Depreciation methods definition
/What are the Most Common Depreciation Methods?
Depreciation is used to gradually charge the book value of a fixed asset to expense. It is intended to approximately reflect the decline in value of an asset over time, due to wear and tear. There are several methods of depreciation, which can result in differing charges to expense in any given reporting period. The following are the general methods of depreciation available for use.
Straight-Line Depreciation
The straight-line method charges the same amount of depreciation to expense in every reporting period. This approach probably approximates the average usage pattern of most assets, and so is a reasonable way to match revenues to expenses. It is also the easiest depreciation method to calculate, which makes it by far the most commonly-used depreciation method. Using this approach makes it easier to close the books at the end of each month, since it is so simple to calculate.
Under the straight-line method of depreciation, recognize depreciation expense evenly over the estimated useful life of an asset. The straight-line calculation steps are:
Subtract the estimated salvage value of the asset from the amount at which it is recorded on the books.
Determine the estimated useful life of the asset. It is easiest to use a standard useful life for each class of assets.
Divide the estimated useful life (in years) into 1 to arrive at the straight-line depreciation rate.
Multiply the depreciation rate by the asset cost (less salvage value).
Example of Straight-Line Depreciation
Pensive Corporation purchases the Procrastinator Deluxe machine for $60,000. It has an estimated salvage value of $10,000 and a useful life of five years. Pensive calculates the annual straight-line depreciation for the machine as:
Purchase cost of $60,000 – Estimated salvage value of $10,000 = Depreciable asset cost of $50,000
1 ÷ 5-Year useful life = 20% Depreciation rate per year
20% Depreciation rate × $50,000 Depreciable asset cost = $10,000 Annual depreciation
Units of Production Depreciation
Under the units of production method, the amount of depreciation charged to expense varies in direct proportion to the amount of asset usage. Thus, a business may charge more depreciation in periods when there is more asset usage, and less depreciation in periods when there is less usage. It is the most accurate method for charging depreciation, since this method is linked to the actual wear and tear on assets. However, it also requires that someone track asset usage, which means that its use is generally limited to more expensive assets.
Follow these steps to calculate depreciation under the units of production method:
Estimate the total number of hours of usage of the asset, or the total number of units to be produced by it over its useful life.
Subtract any estimated salvage value from the capitalized cost of the asset, and divide the total estimated usage or production from this net depreciable cost. This yields the depreciation cost per hour of usage or unit of production.
Multiply the number of hours of usage or units of actual production by the depreciation cost per hour or unit, which results in the total depreciation expense for the accounting period.
Example of Units of Production Depreciation
Pensive Corporation’s gravel pit operation, Pensive Dirt, builds a conveyor system to extract gravel from a gravel pit at a cost of $400,000. Pensive expects to use the conveyor to extract 1,000,000 tons of gravel, which results in a depreciation rate of $0.40 per ton (1,000,000 tons divided by $400,000 cost). During the first quarter of activity, Pensive Dirt extracts 10,000 tons of gravel, which results in the following depreciation expense:
= $0.40 depreciation cost per ton x 10,000 tons of gravel
= $4,000 depreciation expense
Accelerated Depreciation
An accelerated depreciation method is designed to charge the bulk of the depreciable amount of a fixed asset to expense as soon as possible, with a rapidly-declining amount being charged to expense in later periods. Examples of this method are the double-declining balance method and the sum of the years' digits method. This approach is useful for depressing short-term profits in order to reduce the amount of taxable income. However, it is difficult to calculate, usually does not reflect the actual usage pattern of a fixed asset, and skews the reported results of a business.
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Usage-Based Depreciation
A usage-based depreciation method is designed to have a variable periodic depreciation expense that is based on the amount that a fixed asset is actually used. An example of this method is the units of production method. This is the most accurate of the depreciation methods in matching actual usage to the related depreciation expense, but suffers from an inordinate amount of record keeping to track usage levels. Given this problem, it is usually restricted to the more expensive fixed assets whose usage levels vary considerably over time.
Depreciation Best Practices
Of the methods of depreciation noted here, the most practical one is the straight-line method, since it requires minimal upkeep and is the easiest to understand. The only value of an accelerated method is in deferring the payment of income taxes. A usage-based method should not be used unless there is a demonstrable need for an increased level of depreciation accuracy, since it is a time-consuming approach.
Any method of depreciation is time-consuming over the lifespan of an asset, and so is not efficient. To improve the efficiency of the accounting staff, set a high capitalization threshold, below which all expenditures are charged to expense as incurred. Doing so can eliminate a large number of depreciation calculations.
From an auditing perspective, it is best to use the straight-line method, since these calculations are easiest for auditors to verify. This can reduce the annual audit fee charged to a business.