Depreciation

Reviewed by Athena | Updated on Aug 27, 2020

What is Depreciation?

Depreciation is the reduction in the monetary value of a tangible asset over time due to use, wear and tear, or obsolescence. It is an accounting method used to allocate a portion of the cost of the asset, over its useful life, to the profit and loss statement for a financial year. Simultaneously, the holding cost of the asset gets reduced to that extent in the balance sheet. Depreciation is a non-cash expense as it reduces the profits of a business without a cash outflow involved.

What are the Methods Used to Calculate Depreciation?

To calculate depreciation, the depreciable base needs to be first calculated. The depreciable base is the base value on which the percentage of depreciation is then applied.

Depreciable base = (Cost of the Asset) - (Salvage or Residual Value at the End of its Useful Life)

The common methods of depreciation followed are:

1. Straight-line method This is a simple method of calculating depreciation wherein a fixed percentage is applied on the depreciable base calculated, and the depreciation amount remains equal over the life of the asset until it is reduced to its salvage value. The percentage applied is obtained by dividing the depreciable base of the asset over its useful life in years.

2. Written-down balance or reducing balance or diminishing balance method Under this method, a fixed rate of depreciation is applied to the reducing or diminishing value of the asset held in the books of accounts at the beginning of the financial period, and not to the cost of the asset. In this method, the carrying value of the asset, as well as the depreciation per year, will be higher in the initial years and reduces with time.

3. Annuity method This method is not time-based and does not take into consideration the useful life in terms of years, but instead in terms of production capacity. For a production machine, the total cost of the machine will be divided by the total units manufactured by the machine over its lifetime to get the depreciation cost per unit. This cost will be multiplied by the number of units manufactured in a particular financial period to get the total depreciation for the year.

4. Sum-of-years digits method This method involves accelerated depreciation, where the years of the asset’s useful life are added, in order to calculate the depreciation rate. If an asset’s useful life is 5 years, the sum of digits will be 1+2+3+4+5=15. The depreciation for a period will then be calculated based on the remaining years of the useful life of the asset. Hence, the first year will have a depreciation rate of 5/15, the second year will be 4/15, and so on.