3. Comparison of Depreciation Methods

So, next is a sum of the years digit method. So, here, how do you calculate the depreciation for the first year when you calculate the number of years left in the recovery period is say n = 9. So, number of years left in the recovery period is 9 divided by the sum of the years in the useful life 1 + 2 + 3 + 4 + 5 + 6 + 7 + 8 + 9 multiplied by initial cost minus the salvage value minus tire cost.

In the Sum of the Years Digit (SYD) method, to calculate depreciation for the first year, we divide the number of years left in the recovery period (9 years) by the sum of the years in the useful life of the asset. The useful life is represented by the sum of the first nine numbers: 1+2+3+4+5+6+7+8+9 = 45. We then multiply this by the adjusted initial cost (initial cost minus tire cost and salvage value) to find the depreciation for the first year.

Imagine you have a cake that you want to share with your friends over 9 days. The total amount of cake pieces represents the sum of years. On the first day, you would take a larger portion since it's the beginning. The portion you take is determined based on how many total pieces of the cake there are and how many you (the friend) are left to share. Similarly, SYD allows you to take more depreciation upfront when the asset is new.

Similarly, depreciation for the second year number of years left in the recovery period is nothing but the number of years left in the recovery period from the beginning of the second year to the end of the useful life of the machine is 8 year. So divided by the sum of the years in the useful life multiply by initial cost minus tire cost minus salvage value.

For the second year's depreciation in the SYD method, we now update the number of years left to 8 (since a year has passed). Again, we will divide this by the total sum of years (45) and multiply it by the adjusted initial cost. This process repeats for each subsequent year, decreasing the numerator by 1 each time while keeping the denominator constant.

Continuing with the cake analogy, on the second day, you now have fewer pieces of cake to share because you already took a large piece on the first day. Each day you take slightly less until, eventually, on the last day, you take just a crumb. This mimics how the SYD method allows for larger depreciation initially, gradually decreasing over time.

Now, let us move on to the double declining balance method. In double declining balance method it is totally different from the earlier method as I told you here, we are not using salvage value in the estimation of the depreciation of the machine.

The Double Declining Balance (DDB) method accelerates depreciation by taking double the standard straight-line rate. Unlike SYD, the DDB does not consider salvage value in its calculations, focusing on the current book value instead. This results in higher depreciation expenses in the earlier years, thereby reducing taxable income more quickly.

Think of a new car. When you first drive it off the lot, it loses value quickly. The DDB method acts like that—it quickly depreciates its value as you use it. Just like in the first year, your car is worth significantly less than when it was new, and the DDB reflects that sharp decline in its worth.

So, for the first year, what is the book value at the beginning of the year? It is 76 lakh how did you get this up to 76 lakh your initial cost is 82 lakhs minus your tire cost 6 lakh.

To begin the calculations in the DDB method, we first determine the book value at the start of the year by subtracting tire costs from the initial cost. This gives us the book value to which we'll apply the DDB calculations to determine depreciation for the year. This year, we're taking the book value as 76 lakhs.

Using the car example again, let's say you bought a car for 82,000 but had to add new tires costing 6,000. The actual value you account for when calculating depreciation is the original price minus the cost of tires—76,000. It's important to know how much value is considered for depreciation calculations.

So, your estimated depreciation using double declining balance method requires calculating the book value at the end of each year. If at any point the calculated book value drops below salvage value...

In DDB, if the depreciation calculated results in a book value that is less than the salvage value set for the asset, we must backtrack and adjust the calculations to stop at the salvage value. Essentially, we ensure that the asset does not lose more value than its salvage value at any stage of calculation.

Consider your car again. If your car's calculated value after a few years is less than what you could sell it for (its salvage value), you wouldn't want that number to go too low. Just like ensuring you don’t lose more money than you can recover, we adjust the depreciation to prevent the book value from falling below the salvage value.

Now, let us compare the depreciation estimated using 3 different methods you can say straight-line method depreciation is always same every year. So, when you compare sum of the years, as well as the double declining method, you can see that the double declining method is giving accelerated depreciation.

When we compare the three methods, we see that: the Straight-Line method offers consistent yearly depreciation; the Sum of the Years method gives higher depreciation upfront but gradually decreases; and the Double Declining Balance method results in significant early depreciation due to its accelerated nature. This affects tax liabilities for businesses that might prefer quicker deductions in the early years.

Imagine three friends sharing a pizza. One takes an equal slice every time (Straight-Line), one takes larger slices at the start (Sum of the Years), and one takes big slices early and smaller later (Double Declining). Depending on how the pizza is consumed, some might end up with more than others at different stages, just like businesses do with depreciation and taxes.

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