Question

Explain in your own language the impact of three depreciation methods on yearly depreciation expense, total depreciation expense charged over the life of the asset, and the book value of any plant asset.

Answer 1

Depreciation

depreciation is defined as the reduction of recorded cost of a fixed asset in a systematic manner until the value of the asset becomes zero or negligible.

There three methods commonly used to calculate depreciation. They are:

1. Straight line method
2. Unit of production method
3. Double-declining balance method

Three main inputs are required to calculate depreciation:

1. Useful life – this is the time period over which the organisation considers the fixed asset to be productive. Beyond its useful life, the fixed asset is no longer cost-effective to continue the operation of the asset.
2. Salvage value – Post the useful life of the fixed asset, the company may consider selling it at a reduced amount. This is known as the salvage value of the asset.
3. The cost of the asset – this includes taxes, shipping, and preparation/setup expenses.

Types of depreciation

1) Straight-line depreciation method

This is the simplest method of all. It involves simple allocation of an even rate of depreciation every year over the useful life of the asset. The formula for straight line depreciation is:

Annual Depreciation expense = (Asset cost – Residual Value) / Useful life of the asset

Example – Suppose a manufacturing company purchases a machinery for Rs. 100,000 and the useful life of the machinery are 10 years and the residual value of the machinery is Rs. 20,000

Annual Depreciation expense = (100,000-20,000) / 10 = Rs. 8,000

Thus the company can take Rs. 8000 as the depreciation expense every year over the next ten years as shown in depreciation table below.

Year	Original cost – Residual value	Depreciation expense
1	Rs. 80000	Rs. 8000
2	Rs. 80000	Rs. 8000
3	Rs. 80000	Rs. 8000
4	Rs. 80000	Rs. 8000
5	Rs. 80000	Rs. 8000
6	Rs. 80000	Rs. 8000
7	Rs. 80000	Rs. 8000
8	Rs. 80000	Rs. 8000
9	Rs. 80000	Rs. 8000
10	Rs. 80000	Rs. 8000

2) Unit of Production method

This is a two-step process, unlike straight line method. Here, equal expense rates are assigned to each unit produced. This assignment makes the method very useful in assembly for production lines. Hence, the calculation is based on output capability of the asset rather than the number of years.

The steps are:

Step 1: Calculate per unit depreciation:

Per unit Depreciation = (Asset cost – Residual value) / Useful life in units of production

Step 2: Calculate the total depreciation of actual units produced:

Total Depreciation Expense = Per Unit Depreciation * Units Produced

Example: ABC company purchases a printing press to print flyers for Rs. 40,000 with a useful life of 1,80,000 units and residual value of Rs. 4000. It prints 4000 flyers.

Step 1: Per unit Depreciation = (40,000-4000)/180,000 = Rs. 0.2

Step 2: Total Depreciation expense = Rs. 0.2 * 4000 flyers = Rs. 800

So the total Depreciation expense is Rs. 800 which is accounted. Once the per unit depreciation is found out, it can be applied to future output runs.

3) Double declining method

This is one of the two common methods a company uses to account for the expenses of a fixed asset. This is an accelerated depreciation method. As the name suggests, it counts expense twice as much as the book value of the asset every year.

The formula is:

Depreciation = 2 * Straight line depreciation percent * book value at the beginning of the accounting period

Book value = Cost of the asset – accumulated depreciation

Accumulated depreciation is the total depreciation of the fixed asset accumulated up to a specified time.

Example: On April 1, 2012, company X purchased an equipment for Rs. 100,000. This is expected to have 5 useful life years. The salvage value is Rs. 14,000. Company X considers depreciation expense for the nearest whole month. Calculate the depreciation expenses for 2012, 2013, 2014 using a declining balance method.

Useful life = 5

Straight line depreciation percent = 1/5 = 0.2 or 20% per year

Depreciation rate = 20% * 2 = 40% per year

Depreciation for the year 2012 = Rs. 100,000 * 40% * 9/12 = Rs. 30,000

Depreciation for the year 2013 = (Rs. 100,000-Rs. 30,000) * 40% * 12/12 = Rs. 28,000

Depreciation for the year 2014 = (Rs. 100,000 – Rs. 30,000 – Rs. 28,000) * 40% * 9/12 = Rs. 16,800