DEPRECIATION METHODS
Sunnyside Hospital purchases $300,000 of testing equipment that has a useful life of 5 years. The hospital pays $20,000 to install the equipment and make it usable. The hospital also expects that after five years, it can sell the equipment for $10,000.
Depreciation is an accounting method of allocating assets over its useful life. By depreciating assets, the company earns revenue from assets while charging a cost on assets each year. If depreciation is not accounted for by the companies, it affects the profits of the organization.
Salvage value is the estimated book value of an asset after depreciation
STRAIGHT LINE DEPRECIATION METHOD
In the straight-line deprecation method, the fixed asset cost is uniformly reduced over a while. Under this method, the depreciation should be charged with the same amount over the useful life.
The depreciation charge will be calculated as follows:
Depreciation under straight-line method= (Cost-Salvage value)/Useful life
In the straight-line deprecation method, the cost of installation is part of the cost of the asset.
Calculation of the rate of depreciation will be calculated as follows:
Rate of deprecation= (annual depreciation charge/cost of asset) 100%
Merits of the straight-line method
- Easy to understand and very simple to operate
- Does not take into considerations seasonal fluctuation of use of asset since the same amount is charged as depreciation every year.
Demerits of the straight-line method of depreciation
- It ignores the time value of money
- The method does not take into consideration the interest on capital invested in the asset
- It is not logical as the technique is based on the time factor and ignores the actual usage of the asset
Account treatment under the straight-line method of depreciation is as follows:
When charging depreciation on the asset under this method, depreciation charge is credited from the value of asset account and debited to profit and loss account.
When providing for depreciation under this method, the amount of depreciation is credited to provision for depreciation a/c or accumulated depreciation a/c
.
In the double-declining balance method, the asset is depreciated twice the rate. It is done in a straight-line method.
The following steps are involved when calculating depreciation using Double declining balance
- Determine the initial cost of the asset
- Determine asset salvage value
- Determine asset usefulness
- Calculate the depreciation rate
- find depreciation expenses by multiplying the opening value by twice the depreciation rate
- Deduct the depreciation expenses from the opening amount to calculate ending period value
- Repeat the above steps until salvage value is reached
Double declining balance method=2Xcost of asset Depreciation rate
The advantage of double declining balance depreciation is that it’s used for tax consideration of the assets earlier years and balancing the maintenance cost of the asset in the later years
SUM OF THE YEARS DIGITS DEPRECIATION METHODS.
The Sum of the year digit depreciation method is based on the assumption that asset productivity reduces with time. Under this method depreciation expenses is charged at a higher rate during the assets early years since the asset is more productive in the first years of its life
The formula below is used to calculate depreciation expense under the Sum of years’ digits method
Depreciation expenses= remaining useful life of asset X depreciation cost. Sum of year digits
The advantage of using this method the depreciation recorded is accelerated earlier in the assets life hence reducing the taxable income and the taxes owed during the early years
The downfall of this method is that it is more complex to compute
CAUSES OF DEPRECIATION
- WEAR AND TEAR
While using an asset over a specific time, it breaks down gradually and needs to be repaired or parts replaced. When it can no longer be fixed, it must be disposed of.
- USAGE RIGHTS
Assets such as software are usable for a specified period. Its lifetime ends when usage expires.
- PERISHABILITY
Some assets have a short life span e.g., inventory
- OBSOLESCENCE
Old equipment becomes inefficient when more efficient equipment becomes available; hence its usage reduces.
References
Boyd, K. Accounting All-in-One for Dummies, 2nd Edition.
Flood, J. Wiley practitioner’s guide to GAAP 2020.
fundamentals of accounting. (2016) (23rd ed.).
Walther, L. (2013). Financial accounting. Principlesofaccounting.com.
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