- Longer or Shorter Depreciation of an Asset - iChaz on Flickr
All assets, except land, are considered in business to have a limited useful life. It is important when depreciating assets that their expense, or depreciation, be matched with their useful life, or time that the asset will generate revenues. Some common methods of depreciation include the straight-line, units of production, and double declining balance.
To calculate depreciation, three asset amounts are required: Acquisition cost, estimated useful life, and salvage value. Of these three amounts, only one is certain. The acquisition cost is the only known number used in calculating depreciation. Therefore, depreciation is an estimate. The best estimate will most accurately reflect the actual income and expenses of the asset on the company's financial statements.
Below are three common methods of depreciation. We will look at each example for plant machinery costing $11,000, having a salvage value of $1,000, and a useful life of 5 years.
Straight-Line Depreciation
(Cost - Salvage Value) x 1/Useful Life = Depreciation Expense
($11,000 - $1,000) x 1/5 = $2,000
- Year 1 - $2,000
- Year 2 - $2,000
- Year 3 - $2,000
- Year 4 - $2,000
- Year 5 - $2,000
The depreciation amount is the same in all 5 years, thus the name Straight-line method. This method would be sufficient for an asset which was expected to bring in consistent amounts of revenue throughout its useful life.
Units of Production Method of Depreciation
This methods relates the depreciation cost directly to an expected total production amount of the asset. For the following example, we will assume that the plant machinery will produce 100,000 units in it's 5 year life. We will assume that the machine produces 30,000 units in year 1, 20,000 units in years 2 - 4, and 10,000 units in year 5.
(Cost - Salvage Value) / Estimated Total Production x Actual Production = Depreciation Expense
- Year 1 - ($11,000 - $1,000) / 100,000 x 30,000 = $3,000
- Year 2 - ($11,000 - $1,000) / 100,000 x 20,000 = $2,000
- Year 3 - ($11,000 - $1,000) / 100,000 x 20,000 = $2,000
- Year 4 - ($11,000 - $1,000) / 100,000 x 20,000 = $2,000
- Year 5 - ($11,000 - $1,000) / 100,000 x 10,000 = $1,000
This method is very accurate in tying the depreciation expense to the assets revenues. It's drawback is that estimating total output may be difficult for some assets.
Accelerated Depreciation a Shorter Method
Accelerated depreciation, such as double declining balance, raises expenses in early years, therefore, decreasing net income. However, it reduces expenses in later years, raising net income. Sometimes, double declining balance is referred to as double the amount that would be expensed under the straight-line method. Other methods of accelerated depreciation are 1.5 times that of straight-line or 1.75 times that of straight-line.
Double Declining Balance Depreciation
(Cost - Accumulated Depreciation) x 2/Useful Life = Depreciation Expense
- Year 1 - ($11,000 - $0) x 2/5 = $4,400
- Year 2 - ($11,000 - $4,400) x 2/5 = $2,640
- Year 3 - ($11,000 - $7,040) x 2/5 = $1,584
- Year 4 - ($11,000 - $8,624) x 2/5 = $950
- Year 5 - $426 Note: The final year must be adjusted to the total depreciation ($11,000 - $1,000) = $10,000 less the depreciation claimed in the previous years.
Companies that expect an assets value to decline rapidly should use the double declining balance, or other accelerated method of depreciation.
Which is better longer depreciation or shorter depreciation? The best practice for selecting depreciation is to consider the assets useful life or total production. Choose the method of expensing depreciation that most accurately reflects the revenues that will be generated by the asset. Choosing longer or shorter depreciation based on the individual asset most accurately reflects actual income and expenses on the financial statements.
Credits:
Photo by iChaz on Flickr
Stickney, Clyde P., and Roman L. Weil. Financial Accounting: An Introduction to Concepts, Methods, and Uses. Cincinnati, OH: Thomson/South-Western, 2003.
Heather Schulte - Heather Schulte is a freelance writer based in the Midwest. She writes web content for a variety of publications such as Suite101, eHow, ...
