Financial Education

There are two basic ways to record depreciation: straight line and accelerated.

While straight-line depreciation results in the same depreciation charge in each of the asset’s useful years, accelerated methods show more depreciation in the early years of an asset’s life. These methods reflect the fact that some assets wear out (depreciate) more quickly in the early years. Mathematical techniques to calculate accelerated depreciation include the sum-of-the-years’-digits (SYD) method and the declining balance (DB) method.

In the SYD method, the percentage applied to calculate annual depreciation begins at a higher rate than straight-line but decreases over time. Under the SYD method, the digits of each of the years of the equipment’s life are summed to create the denominator of a fraction, the numerator of which declines each year, beginning with the number of years in the asset’s life. In our example, a company purchases a $450,000 piece of equipment that is expected to have a useful life of four years and a salvage value of $50,000 at the end of that time. Using SYD the denominator would be calculated as 1+2+3+4=10. Depreciation in year 1 would be 4/10 of $400,000, or $160,000; in year 2 it would be 3/10, and so on. The total depreciation expense for the four-year period is $400,000, just as it was under the straight line method. The sole difference is manifested in the allocation of depreciation among the years.

In the DB method, the percentage applied is also higher than straight-line but remains constant as it is applied to the declining balance of the asset. In the DB method, the first step is to determine the straight-line rate of depreciation (1/Useful Life), which in this example is 25%. This rate is then multiplied by an acceleration factor (usually 150%, 175%, or 200%) to get the accelerated rate. Using an acceleration factor of 150% would result in an accelerated rate of 37.5%. Under this method, 37.5% of the asset’s net book value (cost minus accumulated depreciation) is depreciated each year. Depreciation for the first year would be 37.5% of $450,000, or $168,750. Year 2’s depreciation would still be computed using the 37.5%, but that rate would now be multiplied by ($450,000 - $168,750). Unlike the previous two methods, salvage value is not incorporated directly in the computation. Instead, we simply stop depreciating the asset when the net book value equals the salvage value.

In the final year, depreciation is adjusted to the amount needed to reduce the carrying value to the estimated salvage value. Again, note that the total depreciation over the life of the asset remains $400,000.

For more information, see all articles on: Accounting, Financial Statement Analysis, Fundamental Analysis

See also:

What is Depreciation and Amortization Expense?

Straight Line Depreciation

Depreciation

What is Earnings Quality?

Deferred Tax Liabilities