Methods of Computing Depreciation
Computation of the depreciation amount is the creation of an allowance that will be deducted from the cost value of an asset so as to portray the material information pertaining the end of financial period monetary value. It is logical that, as long as an asset is being utilized, the end economic value cannot be the same. Most likely it will have declined with time. This information need to be factored in to avoid reporting partial information on assets. This accounting practice is in tandem with the Historical Cost Principle. The aspect of depreciation is subject to the entrepreneur’s discretion, hence the amount of depreciation charged to an asset at the end of the year is based on the judgement of the management who sets a policy to guide the accountant of the approach to use. Based on this line of thinking, determination of monetary value of depreciation is based on several approaches supported with an illustration to demonstrate how each case works. These approaches are;
1.Straight line method
2.Reducing balance method
3.Revaluation method
4.Sum of the digit
The individual businesses are at their discretion to choose the most appropriate method for them. The following section entail explanation of how each method works
i)Straight line Method
The straight line method entails computation of uniform depreciation amount for the whole period that the fixed asset was useful. As the name suggests, the amount charged at the end of each financial period is the same.
Formula;
Whereby;
Cost is the original monetary value that was incurred or paid to acquire the fixed asset.
Salvage value is the economic value after the life span period of the asset lapses. It is also referred to as scrap value. It can assume a zero value or more than zero value
Useful life is the time duration the asset is under positive utilization in terms of years.
Illustration 1
1st/01/2014 Our Co. ltd bought a motor vehicle for $100,000 by check. Useful life was 5 years with zero salvage value. Determine the depreciation value per annum.
Solution
NB: Suppose the salvage value in illustration one was not zero, the learner need to compute the yearly depreciation by determining the difference between the cost and salvage value to get the net cost to be subjected to depreciation. If this be the case, for instance assume the salvage value was $10,000 then the depreciation amount would be;
Find another example of salvage value in depreciation on our blog.
ii)Reducing Balance Method
The reducing balance methodology is slightly different from the straight line approach for as the name suggests, it demonstrates a reduction in the total amount of depreciation each year. The approach advocates use of a constant/ uniform depreciation rate which is pegged on the net book value of the asset at the beginning of the financial period. As a result, the net book value (NBV) varies hence giving different values for depreciation.
Illustration 2
Suppose we consider illustration 1 above and then we assume that on 1st/01/2014 Our Co. ltd bought a motor vehicle for $100,000 by check. Useful life was 5 years and the depreciation rate was 20% per annum. Determine the depreciation value per annum for the five years
Solution
For the two cases, it can be concluded that the outcome of the two methods of computing depreciation are different. The straight line method advocate for a uniform depreciation amount and a zero salvage or scrap value of the asset at the end of the useful life span unless stated otherwise. On the other hand, reducing methodology advocate for a varying depreciation amount and the salvage value of more than zero value. In illustration two the salvage value was $32,768. The learner need to understand that the choice of the depreciation method used has implications to profit determination. The depreciation method could either increase or decrease the net profit of the firm.
iii) Revaluation Method
As the name suggests, it entails valuing and revaluing the asset at the beginning and at the end of the financial period to determine the monetary difference which is assumed to be the depreciation for the year. It is a common method in determining the depreciation amount for farm implements.
Illustration 3
1st January 2017, Our Co. ltd acquired some farm implements for bush clearing in its office compound costing $45,000. The asset was assessed at the end of 2017, 2018 and 2019 and the results were as follows;
iv)Sum of the Digit Method
Sum of the digit approach is a method of depreciation that factors the summation of the nth useful years of an asset so as to establish a fraction to compute the depreciation of the asset at the end of each year. The method assumes that the asset is very productive in its early years unlike its years towards the tail end of its useful fife. As a result the approach charges more depreciation in the early years than the last years of the asset performance. The fraction is established using the formula below;
Illustration 4
1st/1/2018, Our Co. ltd purchased an office machine. The details were as provided herein:
Cost of the office machine: $250,000
Expected useful life of machine: 5 years
Salvage value: $10,000
Required:
Prepare a per annum depreciation schedule for the machine utilizing the sum of years’ digits approach.
