Last week, we began our dive into Depreciation methods by briefly discussing the differences between book depreciation and tax depreciation. Next, we looked at a couple of the classic textbook methods of book depreciation.
As just a point of review, book depreciation is the amount recorded in your books and reported on your financial statements, based upon the matching principle of accounting. On the other hand, tax depreciation represents the amount reported on the company’s income tax returns based upon the Internal Revenue Code.
Tax deprecation can differ significantly from book depreciation, typically necessitating an annual reconciliation between the two methods while preparing annual tax returns.
This week, we want to continue looking at two more textbooks methods for the computation of book depreciation:
Sum-of-the-Year’s Digits Depreciation
This depreciation is based upon the sum of the number of years in an asset’s useful life. This is another accelerated depreciation model that allocates higher depreciation expense in the earlier years of an asset’s useful life, and allocating lower depreciation expense in the later years of an asset’s useful life.
Several steps are necessary to compute this depreciation method. But, before we begin our computations, we need a working scenario to compute our book depreciation.
In the case of our Dongle-maker, we have decided to purchase a new dongle dilator as of the start of the year. I have no idea what that is, but it costs $1,000, so we consider it a depreciable asset. The manufacturer advises us that the dongle dilator most likely will have a useful life of four years, and it will have an expected residual value of $100 at the end of the four-year lifespan.
Step 1 – Compute the Sum of the Year’s Digits for the Asset’s Useful Life
Sum of the year’s digits for 4 years = 4 + 3 + 2 + 1 = 10
So, the sum of the digits for our Asset’s four-year useful life is 10.
Step 2 – Compute the Depreciable Amount
The depreciable amount = $1,000.00 - $100.00 = $900.00
Step 3 – Compute the Un-depreciated Useful Life
The un-depreciated life is defined as the asset’s useful life (in years) less the number of years for which the asset has been depreciated.
Out asset, based upon the four-year useful life, would have the following un-depreciated useful life in year of it’s useful life.
Year 1 = 4 years
Year 2 = 4 years – 1 year = 3 years
Year 3 = 4 years – 2 years = 2 years
Year 4 = 4 years – 3 years = 1 year
Year 5 = No un-depreciated useful life
Step 4 – Compute Sum-of-the-years Depreciation
The formula for this step is:
Sum of years Depreciation
In the case of our scenario our computations look like this:
Year 1: 4 / 10 X 900.00 = 360.00
Year 2: 3 / 10 X 900.00 = 270.00
Year 3: 2 / 10 X 900.00 = 180.00
Year 4: 1 / 10 X 900.00 = 90.00
Total Depreciation: $900.00
Advantages of Using Sum-of-the-Year’s Digits Depreciation
This method tends to more accurately compute depreciation for an asset that has greater productivity and value during the early years of its useful life, and declining productivity and value during the later years of its useful life.
Disadvantages of Using Sum-of-the-Year’s Digits Depreciation
Somewhat complicated to compute, especially when depreciation periods do not reflect a full year of use.
This method of depreciation – sometimes called Units of Usage Depreciation or Units of Production Depreciation – computes depreciation on the basis of the projected activity (usage or production). In order to make use of this depreciation method, it is necessary to estimate the useful life of an asset based upon it’s activity, usage or production rather than years in service.
Obviously, this method requires a business to keep track of the actual usage of each asset in relationship to the projected lifetime usage. For example, if a specific welding machine had a 6,000-hour life expectancy, and it cost $6,300, with an estimated residual value of $300 at the end of the 6,000-hour life, we could compute depreciation using the Units-of-Activity method each year if we know how many hours the welder is used each year.
To compute the Units-of-Activity Depreciation perform these steps:
Step 1 – Compute the Depreciable Value
Depreciable Value = Cost – Residual Value
In our example, this would be:
$6,300.00 - $300.00 = $6,000.00 (The depreciable value is $6,000.00)
Step 2 – Compute annual units of production as a percentage of life expectancy.
Annual Usage / Total Expected Usage = Percentage of life expectancy
If our welder is used for only 500 hours in the first year, the annual units of production percentage would be:
500 / 6,000 = 0.0833 (The period's percentage of life expectancy is 0.0833)
Step 3 – Compute Units-of-Usage Depreciation for the Year
Depreciation Expense = Depreciable Value X Annual Percentage of Life Expectancy
In our example, the first year’s depreciation for the welding machine would be:
$6,000.00 X 0.0833 = $500.00 (The first year's depreciation is $500.00)
Each subsequent year’s depreciation is based upon that year’s actual usage as a percentage of estimated usage over the asset’s lifetime. For any year in which an asset remains idle, like a drilling rig taken out of service, no depreciation is expensed.
This means that while the Units-of-usage may seem more appropriate a method of depreciation because it values life expectancy against actual earnings value, non-depreciated idle time may not take into account the diminished life of an asset due to technological changes.
Advantages of using Units-of-Usage Depreciation
When an asset’s decline in value is actually related to the number of cycles, number of hours, number of miles or other "measures" performed by the asset, this method of depreciation is a highly accurate valuation of the asset in relationship to its economic benefit.
Disadvantages of using Units-of-Usage Depreciation
This is somewhat more complex to compute. It requires knowledgeable estimate of expected useful life in measurement units (hours, miles, cycles, etc.). It requires accurate measurement of the units-of-usage (hours, miles, cycles) and recordkeeping related thereto.
All of the methods we have looked at have specific benefits. And while some may have disadvantages in the form of complexity or extra records or tracking, the goal is to use the depreciation method that most accurately reflects an asset's value in relationship to its overall economic benefit to the business.
The under, or over, valuation of assets due to improper depreciation methodology can seriously impact the quality and integrity of the financial statements.