18.5. Methods of Depreciation

• Straight Line Method (SLM) Also known as the Fixed Installment Method. The same amount is charged each year. Formula:

  Cost of asset−Residual value Depreciation per year= Useful life

  • Simple and widely used.
  • Suitable for assets with consistent usage.

The Straight Line Method (SLM) of depreciation spreads the cost of an asset evenly over its useful life. This means that each year, a fixed amount is deducted as depreciation expense until the asset's value reaches its residual value. To calculate the annual depreciation, you subtract the asset's residual value (the estimated value at the end of its life) from the initial cost and then divide that by the number of years the asset is expected to be in use. This method is simple and best suited for assets that provide consistent utility over time, such as furniture or office equipment.

Think of SLM like a book that costs $100 and can be read for 4 years until it becomes outdated. Each year, you acknowledge that the book loses$25 of its value, so by the end of the fourth year, it’s perceived to be worth only its residual value, which might be $0.

• Written Down Value (WDV) Method Depreciation is charged at a fixed percentage on the book value of the asset. Formula:

  Depreciation=Book value at beginning of year×Rate of Depreciation

  • Results in higher depreciation in initial years.
  • Suitable for assets whose efficiency decreases over time.

The Written Down Value (WDV) method calculates depreciation as a fixed percentage of the asset’s current book value at the start of each year. This leads to higher depreciation expenses in the earlier years when the asset is new and likely being used more intensively. As the asset ages and its book value decreases, the amount depreciated each year is also lower. This method is particularly fitting for assets like machinery, where usage decreases as the machine ages.

Imagine you have a car valued at $20,000 and you expect it to depreciate by 20$4,000 depreciation for that first year. In the second year, you would apply the 20% to the reduced value of $16,000, resulting in only$3,200 of depreciation.

• Sum of Years’ Digits Method Accelerated method of depreciation. Formula:

  Remaining life of asset Depreciation= ×(Cost−Residual Value) Sum of years’ digits

The Sum of Years’ Digits method provides an accelerated rate of depreciation, which means more depreciation happens in the earlier years of the asset’s life. To compute it, you first calculate the sum of the digits for the asset's useful life. For example, if an asset has a useful life of 5 years, the sum of the digits would be 1+2+3+4+5=15. Then, you determine how many years are left in the asset's life, and this becomes the numerator in the formula. The remaining value is multiplied by the depreciation base (cost minus residual value) to determine the expense for that year.

Consider you have a piece of equipment used for five years. In the first year, you might allocate 5/15 of the total value for depreciation. In the second year, it becomes 4/15 of the remaining value, gradually reducing until the fifth year when it is only 1/15. You might think of this as a new car losing most of its value in the first few years due to rapid technological advancements.

• Units of Production Method Depreciation depends on actual usage/output of the asset. Formula:

  Cost−Residual value Depreciation per unit= Estimated total production

  Then, Annual Depreciation=Depreciation per unit×Actual units produced

The Units of Production Method bases depreciation on the actual use of the asset rather than time. This method is particularly relevant for manufacturing equipment and vehicles where the asset's life is more closely tied to how much it is used rather than how long it has existed. To apply this method, you first determine the total expected production output over the life of the asset. Then, the depreciation expense for the year is calculated by multiplying the number of units produced in that year by the per-unit depreciation calculated from total costs and expected output.

If a printing machine costs $10,000, has a residual value of$1,000, and is expected to produce 100,000 prints in its lifetime, the depreciation per print would be $0.09. If the machine produces 10,000 prints in a year, the depreciation expense for that year would be$900, reflecting the machine's actual usage.

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