Why Are There Different Methods of Depreciation?

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Determine the best method of depreciation as it applies to your assets and business.
Determine the best method of depreciation as it applies to your assets and business. (Image: Yana Paskova/Getty Images News/Getty Images)

Depending on the type of company, different methods of depreciation may come to bear to determine the current value of company assets. It may be more advantageous to depreciate equipment earlier in its use, equally over time, or closer to the end of its expected use. A company can determine the best method of depreciation expense to offset income in a manner that would best allow the business to grow.

Salvage Value

When you have fully depreciated a piece of equipment or other asset, the remaining worth is known as the salvage value, also known as the residual value. The asset will continue to be on your accounting books at its salvage value for as long as it remains in operation but no further depreciation expenses will be taken against the value of the item. It will remain at this value until the asset's owner takes out of commission (for sale or replacement, for example.).

When computing any depreciation expense, you must know the cost (beginning book value) of the asset, the time in use (also known as the useful life of the asset), and the salvage value (residual value) of the asset.

Straight-Line Depreciation

Straight-line depreciation is fairly easy to calculate. The depreciation expense for each year the item is in use is calculated by subtracting the salvage value from the cost of the asset and dividing that figure by the expected useful life of the asset. You can list the resulting amount as a depreciation expense for that asset and the book value of the asset reduces by that expense for calculation in the following year.

This would continue until the remaining book value of the asset matches the salvage value, at which point depreciation expenses would no longer be valid.

Declining Balance and Sum-of-the-Years

The declining balance and sum-of-the-years depreciation methods allow you to enter higher depreciation expenses for an asset earlier in its useful life.

Under the declining balance method, you would take the book value of the asset, multiply it by the straight-line depreciation rate and then multiply that amount by the desired depreciation rate, up to 200 percent. For an object with a useful life of five years, this would allow you to take a depreciation expense up to 40 percent in the asset's first year and highly reduced amounts thereafter, instead of 20 percent a year for five years.

Under the sum-of-the-years depreciation method, you would take the cost and subtract the salvage value and multiply it by a fraction to determine the depreciation expense. The fraction to use would be the remaining lifespan of the asset (for example, two years remaining) over the sum of the useful years of the object (for a five-year lifespan example, this would be 5+4+3+2+1, for a total of 15). In this example, the result would be 2/15.

Depreciation on Use

An alternative to depreciating an asset based on time (as done with straight-line and double-declining balance methods) is to depreciate an asset based on its actual usage.

After subtracting the salvage value from the book value, you would divide by the estimated total production of the asset over its lifespan. This amount would then be multiplied by the actual production of the asset to determine the accumulated depreciation expense that would be applicable, until such point that the book value equals the salvage/residual value.

This method of calculation may be valuable in cases where the majority of production may occur later in the asset's lifespan.

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