What are the methods of calculating depreciation

There are several different methods of calculating depreciation; these methods fall into two general categories, known as straight-line depreciation and accelerated depreciation.

Depreciation is an idea used in finance, economics, and accounting. Depreciation stems from the fact that all assets that have a measurable life-something like a car, machinery, and so on (as opposed to land)-will continue to lose value as time goes on.

When you buy a car, you buy it at a set price, called the historical cost of that asset (this is also known as basis). That car will lose value every year, a fact that you can see simply by looking at the blue book listing for your car each year, and watching that value fall. Depreciation is a way of measuring value that spreads the historical cost of the asset across the entire life of the asset.

In other words, depreciation is a way of allocating the historical cost of an asset across the life of the asset. Depreciation is not linked to the current market value of an asset-depreciation has nothing to do with what people are willing to pay for something at that time. For example, even though an asset has fully depreciated-it has gone through its historical cost-people will still be willing to buy it, in many cases.
Why does a company need to keep track of depreciation of its assets? For two main reasons:

1. A company has to be able to match both what it spends and what it earns from what it spends.


2. When drawing up a balance sheet, it's important for a company to be able to accurately state the value of its assets. Depreciation helps a company accurately calculate what its assets are really worth.
   Methods of depreciation are generally based on the way and the frequency with which an asset is used by the company. We will cover five different methods of calculating depreciation.
   
   1. Straight-line depreciation
   
   
   2. Sinking fund method depreciation
   
   
   3. Declining balance depreciation
   
   
   4. Activity depreciation
   
   
   5. Sum of years digits depreciation

1. Straight-line depreciation
   Straight line depreciation is the most commonly used way to calculate depreciation. The way it works is that the company estimates the salvage value of an asset. The salvage value is an estimated value of the asset whenever it will be sold. This could be zero. The depreciation expense is determined by the cost of the asset divided by the length of its useful life. This number is subtracted for each year of the life of the asset, and is considered its depreciation.


2. Sinking fund method
   The sinking fund technique of calculating depreciation sets the depreciation expense as a particular amount of an annuity. The depreciation is calculated so that at the end of the useful life of the annuity, the amount of the annuity equals the acquisition cost. The sinking fund method calculates more depreciation closer to the end of the useful life of the asset, and isn't used very often.


3. Declining-balance/reducing balance
   This way of calculating depreciation falls under the accelerated depreciation category. This means that it sets depreciation expenses as higher earlier on, more realistically reflecting the current resale value of an asset.
   The way that declining-balance depreciation is calculated is by taking the net book value from the previous year, and multiplying it by a factor (usually 2) which has been divided by the useful life of the asset.
   Depreciation expense = previous period NBV x factor / useful life


4. Activity depreciation
   This way of calculating depreciation bases the depreciation expense on the activity of an asset, like a machine. Multiply the per-whatever (mile, cycle, etc) rate by the actual activity level of the asset to determine the depreciation expense for the year.


5. Sum of years digits
   This way of calculating depreciation falls between accelerated and straight line depreciation.

Here's the formula:
N = depreciable life
B = cost basis
S = salvage value
D(t) = Depreciation charge for year t
Sum = N(N + 1) /2
D (t) = (N - t + 1) x ((B = S) / Sum)

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Categories: Depreciation,

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