Question

Your friend Tom Smith has decided to expand Smith Sales Company. He has acquired an expansion loan and purchased $500,000 of plant assets as part of the expansion. Tom values your advice and requests your help in properly depreciating the plant assets. Tom has paid you well for your advice and you readily accept the challenge.

Explain the different methods that can be used to calculate depreciation including: Straight-line, Double declining balance, Units of production & Sum of years digits.

Answer 1

Tom Smith can provide depreciation on the following methods:

1) Straight-line Method

  Straight line depreciation is the default method used to recognize the carrying amount of a fixed asset evenly over its useful life. It is employed when there is no particular pattern to the manner in which an asset is to be utilized over time.

The formula is as given below:

Annual Depreciation=

(Cost of the asset - Scrap value at the end) ÷ Useful life

Use of this method is highly recommended as it is the easiest of all the methods to calculate depreciation i.e. only a few calculation errors.

3) Double Declining Balance Method

  The double declining balance method of depreciation is also known as the 200% declining balance method of depreciation. It is a form of accelerated depreciation. This means that compared to the straight-line method, the depreciation expense will be faster in the early years of the asset's life but slower in the later years. However, the total amount of depreciation expense during the life of the assets will be the same.

Formula :

Annual Depreciation= Net Book Value^* ×(2 ÷ useful life in years )

* Cost - Accumulated Depreciation

3) Units of Production Method

  This method of charging depreciation on the asset is based on the units produced during the year. The estimated total production of the asset is the criteria for providing depreciation.

  This method is applied where the value of the asset is more closely related to the number of units it produces. Thus, in the years when the asset is heavily used, the amount of depreciation will be high. Assets on which this method can be applied are Plant and Machinery. As their wear and tear will depend on how much we use them.

Formula:

Annual depreciation = Depreciable Value x (Units produced during the year /Estimated total production)

Depreciable Value = Original cost – Scrap value

4) Sum of Years Digit Method

The sum of the years' digits method is used to accelerate the recognition of depreciation. Doing so means that most of the depreciation associated with an asset is recognized in the first few years of its useful life. This method is also called the SYD method.

  The method is more appropriate than the more commonly-used straight-line depreciation if an asset depreciates more quickly or has greater production ca­pacity in its earlier years than it does as it ages.

A problem with using this or any other accelerated depreciation method is that it artificially reduces the reported profit of a business over the near term. The result is excessively low profits in the near term, followed by excessively high profits in later reporting periods.

Formula :

Depreciation =

( Remaining useful life of the asset ÷sum of the years digits ) ÷ Depreciable Cost

N.b. Digits should be assigned to each year on a declining pattern i.e. the useful life is the digit of the first year, useful life less 1 is the digit of the second year etc.

5) Diminishing Balance Method

According to the Diminishing Balance Method, depreciation is charged at a fixed percentage on the book value of the asset. As the book value reduces every year, it is also known as the Reducing Balance Method or Written-down Value Method. Since the book value reduces every year, hence the amount of depreciation also reduces every year. Under this method, the value of the asset never reduces to zero.

This is also used under the assumption that in the earlier years the cost of repairs to the assets is low and hence more amount of depreciation should be charged. Also, in the later years, the cost of repairs will increase and therefore less amount of depreciation shall be provided.

  However, under this method, if the rate of depreciation applied is not appropriate it may happen that at the end of the useful life of the asset full depreciation is not provided.

Formula :

Amount of depreciation = (Book Value x Rate of Depreciation) / 100