Lesson Corporate Finance: Different Methods of Depreciation

Different companies calculate and account for depreciation in different ways. Since depreciation is taken as an expense in the income statement, indicating higher depreciation reduces the income before taxes and thus the taxes to be paid can be reduced. However, the taxes are not eliminated, but deferred for a later period, since larger depreciation in current period would mean lower depreciation later.

Methods of depreciation can be broadly grouped in 2 categories: Straight Line Method and Reducing/Declining Balance Method.

Straight Line Method: In this method, the asset is depreciated over its life in a linear fashion, i.e. by equal amounts every year. In general, the asset is assigned a salvage value which is the expected value obtained by disposing the asset at the time of its disposal. The formula for calculating the depreciation expense every period is as follows:



Example: Calculate the depreciation of an asset with Original Value - $10,000. The useful life of the asset is 5 years and the salvage value at the end of 5 years is 0.

Solution: Depreciation = (Original Value - Salvage Value)/Time = (10,000 - 0)/5 = $2000.

Reducing Balance Method: In this method, the depreciation in a period is equal to a percentage of the Written Down Value (WDV) of the asset at the beginning of the period. The WDV at the beginning of a period is equal to the original value of the asset minus cumulative depreciation. Thus the formulas for calculating the depreciation would be:





where , are the WDV and Cumulative Depreciation at end of period i respectively, and is Depreciation Expense during period i. Depreciation Factor is the rate at which the asset is depreciated. Example of Reducing Balance depreciation can be seen in the lesson on calculating the depreciation schedules.