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Methods of Depreciation

By:   |   Jul 08, 2018   |   Views: 14   |   Comments: 0

Methods of Depreciation

I am pretty sure that we are all aware of the many aspects of financial accounting.  There are a bunch of different charts such as the balance sheet, income statement, statement of cash flows, etc, along with methods of different tasks and basically anything else you could think of.  But for right now, one of the most necessary topics to focus on that is covered in financial accounting is depreciation.  Depreciation is basically the wear and tear that an object has endured.  The longer it is around the lower the "trade in" value will end up being.  Take a car for example.  You buy it, you use it, you get tired of it, and you get a new car.  But a lot of times there is a trade in value.  A way that the amount of money you receive is calculated is with depreciation.  Doesn't really sound all that difficult right?  Well technically€¦it's not.  However, there are three different types of depreciation methods that should be looked at.

Straight Line Method

The most common and in fact the simplest method of depreciation is called the straight line method.  For this you need to know three things about the asset; the initial cost of the asset, the residual life (AKA value at the end of its useful life), and the assets useful life.  Once these are acquired they can finally be put into the equation.   One must subtract the residual life from the initial cost and divide that total by the useful life.  In math terms it looks like (initial cost - residual life)/useful life.   Equations normally are hard to comprehend when put into words, so here is an example. Say there is a machine bought for $20,000.  This machine has a useful life of 5 years and the residual value is $10,000. The three items needed for the equation are known so now all that's left is to plug them in.  It would look like this; (20,000-10,000)/5 = 10,000/5 = 2000.  Therefore this machines annual depreciation price is $2000.

Units-of-Production Method

One of the other simple methods for finding annual depreciation is called the unit-of-production method.  It is very similar to the straight line method except this time instead of dividing by the useful life you should divide by (in this example) the amount of operating hours.  So say this time you have the same machine with an initial cost of $20,000 and the residual value is $10,000.  Now the amount of operating hours is 20 (this is in place of the 5 year useful life).   The equation would now look as such; $20,000 (initial cost) - $10,000 (residual life)/ 20 (operating hours).  20,000-10,000/20 = 10,000/20 = 500.  So the answer to this example of units-of-production would be a depreciation rate of $500 per hour.

Double Declining Balance Method

The last type of depreciation method is, at least in my opinion, one that is completely different from the other two.  The double declining method is used to accelerate the amount of depreciation that is recorded within the first few years of an assets life.  With this method, the straight line rate is found and then doubled.  So what is needed for this type of method is the residual value, initial cost, and useful life.  The equation is set up as follows; (initial cost - residual value)/ useful life = amount of depreciation using straight line method.  The next part is where things could get a little hairy.  Here you need to figure out what percentage the depreciation value is of the initial cost.  To do this you can do (depreciation value/initial cost).  You will get a decimal which is also a percent.  Once that percent is found, double it.  That part is really easy.  Now to find the first year of depreciation value you take the initial cost and multiply it by the (now) doubled percentage.  After that, one must take the declining book value and multiply that by the doubled percentage.  It is important, however, to remember that the asset can never depreciate below its residual value.   Let's try to neaten this up.  Using the same numbers from the previous examples, let's do the double declining balance method.  First you start off with doing the straight line method, ($20,000 - $10,000)/5 = $2000.  Then you have to find what percentage that is of the initial cost; (2000/20,000) = .1 = 10%.  Now double that percentage; 10x2 = 20%.   Next you need to multiply the initial cost by the doubled percentage; 20,000x20% = 4000.  There you have it.  The first year's depreciation value is $4000.  If you wanted to keep going now the book value would be $16,000 (initial - first year deprecation), therefore take 20% of 16,000 giving you 3200.

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