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Depreciation can be defined on the basis of two aspects of the same concept i.e.,
- Decrease in value of assets (also known as fair value depreciation)
- Allocation of the cost of assets to periods of utilization of assets
Depreciation is a process of re-allocating the cost of a tangible asset over its useful life span of it being in motion. Note, businesses depreciates the long-term assets for both tax and accounting purposes such that the former impacts the balance sheet of a business, and the latter impacts the net income reported. Ideally, the cost being allocated, is a as depreciation expense, in the periods in which the asset is expected to be used. Here, this expense is recognized by businesses for financial reporting and tax purposes. The various methods of computing depreciation, and the periods over which assets are depreciated, may vary depending on the types of assets within the same business and on the basis of tax purposes which are specified by law or accounting standards, of the country. Several standard methods for computing depreciation expense, are – fixed percentage, straight line, and declining balance methods.
Depreciation is important to project managers because it has an effect on the overall justification of a project, equipment, and other capital assets that are used on projects and the profitability of projects to the company. Depreciation can make a difference between a project that is justified and one that is not. It can also influence the choice of equipment that is needed for a particular project.
Depreciation can also be defined as an accounting method used for deferring the expense of capital asset items in order to spread out the cost of an item over the useful life of the item rather than taking the full cost of the item in the year in which it is purchased.
Straight-line depreciation
Straight-line depreciation is the most simplest and commonly used method of depreciation. Under this method, the company is required to estimate the residual value (i.e., the scrap value) of the asset at the end of the period during which it will be used to generate revenues. Remember, the salvage value may be zero, or even negative because of the costs required to retire it; but, for depreciation purposes salvage value is not generally calculated at below zero. Companies then charge the same amount to depreciation each year over that period, till the time the value shown for the asset has reduced from the original cost to the salvage value.
Annual Depreciation expense = (Asset cost – Residual Value) / Useful life of the asset
Illustration
Let assume a vehicle is purchased at a cost of Rs. 17,000 which depreciates over 5 years, and will have a salvage value of Rs. 2000. Then this vehicle will depreciate Rs. 3,000 per year, i.e. (17-2)/5 = 3. This illustrates the straight-line method of depreciation where book value at the beginning of the first year of depreciation is the original cost of the asset. At any time book value equals original cost minus accumulated depreciation.
Double-declining-balance method
Under double-declining-balance method, the salvage value is not considered in determining the annual depreciation, but the book value of the asset being depreciated is never brought below its salvage value, irrespective of the method used. The process of depreciation stops when either the salvage value or the end of the asset’s useful life is reached.
Note the double-declining-balance depreciation does not always depreciate an asset fully but by its end of life, some methods also compute a straight-line depreciation each year, and apply the greater of the two. This holds the impact of converting from declining-balance depreciation to straight-line depreciation at a midpoint in the life of the asset.
Depreciation = 2 x Straight line depreciation percent x Book value at the beginning of the accounting period
Where, Book value = Cost of the asset – accumulated depreciation
Illustration
Lets assume a desktop is worth Rs. 10,000. It can be scrapped at the end of a 5 year life for Rs. 1000. Now the value can be depreciated as follows. 10,000 – 1000 = 9000. Further divide by the number of years in it’s useful life 9000 ÷ 5 = 1800. So we can depreciate that laptop Rs. 1800 per year over it’s 5 year life. In case we decided that in year 4 that the laptop was good for an extra 5 years, then we could only deduct a total of Rs. 1800 over the next 5 years or Rs. 360 per year.
The method of double declining balance is an accelerated depreciation method that draws on the math used in straight-line depreciation. So we first compute the straight-line depreciation. Then figure out the total percentage of the asset that is depreciated the first year and double it. So in this case you can look at the calculation above and see that Straight line depreciation applied Rs. 1800 the first year or 20%. Under this method, double that figure the first year: 40% or Rs. 3600. That figure should be applied annually until the remaining value makes that impossible. After that sharp curve has been expended, the values from Straight line depreciation should be used until they too are expended. In this case that means having no value to depreciate in the 4th and 5th year.
Year 1: 5 ÷ 15 = 40% (Rs. 3600)
Year 2: 4 ÷ 15 = 40% (Rs. 3600)
Year 3: 3 ÷ 15 = 20% (Rs. 1800)
Year 4: 2 ÷ 15 = 0% (Rs. 0)
Year 5: 1 ÷ 15 = 0% (Rs. 0)
Sum-of-years-digits (SOYD) method
This method also referred as SOYD is an accelerated depreciation method where more depreciation occurs at the early stage of the asset’s life than in its later stages. It is because of the time value of money, an accelerated method is desirable only for a profitable business because it results in delaying the payment of taxes.
Let, SOYD = Sum-of-years-digits = 1 + 2 + … + N
dt = (N – t + 1) (B – S) / SOYD
BVt = B – (accumulated depreciation through year t)
SOYD a method of applying accelerated depreciation in which the front loads can be deducted instead of spreading it over the useful life. Here, we first take into consideration the asset’s useful life and then add together the digits for each of those years. Like the above illustration, if we take that the desktop again then we add 1 + 2 + 3 + 4 + 5 = 15. Then each number is divided by the “sum of years” to find the percentage by which the asset should be depreciated each year. Note, the largest deduction will be taken in the first year and a lesser amount each successive year.
