Lesson Corporate Finance: Different Methods of Depreciation

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Different companies calculate and account for <A HREF="depreciation_1.lesson">depreciation </A>in different ways. Since <A HREF="depreciation_1.lesson">depreciation</A> is taken as an expense in the <A HREF="income_statement.wikipedia">income statement</A>, indicating higher <A HREF="depreciation_1.lesson">depreciation</A> 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 <A HREF="depreciation_1.lesson">depreciation</A> in current period would mean lower <A HREF="depreciation_1.lesson">depreciation</A> later.

Methods of <A HREF="depreciation_1.lesson">depreciation</A> can be broadly grouped in 2 categories: <A HREF="Straight_line_depreciation.wikipedia">Straight Line Method </A>and <A HREF= "Declining_balance_depreciation.wikipedia">Reducing/Declining Balance Method</A>.

<b><A HREF="Straight_line_depreciation.wikipedia">Straight Line Method</A></b>: 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 <A HREF="salvage_value.wikipedia">salvage value</A> 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:

<center>
{{{Depreciation = (Original Value - Salvage Value)/Time}}}
</center>

Example: Calculate the <A HREF="depreciation_1.lesson">depreciation</A> 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.

<b><A HREF="Reducing_balance_method.wikipedia">Reducing Balance Method</A></b>: In this method, the <A HREF="depreciation_1.lesson">depreciation</A> in a period is equal to a percentage of the <A HREF="Written_Down_Value.wikipedia">Written Down Value</A> (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 <A HREF="depreciation_1.lesson">depreciation</A>. Thus the formulas for calculating the depreciation would be:

<center>
{{{WDV[i] = OriginalValue - CumulativeDepreciation[i]}}}
{{{CumulativeDepreciation[i] = sum(Depreciation[j],j=1,i)}}}
{{{Depreciation[i] = WDV[i-1]*DepreciationFactor}}}
</center>

where {{{WDV[i]}}}, {{{CumulativeDepreciation[i]}}} are the WDV and Cumulative Depreciation at end of period i respectively, and {{{Depreciation[i]}}}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 <A HREF="depr_schedule.lesson">calculating the depreciation schedules</A>.