amount of depreciation expense for the year ended December 31, 2015
Acquisition cost of the asset --> 100,000
Useful life of the asset --> 5 years
Residual value (or salvage value) at the end of useful life --> 10,000
Depreciation method --> sum-of-the-years'-digits method
Calculation of depreciation expense
Sum of the years' digits = 1+2+3+4+5 = 15
Depreciation for 2015 = (100,000 - 10,000) x 5/15 = 30,000
Depreciation for 2016 = (100,000 - 10,000) x 4/15 = 24,000
Depreciation for 2017 = (100,000 - 10,000) x 3/15 = 18,000
Depreciation for 2018 = (100,000 - 10,000) x 2/15 = 12,000
Depreciation for 2019 = (100,000 - 10,000) x 1/15 = 6,000
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