Methods of Depriciation

1)      Straight-Line

  • assumes that the asset will contribute to earning revenue equally during each period
  • depreciation expense is the same for every year of the asset’s useful life
  • Annual Expense: Cost – Salvage Value

Estimated Useful Life

2)      Units of Output

 

  • an equal amount of depreciation is charged for each unit produced
  • appropriate when the amount of use of an asset varies from period to period
  • suitable only when units of output over asset’s entire useful life can be estimated with reasonable accuracy
  • Annual Expense: Cost – Salvage Value     *   # of units

Number of Units of             produced                                                                  Estimated Productive Life

3)                Accelerated Depreciation

 

  • recognition of relatively large amounts of depreciation in early years and less in later years
  • assets more efficient and provide better services earlier
  • therefore should allocate greater portion of asset’s cost to match this greater output
  • popular for tax purposes – reduces tax burden in current year
  • there are two varying techniques of accelerated depreciation:

 

a) Double-Declining Balance

 

  • double straight-line depreciation rate
  • this constant rate is applied to the Net Book Value (NBV) of the asset to determine the amount of depreciation for the period (NBV = Cost – Accumulated Depreciation)
  • continue depreciating until the NBV = Salvage Value
  • Annual Expense = NBV * constant rate

 

 b) Sum-of-Years’ Digits (SYD)

 

  • depreciation rate to be used is a fraction
  • the numerator is remaining years of useful life
  • the denominator = sum of years of useful life
  • Annual Expense:

(Cost   –         *        useful life at beginning of period

Salvage Value)                sum of the years of useful life

 

Partial Year Depreciation

 

  • in the year of acquisition, the amount of depreciation must be apportioned according to the length of time the asset has actually been owned

 

  • if the purchase was made during the first half of the month, include that month in your depreciation calculation

 

  • if the purchase was made during the last half of the month, do not include that month in your depreciation calculation

 

  • partial depreciation must also be calculated when asset disposal occurs

 

  • the half-year rule requires that in the year of acquisition, only a ½ year of depreciation may be taken, regardless of the purchase date

 

Depreciation’s Impact on Financial Statements

  • the choice of depreciation method will have an impact on the income statement
  • using an accelerated method of depreciation (SYD, declining balance) results in a lower net income figure initially and then a higher net income figure near the end of its useful life
  • GAAP requires the consistent application of one depreciation method (consistency principle)
  • but, the same method is not required for different types of plant assets