Financial Accounting

1. What is Depreciation?

Depreciation is an accounting method of allocating the cost of a tangible asset over its
useful life. Businesses depreciate long-term assets for both tax and accounting purposes.
For tax purposes, businesses can deduct the cost of the tangible assets they purchase as
business expenses; however, businesses must depreciate these assets in accordance with
IRS rules about how and when the deduction may be taken.

Each part of an item of property, plant and equipment with a cost that is significant in
relation to the total cost of the item shall be depreciated separately.

2. Methods of Depreciation
a. Straight-line Depreciation

The simplest and most commonly used method, straight-line depreciation is

calculated by taking the purchase or acquisition price of an asset, subtracting the
salvage value (value at which it can be sold once the company no longer needs it)
and dividing by the total productive years for which the asset can reasonably be
expected to benefit the company (or its useful life).

Under the straight-line method of depreciation, recognize depreciation expense

evenly over the estimated useful life of an asset. The straight-line calculation
steps are:

i. Determine the initial cost of the asset that has been recognized as a fixed
asset.
ii. Subtract the estimated salvage value of the asset from the amount at which it
is recorded on the books.
iii. Determine the estimated useful life of the asset. It is easiest to use a standard
useful life for each class of assets.
iv. Divide the estimated useful life (in years) into 1 to arrive at the straight-line
depreciation rate.
v. Multiply the depreciation rate by the asset cost (less salvage value).

Straight Line Depreciation Example

Example: For Rs. 2 million, Company ABC purchased a machine that will have
an estimated useful life of five years. The company also estimates that in five
years, the company will be able to sell it for Rs. 200,000 for scrap parts.

i. Purchase cost of Rs. 2,000,000 – estimated salvage value of Rs. 200,000 =

Depreciable asset cost of Rs. 1,800,000
ii. 1 / 5-year useful life = 20% depreciation rate per year
iii. 20% depreciation rate x Rs. 1,800,000 depreciable asset cost = Rs. 200,000
annual depreciation

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Muhammad Faisal Nadeem (Lecturer)
 Financial Accounting

b. Sum of the Year’ Digits Depreciation

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 ca-
pacity in the earlier years than it does as it ages. The total amount of depreciation
is identical no matter which depreciation method is used - the choice of
depreciation method only alters the timing of depreciation recognition.

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.

Use of the method can have an indirect impact on cash flows, since accelerated
depreciation can reduce the amount of taxable income, thereby deferring income
tax payments into later periods.

Use the following formula to calculate it:

Sum of years Digits= , where n is number of useful years.

Example: For Rs. 2 million, Company ABC purchased a machine that will have
an estimated useful life of five years. The company also estimates that in five
years, the company will be able to sell it for Rs. 200,000 for scrap parts.

Remaining
Estimated Sum of
Applicable Annual
Year Useful year at year Remaining Value
Percentage Depreciation
the beginning Digits
of year
2,000,000
1 5 5/15 33% 600,000 1,400,000
2 4 4/15 27% 480,000 920,000
3 3 3/15 20% 360,000 560,000
4 2 5/15 13% 240,000 320,000
5 1 5/15 7% 120,000 200,000
Total 15 100% 200,000

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Muhammad Faisal Nadeem (Lecturer)
 Financial Accounting

c. Declining Balance Method

Declining balance method of depreciation is a technique of accelerated

depreciation in which the amount of depreciation that is charged to an asset
declines over time. In other words, more depreciation is charged during the
beginning of the life time and less is charged during the end.

Why more depreciation is charged in beginning years? The reason is that assets
are usually more productive when they are new and their productivity declines
gradually. Thus, in the early years of their life time, assets generate more revenue
as compared to the revenue generated in later years of their life. According to the
matching principle of accounting, we should depreciate more of the asset's cost in
early years to match the depreciation expense with the revenue earned from the
use of the asset.

Formula and Calculation Procedure

Declining balance depreciation is calculated using the following formula:

Depreciation = Depreciation Rate × Book Value of Asset

Depreciation rate is given by the following formula:

Depreciation Rate = Accelerator × Straight Line Rate

In the above formula, accelerator is a multiplication factor which accelerates

depreciation. Depreciation is charged according to the above method as long as
book value is less than the salvage value of the asset. No more depreciation is
provided when book value equals salvage value.

Suppose you purchase an asset for your business for $575,000 and you expect it
to have a life of 10 years with a final salvage value of $5,000. You also want less
than 200% of the straight-line depreciation (double-declining) at 150% or a factor
of 1.5.

1. Straight-Line Depreciation Percent = 100% / 10 = 10%

2. Depreciation Rate = 1.5 x 10% = 15%
3. Depreciation for a Period = 15% x Book Value at Beginning of the Period

I. Depreciation for Period 1 = 15% x $575,000 = $86,250

II. For Periods 2 and greater, depreciation is 15% x ($575,000 - Accumulated
Depreciation )
III. Depreciation for Period 2 = 15% x ($575,000 - $86,250 ) = $73,313
IV. Depreciation for Period 3 = 15% x ($575,000 - $159,563 ) = $62,316

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Muhammad Faisal Nadeem (Lecturer)
 Financial Accounting

d. Double Declining Balance Depreciation

The double declining balance method is an accelerated form of depreciation under

which the vast majority of the depreciation associated with a fixed asset is
recognized during the first few years of its useful life. This approach is reasonable
under either of the following two circumstances:
 When the utility of an asset is being consumed at a more rapid rate during
the early part of its useful life; or
 When the intent is to recognize more expense now, thereby shifting profit
recognition further into the future (which may be of use for deferring
income taxes).

However, this method is more difficult to calculate than the more traditional
straight-line method of depreciation. Also, most assets are utilized at a consistent
rate over their useful lives, which does not reflect the rapid rate of depreciation
resulting from this method. Further, this approach results in the skewing of
profitability results into future periods, which makes it more difficult to ascertain
the true operational profitability of asset-intensive businesses.

 To calculate depreciation under the double declining method, multiply the

book value at the beginning of the fiscal year by a multiple of the straight-
line rate of depreciation. The double declining balance formula is:

Double-declining balance (ceases when the book value = the estimated salvage value)

2 × Straight-line depreciation rate × Book value at the beginning of the year

 A variation on this method is the 150% declining balance method, which

substitutes 1.5 for the 2.0 figure used in the calculation. The 150% method
does not result in as rapid a rate of depreciation at the double declining
method.

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Muhammad Faisal Nadeem (Lecturer)
 Financial Accounting

Example of Double Declining Balance Depreciation

ABC Company purchases a machine for $2,000,000. It has an estimated salvage

value of $200,000 and a useful life of five years. The double declining balance
depreciation calculation is:

Year Net Book Value at start of Applicable Annual Remaining Value

the Year Percentage Depreciation

1 2,000,000 40% 800,000 1,200,000

2 1,200,000 40% 480,000 720,000
3 720,000 40% 288,000 432,000
4 432,000 40% 172,800 259,200
5 259,200 59,200 200,000
Total 200,000

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Muhammad Faisal Nadeem (Lecturer)