The Basics of Asset Depreciation
Depreciation (like its related concept amortization) is an often-misunderstood term. In common usage it typically implies the reduction of value or function of a machine, property or device through wear-and-tear, decay, obsolescence, etc. As an accounting/finance term, however, depreciation is used to describe the spreading of an asset’s cost over a set time-span.
Asset depreciation is a complex concept, covered by many tax and financial reporting rules, and there are multiple different methods used to calculate it, depending on either the passage of time or the level of activity/use of an asset. The following list is by no means exhaustive, but covers four of the main time-based depreciation methods currently used (activity-based depreciation models are not discussed here).
Straight-Line Depreciation (SL)
Dj = (C-Sn)/n
Straight-line depreciation is the simplest method to calculate. The amount of depreciation each year (Dj) is the Cost (C) - Salvage Value (Sn), divided by the useful life (n) in years.
An asset’s salvage value (aka scrap value) is the estimated value of the asset at the time it will be sold or disposed of. In this method the depreciation amount is a constant percentage of the asset’s original value.
Sum-of-Years' Digits (SOYD)
Dj = (C-Sn)(n-j+1)/T
SOYD is based on the assumption that an asset is more useful when it is newer, so more of its cost should be written off in earlier years. This is known as an accelerated depreciation method.
SOYD is calculated as (Cost (C) - Salvage Value (Sn)) times (useful life (n) - year (j) + 1) divided by the sum of digits from 1 through n (T). T can be calculated as T = 0.5n(n+1)
Declining Balance Depreciation
Dj = min(d*BVj-1, max(0, BVj-1-Sn) )
This method is similar to SOYD in that it writes off more of an asset’s value early in its life, but differs in that Declining Balance depreciates an asset faster than SOYD. This method is usually double the Straight-Line Depreciation rate.
A Declining Balance Depreciation is calculated as Depreciation Rate (d) times the asset’s Book Value (BV) at beginning of year (j) minus 1. An asset’s Book Value is the difference between its purchase price and its accumulated depreciation.
The use of the minimum and maximum functions may be needed in the final year of depreciation since an asset’s Book Value (BVj-1) is not allowed to be less than its Salvage Value (Sn)
Declining Balance Depreciation with Switch to Straight-Line
Declining Balance Depreciation does not always depreciate an asset by the end of its life, so this method (Switch to Straight-Line) concurrently calculates both models and switches from declining balance to straight-line when straight-line’s depreciation is the greater of the two.