Depreciation Methods Compared

Depreciation is the allocation of the cost of a tangible asset over its useful life. It follows the matching idea: spread the cost to the periods that benefit from the asset. It does not measure what the asset could sell for, which is the most common misreading of it.

Three methods appear in a first accounting course, and they differ in only one thing: how much of the cost lands in each year. This post runs all three on the same asset so the differences are visible, then covers partial years and changed estimates. The depreciation calculator builds the full schedule for any inputs.

The vocabulary

• Cost: the full cost of the asset, which is the price plus shipping, taxes, setup and legal fees, never recorded net of salvage value.
• Salvage (residual) value: what you expect to get for the asset at the end of its life.
• Depreciable base: cost minus salvage.
• Book value: cost minus accumulated depreciation.
• Accumulated Depreciation: a contra asset with a credit balance, so the original cost of the asset stays visible on the books.

An asset is never depreciated below salvage, and every method records the same two-line entry each year: debit Depreciation Expense and credit Accumulated Depreciation. All methods give the same total over the life, cost minus salvage. The only difference is timing.

One asset, three methods

Take Northgate Corp. buying equipment for $90,000 with a salvage value of $10,000 and a 5-year life. For units-of-production, assume it is expected to run 200,000 machine hours in total and, hypothetically, uses 30,000, 50,000, 50,000, 40,000 and 30,000 hours in years 1 to 5.

Book value at the end of year 2 is $58,000 under straight-line and under units-of-production here, but only $32,400 under double-declining-balance. At the end of year 5, all three have reached the $10,000 salvage value.

Straight-line

Annual expense = (cost - salvage) / useful life in years. Here it is (90,000 - 10,000) / 5 = $16,000 a year. It is the simplest method and the right default when an asset is used about evenly over time.

Units-of-production

The expense follows usage, not time. First find a rate per unit, then multiply by the units used in the period:

Rate per unit = (cost - salvage) / total estimated units

Here the rate is 80,000 / 200,000 = $0.40 per hour. A year with 50,000 hours costs 50,000 x $0.40 = $20,000. A year when the asset sits idle gets little or nothing. This method fits machines whose wear depends on how much they run, such as a press measured in machine hours.

A frequent slip is to skip salvage and use 90,000 / 200,000 = $0.45 a unit. That gives too much expense and would eventually take the asset below salvage.

Double-declining-balance

This is an accelerated method: it front-loads expense. The rate is twice the straight-line rate, 2 x (1 / useful life), which is 40% for a 5-year life. The expense each year is the book value at the start of the year times that rate.

Two details make or break the answer:

1. Salvage is ignored in the multiplication. Year 1 is 90,000 x 40% = $36,000, not (90,000 - 10,000) x 40%.
2. The rate applies to book value, not original cost. Year 2 is (90,000 - 36,000) x 40% = 54,000 x 40% = $21,600.

Book value still never goes below salvage. When the next multiplication would cross it, the expense is limited to book value minus salvage, and after that the expense is $0. On a $58,000 press with $10,000 salvage and a 5-year life, the expenses are $23,200, $13,920, $8,352, then a limiting year of $2,528 (book value of 12,528 minus 10,000), then $0. Year 4 would have been 5,011 by the formula, which would drop book value to about 7,517, below salvage, so it is capped.

A company that wants the most expense in the early years of an asset's life, such as a fast-growing one, fits double-declining-balance.

Partial years

If equipment is bought partway through the year, the first year's expense is the annual amount times the months owned over 12. With annual straight-line depreciation of $16,000 on equipment bought April 1 and a December 31 year end, year 1 is 16,000 x 9/12 = $12,000. Bought July 1 with $12,000 annual depreciation, it is 12,000 x 6/12 = $6,000. The final year takes the remainder so that the total equals cost minus salvage. The calculator uses whole years, so work partial years by hand with this rule.

Changing the estimate

If you change the useful life or salvage value after some years, the change is prospective. Earlier years are not restated. New annual expense = (book value now - new salvage) / remaining life.

Suppose the $58,000 press with $10,000 salvage and a 5-year life is depreciated straight-line at $9,600 a year. After 3 years the book value is 58,000 - 28,800 = $29,200. If the company now expects 4 more years and a salvage of $8,000, the new expense is (29,200 - 8,000) / 4 = $5,300 a year from here on.

Estimates change for two reasons the course names. Physical obsolescence is wear and deterioration. Functional obsolescence is loss of usefulness from causes other than wear, such as newer technology making a machine outdated even though it still works.

What IFRS adds

Under IFRS, significant parts of an asset must be depreciated separately when feasible. US GAAP does not require this component approach. It is a short, easy multiple-choice item.

Errors that cost marks

• Applying the double-declining rate to original cost every year, which makes the expense constant.
• Subtracting salvage before applying the double-declining rate.
• Forgetting that the credit goes to Accumulated Depreciation, not to the asset account.
• Treating depreciation as a market value adjustment.
• Using the old estimate to restate prior years after a change in estimate.

Practicing it

Depreciation is a good case for generating answers instead of recognizing them. Cover the schedule, compute year 2 of double-declining-balance, then check. The testing effect says that retrieval beats rereading, and why rereading notes doesn't work explains the trap of a worked example that looks familiar.

Depreciation lives in unit 11, with the first adjusting entry in unit 4. What's in Financial Accounting maps all 16 units, how to study for financial accounting covers the order to learn them, and debits and credits explained is the base for every entry above. The cost-and-volume side of asset decisions is in the break-even point calculator.

The straight-line, double-declining-balance and units-of-production questions are all cards in the free Financial Accounting course.