Methods of Calculating Depreciation

There are different methods of calculating depreciation of assets. These include the following:

Straight Line method

Reducing balance method

Sum-of-the-year digit method

Service hour method

Production output method

Revaluation method

Sinking Fund method

Straight Line Method

This method spreads the entire depreciable value of an asset equally over its useful life. Here, the depreciable value is divided by the number of economic useful years of the asset and allocated yearly.

Suitability of this method

The straight line method of depreciation is best suitable for assets as patent and leases. The reason is that for such assets, time is the important factor that is used to write off the carrying amount of these assets. Although some organizations use this method just because of its simplicity, yet it has some contentious shortcomings. 

The major disadvantage of this method is that

 It is not realistic as equal amount is charged every year, whereas, it is most useful in earlier years than its later years

Reducing Balance Method

This method adopts a rate which is applied annually to the net book value of the asset. Since same percentage is applied yearly, it follows that it charges higher amount in the earlier years than in the later years. This is true because the rate is applied on the balance remaining.

Sum of the Years Digit Method

Here, the depreciation is charged on the reducing balance method but with the digits versed. What this means is that if an asset is expected to last for 5 years for instance, the years are weighed by adding all the digits from year 1 to year 5 as follows:

1+2+3+4+5 = 15

The total weight will be 15 and the year depreciation will be charged using 5 for year1, 4 for year2, 3 for year3, 2 for year4, and 1 for year5 respectively. This implies that this method is a ratio approach in reverse order.

Production Output Method

The production output method is also referred to as the machine out method of depreciation. With this method, the total machine production capacity in units is estimated or established. Then the depreciable value of the machine is divided by the capacity (in units). This gives us the depreciation per unit for every unit produced.

When the per unit amount of depreciation is multiplied by the actual units produced in a year, we have the depreciation amount for that particular year.

Service Hour Method

This method is also called the machine hour method of depreciation. As in the case of machine output method, the depreciable value of the assets is divided by the installed capacity (in hours) to have the depreciation amount per hour. The number of actual hours used is then multiplied by the hourly rate of depreciation to have the depreciation for the year.

Accounting Entries

Here, we will examine two instances to clarify the accounting entries depending on the depreciation policy of the management of the entity concerned.

Policy A – Assets are maintained at Net Book Value

For purchase of assets (non-current assets)

Dr – The Asset account

Cr – Bank

with the value of the asset purchased

For Depreciation Provision

Dr – Income statement

Cr – Asset account

with the amount of depreciation charge for the year

Policy B – Assets are maintained at Cost Price

For purchase of asset

Dr – Asset account

Cr – Bank

with the cost price of the asset

For Depreciation Provision

Dr – Income statement

Cr – Provision for Depreciation account

with the depreciation charge for the year