Question

Discuss/explain the three main methods of calculating depreciation. How does a business choose which method to use? Is depreciation a good thing or a bad thing? Explain

Answer 1

Depreciation is the systematic and rational allocation of the costs of a fixed asset over its expected useful life

In other words depreciation matches the cost of acquiring the asset with the revenues the asset will generate over its useful life.

Three main methods of depreciation

1) Straight-line Depreciation

Straight-line Depreciation results in an amount of depreciation taken each period

Periodic depreciation = Depreciable Base/Estimated useful life

The depreciable base is the assset's initialcost (including all costs required to purchase the asset and make the asset ready for use ) minus the anticipated salvage value

2) Double Declining Balance

The annual depreciation rate in the double declining balance method is two times the percentage that would be recognized under the straight line method , but that percentage is applied to the net book value of the asset at the beginning of each year instead of to its depreciable base as in Straight-line Depreciation

In the double declining balance method the depreciation charge is calculated using the book value at the beginning of the periond not the the original depreciable base

Salvage value is not taken into account when calculating the periodoc depreciation charge

3) Units of Production method

The preceding depreciation methods are based on time. The units of production method is based on actual physical usage of the asset during a given period

Depreciation rate: Cost les salvage value/ estimated number of units to be produced by the asset over its estimated usefullife.

How does a business choose which method to use

If the revenues management expects to receive from an asset will be constant over its useful life , straight line depreciation should be used so that the costs are constant over the asset's useful life

In contrast, if revenues from the use of the asset will be higher at the beginning of the assets life then an accelerated method of depreciation is used.

If revenues from the asset will be lower at the beginning of the asset's life the amount of depreciation recorded in the early years should be lower than the amount recorded in later years. Lower depreciation in the beginning of the asset's life can usually be acheived through the units of production method.

Is depreciation a good thing or a bad thing

Depreciation expense helps a company  to generate tax savings. Tax rules allow depreciation expense be used as tax deduction against revenue in arriving at taxable income. The higher the depreciation expense, the lower the taxable income and, thus, the more the tax savings