Depreciation refers to systematic allocation of asset’s cost over time. In other words, it is a non-cash- operating expense relating to reduction of value of tangible asset over time. An asset depreciate becasue of following reason:
Wear and Tear: Machinery being used in production process may depreciate because of the wear and tear which is possible with continued use of machinery for extended years.
Obsolence: A product may be considered as obsolete and hence is depreciated because there are new and better models available with better efficiency and improved production capacity.
As for the methods of depreciation, which client can consider are the following:
i) Straight Line Depreciation: It is the pre-dominant method of computing depreciation for financial reporting. Under this method, same amount each year over the asset’s estimated life is depreciated and thus is considered to be one of the easiest method of depreciation.
Formula= (Original Cost- Salvage Value)/ Depreciable Life
ii) Accelerated Depreciation:
Under this method, unlike straight line depreciation method, an asset is depreciated at higher amount in the initial years of its installation. Thus, in the initial years, more depreciation expenses is recognized in the early year of an asset’slife and hence lower net income and vice versa. Double Declining Balance Method is one of the most prominent method of accelerated depreciation method:
Formula = [2/ Depreciable Life in Years]* Book Value at beginning of year
iii) Units of Production Method:
Under units of production method, depreciation is based on usage rather than time. Thus, depreciation usage is higher in periods of high usage.
Which method is most suitable?
In terms of selecting Depreciation Methods, the best method should be one that suits the business operations of the client. For Instance, if the client is using the asset for an equal amount each period throughout its life, he should use straight line depreciation method. Similarly, if an asset have high usage in beginning years of its installation, it is likely to use accelerated method of depreciation with asset likely to depreciate more in the initial years. Finally, if the asset is in the nature of producing measurable quantity of output then he must units of production method.
Robinson, T. (2011). Long Lived Assets. In C. Institute, Financial Reporting and Analysis (pp. 198-210). Boston: Custom.