DEPRECIATION METHODS: MAIN METHODS AND EXAMPLES - DUDAS - 2025

The depreciation methods are the different ways that exist to measure the reduction in value of tangible assets are suffering with the passage of time, known as depreciation. This system also helps organizations, by investing in tangible assets, to calculate the return on their investment.

For this, there are depreciation systems, in which its loss of value is calculated during its years of useful life due to aging, obsolescence or wear and tear. It is important to note that depreciation not only serves as a way to calculate the loss of value of material goods.

Depreciation also carries a tax deduction for businesses. For this reason it is a very detailed process and looked at with a magnifying glass in organizations.

There are different methods to calculate the depreciation of assets: straight line, sum of digits, declining balances or data reduction, and units of production.

Main depreciation methods and examples

Straight line method

It is the easiest method to use. To calculate it, you only have to divide the original value of the asset to be depreciated by its years of useful life.

Annual depreciation = Asset value / useful life

Therefore, to calculate it, the first thing to do is calculate the useful life of the asset that is going to be depreciated.

Useful life of fixed assets

By law, real property is usually given a useful life of 20 years, 10 years for furniture and machinery and some transport (trains, airplanes and ships), and 5 years for vehicles and computer equipment.

In addition to the useful life, another piece of information called the residual or salvage value of the assets must be taken into account. This value is the one calculated that the asset will have once its useful life has ended; that is, how much money can be obtained from it. This value is not mandatory in the calculation.

Once we know the years of useful life and the residual value of the asset in question, the depreciation calculation can be performed.

Example

Let's take the example that we buy a van for a value of € 30,000. The useful life of the vehicle, as we have commented in the previous paragraph, is 5 years.

Dividing, we get 30,000 / 5 = € 6,000, which would be the annual depreciation. If you want to know the monthly depreciation, you only have to divide this figure between the 12 months of the year, or the original between the 60 months of the 5 years. This would give us a result of € 500 per month.

Therefore, with the straight-line method the depreciation would be completely equitable; that is, the same for all periods, be they days, months or years of the asset's useful life.

Method of the sum of the digits of the year

This is an accelerated system that increases the annual depreciation rate during the first years of use, and then decreases as the years go by. For this, the following formula is applied:

(Useful life remaining to the asset / sum digits) * Original value of the asset.

To calculate it, the value of the sum of digits is needed, which is calculated as follows: (V (V +1)) / 2 (V = Total useful life of the asset).

Example

In the previous example of the van, the sum of digits would give us: (5 (5 + 1)) / 2 = 15

In this way, the final formula would look like this: (5/15) * 30,000 = € 10,000

This means that the first year the depreciation of the van would be € 10,000, and not € 6,000 as in the straight-line method.

On the other hand, for the second year the useful life would be 4 years instead of 5; then the calculation varies. When doing the calculations, in this other year it would give us: (4/15) * 30,000 = € 8,000.

We would do the same with the rest of the years, which are having a decreasing depreciation.

Data reduction method

This method also looks for a quick depreciation. To implement it, it is necessary to have the residual value of the asset in question. The formula is as follows:

Depreciation rate = 1- (Residual value / Asset value) ^{1 / V}, where V is the useful life of the asset.

Example

Let's go back to the van. If we take into account a salvage or residual value that is 10% of the total value (10% of 30,000 = € 3,000), the formula would look like this:

Depreciation rate = 1 - (3000/30 000) ^1/5 = 0.36904

Once with this data, it is applied to the original value of the asset:

30,000 * 0.36904 = € 11,071.2 that will depreciate in the first year.

For the second year, the value will be (30,000 -11,071.2) = 18,928.8

Therefore, the depreciation for the second year will be as follows:

18,928.8 * 0.36904 = € 6,985.5

And so on, each year having a lower depreciation until the end of the vehicle's useful life.

Production units method

This method, like the straight-line method, makes an equitable distribution of depreciation over the years of useful life.

As its name suggests, it takes into account the units produced by the asset, making it a suitable system for calculating the depreciation of machinery or equipment that produces units. In the previous case of the van it would be more complicated, since it would be necessary to calculate how many units it helps to manufacture it.

To calculate it, first you have to divide the value of the asset by the number of units it produces in its total useful life.

Once this is done, in each period the number of units in that period must be multiplied by the corresponding depreciation of each unit.

Example

This time we have a machine with a value of € 100,000, which in its entire life produces 2,000 units.

Therefore, 100,000 / 2000 = 500. This means that each unit produced has a depreciation cost of € 500.

In the event that the machinery produced 200 units in the first year, the depreciation for that year would be 200 * 500 = € 10,000.

On the other hand, if in the second year it produces 300, the depreciation will then be 300 * 500 = € 15,000 in the second year.

And so we would do it successively for the rest of the 10 useful years that the machine has.

References

1. Raymond H. Peterson, "Accounting for Fixed Assets," John Wiley and Sons, Inc., 2002
2. Kiesco, et al, p. 521. See also Walther, Larry, "Principles of Accounting"
3. System of National Accounts 2008. New York: United Nations, 2008.
4. Baxter, William. "Depreciation and Interest." Accountancy. October 2000.
5. Bernstein, LA Financial Statement Analysis: Theory, Application and Interpretation. Irwin, 1989.
6. Cummings, Jack. "Depreciation Is Out of Favor, But It Matters." Triangle Business Journal. February 25, 2000.