2.2. Depreciation Calculation for Subsequent Years

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. So, this will give you the depreciation for the first year.

To calculate depreciation for the first year using the sum of the years digit method, follow these steps: First, determine how many years are left in the depreciation period; for example, if n = 9, that means there are 9 years. Next, find the sum of all the years in the useful life. In this case, the sum from 1 to 9 is 45 (1+2+3+4+5+6+7+8+9=45). Then, calculate the depreciation by taking the number of years left (9) divided by this total sum (45) and multiplying it by the difference between the initial cost and the salvage value, minus any other costs (like tire cost). This calculation gives the depreciation for the first year.

Think of it like a race where you have 9 laps to complete. The first lap (year) is worth 9 points, the second lap (year) is worth 8 points, and so on until the final lap, which is worth just 1 point. The more laps you have left, the more points you get for that first lap. In depreciation, the earlier years are more valuable in terms of reducing your taxable income.

Similarly, depreciation for the second year number of years left in the recovery period is nothing but 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, you will again calculate how many years are left in the depreciation period, which is 8 now. You follow a similar process as before: take 8 (the years left), and divide by the overall sum (which remains 45), and multiply by the difference between initial costs and costs deducted in the first year. The formula shows that, as you move into the second year, there are fewer years to depreciate, hence slightly lower depreciation compared to the first year.

Continuing with our race analogy, in the second lap, you earn points for 8 remaining laps instead of 9. Each lap gets a lower score, reflecting less value in terms of depreciation as fewer years are left to recover costs.

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 is a form of accelerated depreciation. Unlike the sum of the years digit method, the DDB does not consider the salvage value at the start of the calculation. Instead, it focuses on the book value—how much the asset is worth—at the beginning of each period. You double the straight-line rate for depreciation to quickly reduce the asset's book value. This method is beneficial for assets that lose value quickly in the early years.

Imagine a new car. In the first two years, its value drops significantly faster than in later years. Using DDB is like recognizing that your car's value depreciates more sharply when it's new compared to when it's older, which helps you understand its resale value.

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. So, that will give you the book value at the beginning.

To calculate using the DDB method, determine the book value at the start of year one, which is the initial cost minus any upfront costs (tire cost, in this case). For example, if the initial cost is 82 lakhs and tire cost is 6 lakhs, the book value is 76 lakhs. You then calculate the depreciation for the year by taking 2/n times the book value, where n is the total useful life.

It’s like starting a lemonade stand. You invest some money to get supplies. The stand's value (book value) goes down quickly as you sell your first cups of lemonade because they represent the most immediate loss (depreciation). You recognize that your stand's worth less each day as more cups are sold.

So, one important thing here you have to note here as I told you there are more chances that your book value estimator can go below the salvage value.

It’s essential to keep track of your assets' depreciation carefully. In some cases, especially with the DDB method, the calculated book value can drop below the estimated salvage value, which is not accepted. When this occurs, adjustments are made by back-calculating depreciation to ensure it lines up with the salvage value—this might mean switching methods from DDB to straight line to ensure compliance with policies about asset value.

Imagine you have a savings account that you regularly draw from, but if you withdraw too much money too quickly (depreciate too fast), you might hit zero before expected. Adjustments keep your financial health in check, just like asset values must remain above the estimated salvage point.

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