Depreciation Method: Types of Depreciation Methods With Formulas & Examples

Depreciation is an important accounting term that shows the steady loss of an asset’s value over time. Understanding the different depreciation techniques allows firms to distribute an asset’s cost appropriately throughout its useful life. 

This article delves into different types of depreciation methods, studying their formulae and presenting practical examples to help with understanding. From straight-line to declining balance methods, each approach has distinct advantages and implications, which we will highlight for your better understanding.

What is Depreciation?

Depreciation is a way of allocating the cost of a physical item over its useful life. It recognises the steady loss of asset value owing to causes such as wear and tear, obsolescence, or overuse. This methodical technique assists organisations in matching the asset's expenditure with the income it generates over time. 

Depreciation provides a more realistic picture of an asset's diminishing value and follows accounting standards, assisting in financial reporting and decision-making processes by spreading the expense. There are several systems of depreciation, each with its own set of regulations and implications for financial management.

Why is Depreciation Important?

Depreciation holds significant importance in accounting and financial management for several reasons. Here are some:

• Matching principle

Depreciation allows businesses to match the cost of an asset with the revenue it generates over its useful life, aligning with the matching principle in accounting.

• Accurate financial statements

By spreading the cost of an asset, businesses can present more accurate financial statements that better reflect their financial health and performance.

• Asset valuation

Properly accounting for depreciation assists in determining the fair market value of assets, facilitating accurate valuation for financial reporting purposes.

• Investor and creditor confidence

Accurate depreciation methods contribute to transparent financial reporting, enhancing confidence among investors and creditors.

• Tax implications

Depreciation affects taxable income, influencing the amount of taxes a business owes. A proper depreciation calculation can optimise tax liabilities.

• Asset replacement planning

Understanding the depreciation of assets aids in strategic planning for their replacement or upgrade, ensuring continued operational efficiency.

• True economic value

It provides a more realistic representation of the asset's decreasing value, reflecting its true economic worth over time.

• Budgeting and forecasting

Businesses can make informed budgeting and forecasting decisions by considering the depreciation of assets and their impact on future expenses.

Types of Depreciation Methods

There are different types of depreciation methods, each offering a distinct approach to allocating the cost of an asset over its useful life. Understanding these methods is crucial for businesses to choose the most appropriate one based on the nature of their assets and financial objectives. Here are some common types of depreciation methods:

• Straight-line depreciation

This method spreads the cost of an asset evenly over its useful life. 

• Annuity method of depreciation

This depreciation technique is a less prevalent way of dispersing an asset’s cost over its useful life. It is generally used for assets with a long life, large purchase price and fixed rate of returns.

• Double declining balance

This is an accelerated depreciation method which applies a depreciation rate double that of the straight-line method to the asset's remaining book value.

• Declining balance depreciation

This method applies a constant rate to the asset's remaining book value, resulting in higher depreciation expenses in the initial years. 

• Units of production depreciation

Ideal for assets whose productivity varies, this method allocates depreciation based on the actual usage of the asset.

There are many other depreciation methods that we will discuss in detail below. Choosing the appropriate depreciation method is dependent on criteria such as asset kind, estimated usage, financial goals and firm flexibility in managing financial reporting and tax consequences.

Methods of Calculating Depreciation

Straight-Line Method of Depreciation

The straight-line method of depreciation is a method for distributing an asset’s cost equally across its useful life. It is distinguished by a fixed yearly depreciation expenditure, making financial planning and reporting simple. 

Straight-line method of depreciation formula

Depreciation formula of straight-line method = (Cost of Asset - Residual Value) / Useful Life of Asset

Here, the cost of the asset represents the initial purchase cost of the asset, the residual value is its estimated value at the end of its useful life, and useful life is the anticipated duration of productive use.

Depreciation rate formula of the straight-line method = (Amount of Depreciation / Original Cost of Asset) * 100

Example: 

If a company invests in machinery for Rs.60,000 with a salvage (residual) value of Rs.10,000 and a useful life of 5 years, the annual depreciation under the Straight-Line Method would be (60,000 - 10,000) / 5 = Rs. 10,000. This means the asset's value decreases by Rs. 10,000 each year until its book value reaches the salvage value. 

This method offers simplicity and uniformity in spreading the cost of an asset, aiding in accurate financial reporting and budgeting.

Written Down Value (WDV) Method of Depreciation

The written-down value method, or reducing balance method, is an important approach for calculating depreciation, which is also approved by the Indian Income Tax Act. In this method, a fixed percentage of depreciation is applied to the decreasing value of the asset each year. 

Unlike other methods, the salvage value of the asset is not factored in when determining depreciation in the diminishing balance method. Consequently, the depreciation amount decreases annually using this approach.

WDV method of depreciation formula

Formula for written down value method of depreciation = (Rate of Depreciation / 100) * Book Value

Example:

For example, if a computer is purchased for Rs.50,000 with a depreciation rate of 20%, the first-year depreciation would be 50,000 * 0.20 = Rs.10,000. In the second year, the book value would be (50,000 - 10,000), and the depreciation would be calculated on this reduced value. 

This method results in higher depreciation in the earlier years, reflecting the faster depreciation of the asset. The WDV method is especially suitable for assets that experience significant wear and tear in the initial stages of their useful life.

Annuity Method of Depreciation

The annuity method of depreciation is a method of allocating an asset’s cost throughout its useful life, considering it as a sequence of cash payments comparable to an annuity. This strategy presupposes that the asset will provide a steady stream of benefits throughout time. 

Moreover, this method takes a more subtle approach by accounting for the time value of money, making it appropriate for assets with changing cash flows during their useful lifetimes.

Annuity method of depreciation formula

Formula for the annuity depreciation method = 

Annuity = [i * TDA * (1+i)^n] / [(1 + i) - 1^n]

Depreciation = Annuity - (i * BVSY)

Here,

• i = Interest rate percentage / 100
• TDA = Total depreciation on amount
• n = Annuity number of years
• BVSY = Book value at the start of the year

​Example: 

If a company invests in a vehicle for Rs.80,000 with a salvage value of Rs.10,000, and the discount rate is 8% over 5 years, the annual depreciation would be (80,000 - 10,000) / ((1 - (1 + 0.08)^(-5)) / 0.08) = Rs.15,722.

Double Declining Method of Depreciation

The double declining balance method is an accelerated depreciation method that front-loads an asset's depreciation expenditures, recognising a larger amount in the asset's early years of useful life. 

This strategy is helpful for organisations that wish to display increased depreciation charges early on, which is commonly employed for assets that lose value quickly in their initial years. However, when the asset's book value declines, depreciation charges reduce.

Double declining method of depreciation formula

Formula for double declining depreciation method = 2* Beginning Book Value* Depreciation Rate

Here,

Beginning book value is the asset’s value at the start of the year. This figure changes every year.

Rate of depreciation = (100% / Useful life of the asset). This figure stays the same.

Example: 

Consider a machine with an initial cost of Rs.60,000, a useful life of 5 years, and no salvage value. Using a straight-line rate of 20% (100% / 5), the Double Declining Balance rate would be 40% (2 * 20%). In the first year, the depreciation would be 60,000 * 0.40 = Rs. 24,000. The book value for the second year would then be (60,000 - 24,000), and the depreciation will be recalculated on it.

Depletion Method of Depreciation

The depletion method of depreciation is used to spread the cost of natural resources like minerals, oil, or lumber across the time period in which they are harvested or used. This strategy recognises the steady decrease in quantity or quality of a natural resource as it is utilised. 

Moreover, the depletion method is critical for enterprises that rely on natural resource extraction. This is because it provides a systematic technique to account for resource quantity reductions while also ensuring correct financial reporting and cost allocation.

Depletion method of depreciation formula

Formula for depletion depreciation method = (Cost of Resource - Salvage Value) / Total Units of Resource

Example:

Suppose a mining company acquires a mineral deposit for Rs.5,00,000, expects to extract 1,00,000 tons of minerals, and estimates a salvage value of Rs.20,000. The depletion expense per ton would be (5,00,000 - 20,000) / 1,00,000 = Rs. 4.80. As the company extracts minerals, it records depletion expenses based on the actual amount extracted.

Diminishing Method of Depreciation

The diminishing balance method is an accelerated depreciation approach used to allocate the cost of an asset over its useful life. Instead of spreading the cost evenly, it deducts a fixed percentage from the remaining book value each year. This results in higher depreciation expenses in the earlier years, reflecting a faster reduction in value.

Diminishing method of depreciation formula

Formula for diminishing balance method of depreciation = (Book Value * Rate of Depreciation) / 100

Example:

If a company purchases equipment for Rs.50,000 and applies a diminishing balance rate of 30%, the first-year depreciation would be 50,000 * 0.30 = Rs.15,000. In subsequent years, the depreciation is calculated based on the reduced book value. This method is suitable for assets that experience more significant wear and tear in their initial years.

Sinking Fund Method of Depreciation

The sinking fund approach is a way to figure out how much an asset has depreciated and, at the same time, set aside money to replace the asset when it's no longer useful. This method is handy when dealing with costly assets that will eventually need replacement. Instead of facing a big expense all at once, companies set up a sinking fund. 

This fund helps them cover the cost of the asset's depreciation over time and saves up for its eventual replacement. Industries with big, expensive assets, like utility companies, often use the sinking fund method to manage their finances effectively.

Sinking fund method of depreciation formula

Formula of sinking fund depreciation method = A = [{1+(r/m)}^(n*m) - 1} / (r/m)] * P

Here,

P - Periodic contribution to sinking fund

A - Money accumulated

r - Rate of interest

n - total number of years

m - number of payments each year

Production Unit Method of Depreciation

The production unit method of depreciation is a way of allocating the cost of an asset based on its actual usage or production. This method is often used for assets where the wear and tear depend on the level of activity rather than the passage of time. This method is particularly useful for assets like manufacturing equipment or vehicles, where depreciation is closely tied to the production or activity level.

Units of production depreciation method formula

Formula of production unit depreciation = [(Estimated Total Cost - Residual Value) / Estimated Total Output] * Actual Output during the year

Example:

An organisation purchases a machine for Rs.1,00,000, expects it to produce 50,000 units, and has a salvage value of Rs.10,000, the depreciation per unit would be (1,00,000 - 10,000) / 50,000 = Rs.1.80. If in a given year the machine produces 10,000 units, the depreciation for that year would be 10,000 * 1.80 = Rs.18,000.

Conclusion

Overall, the various depreciation methods provide firms with strategic tools for controlling asset expenses and financial planning. Each strategy caters to distinct demands, from the simplicity of Straight-Line to the subtle concerns of annuity and depletion systems. Businesses can adapt the method to prioritise even distribution, faster depreciation, or resource depletion. 

The option is ultimately determined by the type of assets, industry details, and financial goals. Businesses may improve financial accuracy, optimise tax positions, and make educated decisions regarding asset replacement and general financial well-being by understanding and employing these strategies wisely.