Assets are resources that companies own or control and result in future economic inflows. These are expenses that companies and businesses must bear for long-term success. Unlike other expenses, companies cannot charge an asset’s total cost to a single accounting period. It is because the matching principle in accounting requires entities to match their expenses with the revenues they help generate.
Therefore, companies use depreciation to spread an asset’s cost over various accounting periods. There are several depreciation methods in accounting. However, it is crucial to understand what depreciation is first.
What is Depreciation?
Depreciation is a systematic process that companies use to spread an asset’s cost over various accounting periods. Companies use depreciation to allocate an asset’s cost to the period in which it helps generate revenues. The concept of depreciation applies to every asset owned by companies that has a finite life. It includes property, plant, and equipment but usually excludes land.
Depreciation helps companies calculate their net income in each accounting period. If a company charges an asset’s total cost to a single period, it will distort the true view of its profitability. Therefore, it must allocate it over several accounting periods.
What are the various Depreciation methods in accounting?
There are several methods for depreciating assets that companies may use. These include the straight-line, declining (or reducing) balance, sum-of-the-years’ digits, and units of production methods. Each of these produces varying results for depreciation. Therefore, it is crucial to understand what each of these is.
Straight Line Depreciation
The straight-line method of depreciation is the most straightforward way to calculate depreciation. For this method, companies need to establish a useful life for an asset. It also considers the asset’s salvage value at the end of its life. Once companies measure both of these, they can calculate the straight-line depreciation using the formula below.
Depreciation = (Asset’s Cost – Asset’s Salvage Value) / Asset’s Useful Life
Depreciation calculated using the straight-line method will always result in the same depreciation over several periods.
Declining Balance Depreciation
The declining balance method of depreciation is a type of accelerated depreciation. With this method, companies must establish a percentage to use for depreciation. Unlike the straight-line method, this method results in higher depreciation in an asset’s initial years. Companies use this method for assets that have more utility in earlier years.
There are several advantages of using this method over others. Companies may also use the double-declining depreciation method, which accelerates depreciation even further.
Sum-Of-The-Years’ Digits Depreciation
The sum-of-the-years’ digits depreciation method is another accelerated depreciation method. It produces higher depreciation than the straight-line method but lower than the declining balance method. With this approach, companies apportion an asset’s depreciation based on the year of its useful life. They use the sum of these years to apportion the depreciation.
The SYD method is more appropriate for assets with higher utility in the initial years.
Units of Production Depreciation
The units of production depreciation method allocates an asset’s cost based on the number of units it produces. Instead of establishing a useful life for it, companies determine the expected number of units an asset will produce. Then, they calculate the depreciation based on the actual production units. With this method, companies experience higher depreciation during high production periods.
This method of depreciation is useful for manufacturing companies.
Conclusion
Depreciation is a technique that companies use to allocate an asset’s cost over several periods. There are various depreciation methods in accounting. These include straight-line, declining balance, sum-of-the-years’ digits, and units of production methods.
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Read excerpts from columns that appeared in April, May and June 2024 in FP Comment. This in the second instalment in a series
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