Depreciation is the allocation of the cost of a plant asset to expense over its useful (service) life in a rational and systematic manner” (Weygandt, Kieso and Kimmel, 2003:416). There are three factors affect the calculation of depreciation, which are asset cost, useful life and salvage value (Weygandt, Kieso and Kimmel, 2003). Accountant in different companies will use various methods to compute the depreciation. There are straight-line method, reducing balance method (double declining balance, sum of digits, reducing percentage), annuity method, and unit of production method (Mike, Ron and Allister, 1994). And in most companies, especially in the large corporations, they will use the straight-line method, because it is the easiest one to compute the depreciation. This essay will illustrate some method that usually used in the companies and contract with each method to find out which one is the most useful. At the beginning, the essay will illustrate the straight-line method, the second one is reducing balance method, the third method is sum of digits, and the last one is the unit of production method. Below each method, the essay will give an example, which is calculated by me.
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Under the straight-line method, the annual depreciation expense is the same over the asset’s estimated useful life every year. The annual depreciation expense is determined by depreciation cost divided by the useful life of the asset or multiplied by the annual rate of depreciation (Weygandt, Kieso and Kimmel, 2003).
An asset costs ¿¡11,000, its expected salvage value is ¿¡1,000, its estimated useful life is 5 years.
Depreciable cost =¿¡11,000-¿¡1,000 =¿¡10,000
Annual depreciation expense =¿¡10,000/5years=¿¡2,000
Annual rate of depreciation =100%÷5years=20%
Annual depreciation expense =¿¡10,000*20%=¿¡2,000
Year 1 Cost ¿¡11,000
Year 2 Net book value 9,000
Year 3 Net book value 7,000
Year 4 Net book value 5,000
Year 5 Net book value 3,000
Net book value 1,000
The straight-line method is the simplest way among all the methods; it suitable for the use of asset is unvarying during the useful life; it is popular used by large corporation, such as Campbell Soup, Marriott Corporation and General Mills.
However, the reducing balance method has a falling depreciation amount every year during the useful life of the asset. The changing depreciation is depended on the book value (cost less accumulated depreciation). It is calculated to multiply the book value at the beginning of the year and the reducing balance depreciation rate (Weygandt, Kieso and Kimmel, 2003).
An asset costs (book value at the beginning of year) ¿¡11,000, its expected salvage value is ¿¡1,000, its estimated useful life is 5 years.
Reducing balance depreciation rate = 100%÷5years=20%* Calculation of ¿¡901.12(¿¡4505.6Ã-20%) is adjusted to ¿¡3505.6 in order to make the book value equal salvage value (Weygandt, Kieso and Kimmel, 2003).
Sum of digits is another kind of reducing balance method, which has the closest connection with useful life and salvage value of the asset. The depreciation cost is multiply depreciation cost (asset cost less salvage value) by digits of each year (Mike, Ron and Allister, 1994).
An asset costs ¿¡11,000, its expected salvage value is ¿¡1,000, its estimated useful life is 5 years
The digits add up is 1+2+3+4+5=15
Depreciation cost =¿¡11,000-¿¡1,000=¿¡10,000
Year 1 Cost ¿¡11,000
Depreciation (5/15Ã-¿¡10,000) 3,333
Year 2 Net book value 7,667
Depreciation (4/15Ã-¿¡10,000) 2,667
Year 3 Net book value 5,000
Depreciation (3/15Ã-¿¡10,000) 2,000
Year 4 Net book value 3,000
Depreciation (2/15Ã-¿¡10,000) 1,333
Year 5 Net book value 1,667
Depreciation (1/15Ã-¿¡10,000) 667
Net book value 1,000
The double declining balance method is very similar to the educing balance method. It just doubles the reducing balance depreciation rate and has the same way to compute the depreciation. Reducing percentage is a method alike to Sum of digits. It gives a fix amount of the asset in advance to write off each year. When company use the reducing balance method, it can combine the depreciation expense to the maintaining cost and run the asset (Mike, Ron and Allister, 1994). The depreciation charges will large in the early years and become smaller and smaller later.
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Rather than the time period, the unit of production method write off the asset by expressing the total of units of production. Because it links to the machine’s usage and output closely, it is used in extractive corporations popularly (Mike, Ron and Allister, 1994). This method is used by some large corporation, such as ChevronTexaco Corp. and Boise Cascade Corporation (Weygandt, Kieso and Kimmel, 2003). The depreciation expense in this method is determined by depreciation cost per unit multiply by units of activity during the year. The depreciation cost per unit is computed by depreciation cost divide by total units of activity.
Asset costs ¿¡11,000, its expected salvage value is ¿¡1,000. The manufacture will produce 20,000 produces in the first year, 15,000 produces in the second year, 30,000 produces in the third year, 10,000 produces in the forth year and 25,000 produces in the fifth year.
Depreciation cost =¿¡11,000-¿¡1,000=¿¡10,000
Depreciation cost per unit=¿¡10,000÷100,000units=¿¡0.1
To compare the three main methods, we find that each method will have the same book value in the last year, but the depreciation expense is different during the useful life. The straight-line method keeps same; the reducing balance method is large in the early years and decreases in the later years, and the unit of production method is fluctuant bases on the unit it produces.
In the SSAP 12, it allows company to decide which depreciation method to use by them. But the company must consider if the method they choose is suitable for the companies’ asset, and the depreciation allocated is fairly to the best of their abilities to benefit form the use of the asset (Mike, Ron and Allister, 1994:541, paragraph 8 in the explanatory note section of SSAP12). The purpose of all the depreciation methods is the return of the money invested in the asset finally, but different methods have its rate of recovering (Robert, Helen and David, 1978). Companies considerate when their money invest will receive and the net income.
Obviously, the methods talked above can be divided into two categories. One is based on useful life, which is straight-line method and reducing balance method. The other one is base on the number of the production; it is unit of production method. So which method is useful will first depend on the way it estimate in the depreciation.
Between the straight line method and the reducing balance method. The benefit of the straight-line method is easy to calculate and the depreciation expense will not change every year. While the reducing balance method has a high depreciation in the early years, this will save the income tax during these years because depreciation cost reduce the income reported for tax purpose (Robert, Helen and David, 1978). For many company, the money is better to receive as soon as quickly. The fall in the tax means there is more money can be used. Also, Robert, Helen and David (1978:313) compared the different depreciation methods on a present value discounted from the depreciation expense (see the table blow). They assumed that the money will earn 8% for the company and found the reducing balance method have more present value than the straight-line method.
As it mentions above, for a business, if it is based on use for the depreciation, the most useful depreciation method should be unit of production method. And if the company is based on the useful life for the depreciation, the most useful one may be the reducing balance method even though the straight-line method is easy to compute.
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