Depreciation Methods:

Accruals vs cash accounting

Depreciation: It is a systematic allocation of the cost of the capital asset over the
depreciable life of that asset. There are numerous alternative methods used for the
calculation of depreciation of capital assets. Different depreciation methods can be chosen
for tax reporting and financial reporting. Most of the firms prefer to use an accelerated
depreciation method for tax reporting purposes – one that allows for a more rapid write-
off and, hence, a lower taxable income figure. Different depreciation methods are as
follows.

Straight-Line Method: The straight-line method recognizes depreciation in equal amounts

over the estimated life of the asset

Cost−Salvage Value
Annual Depreciation =
Estimated Life

Consider the following example:

Consider an asset with the cost of asset = Rs10,000, Estimated life of asset = 5 years,
Estimated salvage value = 0 and Estimated total hours of use =16,000.
Cost−Salvage Value 10,000
Annual Depreciation = = = Rs2,000.
Estimated Life 5

Each year the depreciation will be the Rs2,000 for next five years.

2,000 100 100 %

Alternatively 20 % of 10,000. Where 20% = ∗100∨ =
10,000 5 Estimated Life

Declining-Balance Method:

The declining-balance method, an accelerated method, applies a multiple times the straight-
line rate to the declining book value (cost minus accumulated depreciation) to achieve a
declining depreciation charge over the estimated life of the asset. We will use double the
straight-line rate, which is the maximum rate that can be used (also called double declining

100 % 100 %
balance method). Rate = ∗2 = ∗2 = 40%
D. Life 5
 1 1
Annual Depreciation = * 2 * Net Book Value = * 2 * Net Book
Estimated Life of the Asset 5

1 1
Value = * 2 * (10,000 – 0) = * 2 * (10,000) = Rs4,000.
5 5

Importantly if salvage value is equal to zero then the depreciation of last year should equal to
book value of last year. Otherwise the asset should not be depreciated below its salvage
value.

Sum-of-the-Years’-Digits Method:

The sum-of-the-years’-digits method is an accelerated depreciation method. Thus, the

depreciation expense declines steadily over the estimated life of the asset.

This method takes a fraction each year times the cost less salvage value. The numerator of the
fraction changes each year. It is the remaining number of years of the asset’s life. The
denominator of the fraction remains constant; it is the sum of the digits representing the years
of the asset’s life. Compute depreciation using the sum-of-the-years’-digits method as
follows:

Remaining Number of Years of Life

Annual Depreciation =
∑ of the Digits Representing theYears of Life * (Cost – Salvage
value)

5 5 1
= * (10,000 – 2,000) = * (8,000) = * (8,000) =
1+ 2+ 3+4 +5 15 3
2,666.67

Unit-of-Production Method:

The unit-of-production method relates depreciation to the output capacity of the asset,
estimated for the life of the asset. The capacity is stated in terms of units of production, hours
of use, or miles. Hours of use will be used for the asset in our example. For the life of the
asset, it is estimated that there will be 16,000 hours of use. The estimated output capacity is
divided into the cost of the asset less the salvage value to determine the depreciation per unit
of output. For the example asset, the depreciation per hour of use would be:

Cost of Asset−Salvage Value 10,000−2,000 8,000

Depreciation per hour of use = = = =
Total Hours 16,000 16,000
Rs0.5 per hr.
The depreciation for each year is then determined by multiplying the depreciation per unit of
output by the output for that year. Assuming that the output was 2,000 hours during the first
year,

Annual Depreciation (for first year) = 2,000 * 0.5 = Rs1,000

Further depreciation cannot be taken when the accumulated depreciation equals the cost
of the asset less the salvage value.

Modified Accelerated Cost Recovery System (MACRS): The basic objective of the
declining balance method is to increase the depreciation expenses but this only protected in
first years. In last year’s depreciation by declining balance method is less than the straight
line methods. In MACRS double declining balance (also called 200% declining balance)
depreciation method is used. This method then switches to straight-line depreciation for the
remaining undepreciated book value in the first year that the straight-line method yields an
equal or greater deduction than the declining-balance method. Assets in the 3-, 5-, 7-, and 10-
year property classes uses the double declining balance (also called 200% declining
balance) depreciation method while assets in 15- and 20-year classes are depreciated using
the 150 percent declining balance method. Normally, the half-year convention must be
applied to all declining-balance methods. This calls for a half year of depreciation in the year
an asset is acquired, regardless of the date of purchase. There is also a half year of
depreciation in the year an asset is sold or retired from service.

Example: Consider an asset having depreciable life of 5-year with the costing of 10,000 is
acquired in February with zero salvage value.

Ye Depreciation Depreciation Depreciation Net Book MACRS

ar Declining Balance Straight-Line Expenses / Value Rate
Method Balance Method Charged (NBVYE) %
0 - - - 10,000 -
1 0.4(10,000) 1,000 ( 2,000 8,000 2,000
2,000 ( ¿ 20( )
2 10,000
0.2∗10,000¿ ¿ ¿
2
2 3,200 (0.4∗8,000 ¿ 1,778 ( 3,200 4,800 3,200
32( )
10,000
8,000 ¿ ¿ ¿
4.5
3 1,920 (0.4∗4,800 ¿ 1,371( 1,920 2,880 1,920
19.2( )
10,000
 4,800 ¿ ¿ ¿
3.5
4 1,152(0.4∗2,880 ¿ 1,152( 1,152 1,728 11.25(

2,880 ¿ ¿ ¿ 1,152
2.5 )
10,000
5 691(0.4∗1,728) 1,152( 1,152 576 11.25(

1,728 ¿ ¿ ¿ 1,152
1.5 )
10,000
6 576 576 576 0 576
5.76( )
10,000

Challenge: Find the MACRS rate for 3-years property class for above question.