Depreciation

What is Depreciation

Depreciation is basically the wear tear of the asset. This is very common that an asset can only be used for a certain period of time and then it is disposed off. The reduction in value over the time is known as depreciation.

In accounting terminology Depreciation is systematic allocation of Depreciable amount of asset over its useful life.

Types of Depreciation of Methods

The most commonly used methods are as under

1.     Straight Line Method

2.     Reducing Balance Method

3.     Sum of Digit Method

1. Straight line Depreciation Method 

Straight line method is the easiest  method among all method of depreciation.Depreciation is calculated once in the first year and then apply in all period.

Straight line method provide a constant charge to the income statement. This method is used where the asset has relatively constant usage during its useful life. This method is called straight line method because when the depreciation put on a graph it will produce a straight line on the graph. 

Formula Straight line Depreciation Method

(Cost - Residual Value)/Useful life

Cost = The purchase price and installation and transportation charges.

Residual Value=  The amount expected to be released from the asset at the end of useful life.

Useful life = the period for which asset can be used or period during which the economic benefit will flow from the asset.

2. Reducing Balance Depreciation 

Reducing method used when asset has maximum usage in the early years life and then usage reduces over the period of time.The Information technology equipment is great example for this kind of equipment.

This method is relatively difficult than straight line method and each year depreciation amount is different from the last year.  The depreciation method is based on net book value of the asset and therefore it is called reducing balance method.

Formula for Reducing Balance Method

(Net book Value- Residual Value) X Depreciation Rate

Example of Net Book Value

A Computer has 22,000 and have residual value 2000 and have depreciation rate 40%

First year  22,000-2000    = 20,000X40%    = 8,000

2nd Year  12,000              =  12,000X 40% = 4,800

3rd Year    7,200               =  7,200 X 40%  = 2,880

3. Sum of Digit Depreciation Method 

This method used when there is a high usage of asset in the early year and then the usage reduces over the period of time. The depreciation is more like reducing balance but in reducing depreciation method you required a rate of depreciation and under this method there is no such requirement.

Formula of Sum of Digit Method

5+4+3+2+1 = 15 sum of digit is calculated

first year charges is 5/15 * Decipherable amount

Example of Sum of Digit Method

A machinery is purchased for 20,000 and useful life of five year.

5/15 * 20,000= 6,667  (first year)

4/15 * 20,000 = 5,333 (2nd Year)

3/15* 20,000 = 4,000  (3rd Year)

2/15 * 20,000 = 2,667 ( Fourth Year)

1/15* 20,000=  1,333 (Fifth Year)