Depreciation Methods

What is depreciation?

Most goods lose value over time.

• Boats rot.
• Patents expire.
• Machinery wears out.
• Computers slow down.

Depreciation is an attempt to estimate and record this loss of value.

Why is depreciation important?

If we don't think about how much an asset's value has dropped, we'll wind up forgetting that these items will eventually become useless. That's will cause owners to forget about saving money for replacements.

There are other uses too. Being able to figure out how much life an asset has left will help buyers and sellers figure out a reasonable price when negotiating a resale. In addition, the values of existing assets are often used to determine tax liabilities. The more depreciation a business can show, the less tax it is often required to pay.

Think about the roof on a building. Every few decades, it will need to be replaced. A fifteen-year old roof will probably have a lot of accumulated problems. A brand-new one will not. This difference in value can be recorded in a spreadsheet as depreciation.

Depreciation is a cheat

While accountants agree that depreciation is a great concept in the abstract, it can be very difficult to figure out the exact level of depreciation that has taken place.

Imagine how much time, energy and expertise would be required to determine exactly how much depreciation there was on every chair, window, desk car that it owned. The resources required to generate the figures would be enormous and far outweigh any benefit to the company.

Fortunately, there's a better way.

Businesses can apply mathematical estimates of depreciation instead. While these estimates may prove inaccurate when used for a single asset, they tend to prove trustworthy for large and diverse collections of items.

So, how do you depreciate?

There are several methods that businesses tend to calculate depreciation.

Why so many? Different types of assets lose value in different ways. Some products (such as automobiles) lose most of their value in the first few years of ownership. Other products (like patents) may behave very differently.

Quick reminder: don't forget the salvage value!

Many people think that the value of every asset is eventually reduced to zero.

This is not the case for every asset. Many items (like cars and machinery) can be sold for scrap when it reaches end of life. The amount that these used-up items goes by many names. Accountants may refer to it as residual value, but many business people may refer to it as scrap value or salvage value.

In any case, when calculating depreciation, it is vitally important to never depreciate below an item's residual value.

Common Depreciation Methods

• Straight-Line Depreciation
• Double Declining Balance
• Sum-of-Years
• Units-of-Production

Straight-Line Depreciation

Summary

Straight-line is the simplest method of calculating depreciation.

This method assumes that item loses exactly the same dollar value each and every year. An item that suffered $500 of depreciation in the first year will necessarily lose $500 in the second.

As long as the owner has a good idea of how many years the item is expected to last (or an industry standard has been set), this is a very simple calculation to perform.

To calculate a given year's depreciation, simply divide the difference between the purchase price and the residual value by the number of years in the asset's useful life.

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Pros

• It's very simple to understand.
• Depreciation each year will be the same as the year before.

Cons

• This method underestimates depreciation for many goods in the early years of use.

Example

• A machine was purchased on January 1st of 2010.
• The purchase price was $120,000.
• Its lifespan is four years.
• Its scrap value is $20,000.

Double Declining Balance

Summary

Many assets, like cars, lose most of their value early in their life cycle and less as the years go on.

Double declining balance is used in an attempt to reflect higher degrees of depreciation in an asset's earliest years of ownership.

Each year, an asset's remaining value is reduced by a fixed percentage. Because the percentage is fixed, the dollar amount recorded to depreciation becomes smaller and smaller each year.

To calculate the percentage used for depreciation, the following formula is used:

1 - (Scrap_Value / Purchase_Price) ^ ^{(1 / Estimated_Lifespan)}

This percentage is then multiplied to an item's value from the previous year. The result is the depreciated value for the current year.

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Pros

• This method allows larger levels of depreciation early in an asset's life cycle.
• The percentage change in book value remains constant each year.

Cons

• The math to discover the rate is too difficult to derive via mental calculations.

Example

• A machine was purchased on January 1st of 2010.
• The purchase price was $120,000.
• Its lifespan is four years.
• Its scrap value is $20,000.

Important note for this example:

At the end of each step, the dollar amount was rounded to the nearest penny, and the depreciation percentage was rounded to the nearest tenth of a percent.

This rounding was performed to increase the clarity of this example. However, it leads to a slight under depreciation of the asset.

Sum-of-Years

Summary

Under this method of calculating depreciation, the value of an asset is reduced significantly in the early years of ownership and very little toward the end.

The secret to the system is the sum-of-years calculation. It can be a little confusing at first, but many have come to rely upon it.

The first step is to count up the number of years between the purchase date and the date of each depreciation calculation.

• A two-year period will have a sum equal to 3 (1 + 2).
• A five-year period will have a sum equal to 11 (1 + 2 + 3 + 4 + 5).
• A ten-year period will have a sum equal to 55 (1 + 2 + 3 + 4 + 5 + 6 + 7 + 8 + 9 + 10).

That seems like an awful lot of math, but it provides accountants with numbers that can be used to ensure that they can use a decreasing fraction each year to depreciate the value of an asset.

Each year, an accountant will use a smaller fraction than he did the previous year in order to depreciate the asset's value.

The denominator is always the same for each year of the asset's life: the sum from addition.

To select the numerator, the accountant selects the largest remaining number that was added to calculate the sum. It is then crossed off so that a small number will have to be used in the subsequent year.

Note: Calculating the fraction to use, as described above, is very time-intensive. Outside of an educational setting, the formula (n^²+n)/2, where n is the year, is used to calculate the depreciation rate.

Pros

• Allows for very large depreciation in the early years of asset ownership.

Cons

• Due to the nature of the calculations, non-accountants will think users are trying to play a joke on them.
• Neither the dollar amount nor the percentage of depreciation stays the same from year to year.

Example

• A machine was purchased on January 1st of 2010.
• The purchase price was $120,000.
• Its lifespan is four years.
• Its scrap value is $20,000.

Units-of-Production

Summary

While many depreciation methods focus on time, some assets don't really wear out from old age. Some assets only wear out when they are used.

Take, for example, a washing machine. A given model that might last for a single year when used on an hourly basis might last for a decade when used occasionally.

When armed with good estimates or historical values, an accountant can use usage records to determine just how many uses an item has remaining in its lifetime.

The depreciation rate for a given year is simple to calculate. It is equal to the number of actual uses for the year divided by the total number of uses available in the asset's lifetime.

Pros

• It is easy to understand.
• It is well-suited for assets that wear out with use.

Cons

• This approach may prove misleading for items that are depreciated by both age and number of uses.
• This method will not necessarily show significant depreciation early in a product's lifetime.
• It requires additional information that may not be available.
• It may not be useful for future estimations if future usage patterns are unknown.

Example

• A machine was purchased on January 1st of 2010.
• The purchase price was $120,000.
• Its lifespan is four years.
• Its scrap value is $20,000.
• In the first year, the machine was used 4,000 times.
• In the second year, the machine was used 10,000 times.
• In the third year, the machine was used 20,000 times.
• In the fourth year, the machine was used 6,000 times.

Conclusion

Some people just don't appreciate depreciation.

Terrible jokes aside, depreciation a necessary tool for modern business accounting.

It's a vital component of product valuation and product pricing.