How to Select a Depreciation Method
Depreciation occurs when the value of an asset decreases due to wear and tear, along with age. Organizations can choose between several depreciation methods, depending on their goals and objectives. Some of the more common depreciation methods include straight line, sum-of-the-years digit and declining balance depreciation. Depending on the method chosen, depreciation for a particular asset could be more during the beginning years and less thereafter. The method chosen will have an impact on profits for that particular period.
Review all depreciation methods. It’s important to compare the three methods of depreciation to help determine the method most appropriate for a particular organization.
Review the straight line method of depreciation. For example, if you have an asset, such as equipment, which costs $10,000, has a useful life of three years and a salvage value of $700 at the end of its useful life, you can calculate its depreciation. Subtract the salvage value from the cost. Divide the remaining figure by the number of useful years remaining. This equipment will depreciate by $3,100 every year. The value of the asset at the end of its useful life is the salvage value, which is always an estimate.
Calculate the sum-of-the-years digit method. With this method, you add up each number for the years of the asset's useful life. For example, if your equipment has a useful life of three years, you add 3 + 2 + 1 = 6. The depreciation expense will be 3/6 in the first year, 2/6 in the second year and 1/6 in the third year. An asset worth $10,000 with a salvage value of $700, after three years, can be used to figure out the sum of the digits. Depreciation will be $4,650 in the first year ($10,000 - $700 = $9,300 x 3/6). The second year's depreciation will be $3,100, and the third year will be $1,550.
Determine the depreciation using the double declining balance method. This is similar to the straight line method. First you calculate the percentage of depreciation in the straight line method by taking the depreciation base ($10,000 - $700 = $9,300) and dividing it by $3,100, which is the yearly depreciation expense in the first method, to get 33.33 percent. This percentage is then doubled to get 66.66 percent.
Multiply the balance of $9,300 by 66.66 percent to get $6,199 of depreciation for the first year. The balance remaining ($9,300 - $6,199 = $3,101) is once again multiplied by .6666 to get $2,067 as the depreciation expense for the next year.
Choose a method of depreciation based on the income statement impact. A company that wants to show a reduction in expenses will use the straight line method of depreciation. The amount of depreciation is less in the beginning years using this method. This also reflects higher earnings per share and shows a figure for income and profitability that is higher. The other methods help a company produce an effect of lowering taxable income faster with higher depreciation expenses.