3.1. Depreciation Estimates Comparison

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

This section discusses the Sum of the Years Digit method for calculating depreciation. To find the depreciation for the first year, you take the number of years left in the asset's useful life (n = 9 years) and divide it by the sum of the digits of the years. The formula for the sum of years from 1 to n is the sum (1 + 2 + ... + n). When using this method, you calculate annual depreciation based on the initial cost, subtracting any salvage value and additional costs (like tire cost) for that year. By substituting the numbers, for the first year, the calculation yields this formula: Depreciation = (n / sum of years) * (Initial Cost - Salvage Value - Tire Cost).

Think about how people save for a large vacation. If they have a budget (initial cost) and also account for expenses like travel insurance (tire cost) and hope to come back with some savings (salvage value), they would distribute their savings efforts (years' worth of contribution) unevenly based on their financial priorities. In the same way, the Sum of the Years Digit method allocates more depreciation in the earlier years, as the importance or expense of the asset is more concentrated early on.

Similarly, 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 years. So divided by the sum of the years in the useful life multiply by an initial cost minus tire cost minus salvage value. Similarly, we calculate the depreciation for every year.

For the second year, we repeat the calculation process using adjusted values. The number of years left in the recovery period is now n = 8, reflecting the fact that one year has passed. We again apply the formula: Depreciation = (n / sum of years) * (Initial Cost - Tire Cost - Salvage Value). This cycle continues, decreasing n by one each year and recalculating depreciation.

Consider an ongoing car loan. Each year, as you pay off the principal, your loan balance decreases, similarly reflecting your financial commitment over time. With each payment, you owe a little less, and your calculations for what's left to pay become a bit easier—this is much like how we adjust our depreciation calculations for subsequent years.

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 method (DDB) is a more aggressive approach to accounting for depreciation. Unlike the Sum of the Years Digit method, DDB does not take into account the salvage value when calculating depreciation. Instead, it focuses on the book value of the asset at the beginning of each year, applying a fixed depreciation rate that's double that of the straight-line method. This means that depreciation is recognized more quickly in the earlier years of an asset's life, reflecting higher expenses when the asset is likely to be most used.

Using a smartphone as an example: when you buy a new phone, its value depreciates rapidly over the first couple of years as newer models are released and your phone's features become outdated. DDB reflects this rapid decrease in value, similar to how quickly you could sell an outdated phone compared to one that is newer.

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 that means more depreciation in the early age of the machine when compared to the other methods.

Accelerated depreciation methods, such as DDB, provide higher depreciation amounts in the earlier years of an asset's life. This can be beneficial for businesses as it allows for greater deductions on tax returns when the asset is presumably used more heavily. While the total depreciation over the life of the asset remains the same, the timing of those deductions can significantly affect cash flow and tax obligations in the short term.

Imagine a new car that loses value quickly the first few years after purchase. If you see this loss as depreciation, you realize that dealers often offer lower prices on trade-ins shortly after purchase due to this rapid drop in value. Similarly, DDB allows companies to account for heavy usage right after acquiring equipment or machinery.

But however, selecting the depreciation is totally a business policy decision there is no constraint or any project estimator any company that they have to follow only this particular depreciation method for accounting purpose.

The choice of a depreciation method can be influenced by a company's financial strategy and goals. There are no strict rules that enforce the use of one specific method, and businesses are free to choose the method that best aligns with their financial reporting and tax strategy. Companies may prefer methods that result in earlier, higher deductions for better cash flow management and tax benefits.

Think of a restaurant owner deciding on how to manage their kitchen equipment. Depending on whether they want to reduce current taxes or show higher future profits, they can choose between methods that reflect immediate costs (like DDB) versus a gradual expense allocation (like straight-line). Their choice shapes how they evaluate their financial performance.

This is just a graphical representation of the depreciation values estimated by 3 different methods you can see straight line method is always constant double declining method this one is giving you the accelerated depreciation more depreciation in the early age of the life of the machine.

Graphical representations help in understanding the differences in how each depreciation method affects both the value of the asset over time and the associated expenses each year. The straight-line method shows a flat line, representing consistent depreciation, while the double declining balance method appears steeper at the beginning, illustrating heavier early expenses then gradually leveling off.

Imagine a staircase versus a ramp. The ramp smoothly slopes upward (showing steady and constant growth or income), while the stairs provide a rapid ascent at the start but then get less steep (showing aggressive early gains that level out). These visuals make it easier to compare various methods of depreciation at a glance.

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