Depreciation method of

Valuation
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• DEPRECIATION:-

• is the loss in the value of the property due to is use , life, wear, tear, decay
and obsolescence. The general annual decrease in the value of a property is
known as annual depreciation.

• Usually, the percentage rate of depreciation is less at the beginning and

generally increase during later years.
• Methods of calculating depreciation: -
• 1)Straight line method
• 2) constant percentage method
• 3) Sinking fund method.
Cost Approach: Depreciation

Depreciation causes the difference in value between the cost new of the
improvements and the current contributing value of the improvements. The three
forms of depreciation are physical, functional, and external depreciation.
Physical depreciation results from normal wear and tear on the property that
happens with age. Functional depreciation is the result of changes in needs or
preferences over time that cause a reduction in the property’s utility. External
depreciation is the result of adverse neighborhood or economic trends.

There are three methods that appraisers can use to estimate depreciation.
  The Age-life Method– This method is the simplest and most common method of
estimating depreciation. The appraiser estimates the total age, effective age, and
remaining life of the improvements. Effective age is a function of the property’s current
condition as well as its utility and location in the current market

 The Breakdown Method– This is the most accurate and comprehensive way to estimate
all forms of depreciation. It is, however, extremely complicated and time-consuming. The
breakdown method identifies each individual form of physical, functional, and external
depreciation. Then, the depreciation from each individual factor is quantified and added
together to calculate accumulated depreciation on the property

  The Market Extraction Method– The market extraction method uses data from
comparable sales to estimate the appropriate depreciation percentage to apply to the
subject property. Appraisers find the depreciated value of the improvements on the
comparable property by subtracting the land value and contributing value of the
improvements from the sales price. The percent the comparable property value has
depreciated is the depreciated value of the improvements divided by the cost new of
those improvements. This percent is then applied to the subject property
Straight-Line Depreciation Method
Straight-line depreciation is a very common, and the simplest, method of calculating depreciation
expense. In straight-line depreciation, the expense amount is the same every year over the useful
life of the asset.

Depreciation Formula for the Straight Line Method:

Depreciation Expense = (Cost – Salvage value) / Useful life

Double Declining Balance Depreciation Method

Compared to other depreciation methods, double-declining-balance depreciation results in a larger

amount expensed in the earlier years as opposed to the later years of an asset’s useful life. The method
reflects the fact that assets are typically more productive in their early years than in their later years –
also, the practical fact that any asset loses more of its value in the first few years of its use. With the
double-declining-balance method, the depreciation factor is 2x that of the straight-line expense
method.

Depreciation formula for the double-declining balance method:

Periodic Depreciation Expense = Beginning book value x Rate of depreciation

Units of Production Depreciation Method
The units-of-production depreciation method depreciates assets based on the total number
of hours used or the total number of units to be produced by using the asset, over its useful
life.

The formula for the units-of-production method:

Depreciation Expense = (Number of units produced / Life in number of units) x (Cost –

Salvage value)
Sum-of-the-Years-Digits Depreciation Method
The sum-of-the-years-digits method is one of the accelerated depreciation methods. A higher expense is
incurred in the early years and a lower expense in the latter years of the asset’s useful life.

In the sum-of-the-years digits depreciation method, the remaining life of an asset is divided by the sum
of the years and then multiplied by the depreciating base to determine the depreciation expense.

The depreciation formula for the sum-of-the-years-digits method:

Depreciation Expense = (Remaining life / Sum of the years digits) x (Cost – Salvage value)
• CONSTANT PERCENTAGE METHOD

• In this method it is assumed that the property will lose its value by a constant
percentage of its value at the beginning of every year.
• By this method, decrease in the value of property in the beginning years is at this
faster rates, while decrease in value in the later years is at slower rate.
• This method is more suitable for calculating depreciation of machines.
• Percentage rate of annual depreciation.

• Where,
• P = Percentage rate of annual depreciation
• S = scrap value
• C = original cost
• If age of property is m years, value of property
after m years after depreciation,
• SINKING FUND METHOD

• In this method the depreciation of the property is assumed to be equal to the

annual sinking fund plus the interest on the sinking fund for that year.
• Depreciation = Annual sinking fund + Interest on the sinking fund for that year.
• If, A. Annual sinking fund b. c. d etc. = Interest on the sinking fund for the
subsequent years.
• C = Original cost.
• Straight Line Depreciation Method Examples
• Suppose a business has bought a machine for $ 10,000. They have estimated the useful life of the machine
to be 8 years with a salvage value of $ 2,000.
• Now, as per the straight line method of depreciation:
• Cost of the asset = $ 10,000
• Salvage Value = $ 2000
• Total Depreciation Cost = Cost of asset – Salvage Value = 10000  – 2000 = $ 8000
• Useful life of the asset = 8 years
• Thus, annual depreciation cost = (Cost of asset – Salvage Cost)/Useful Life = 8000/8 = $ 1000
• Hence, the Company will depreciate the machine by $1000 every year for 8 years.
• We can also calculate the depreciation rate, given the annual depreciation amount and the total
depreciation amount which is annual depreciation amount/total depreciation amount
• Hence, depreciation rate = (annual depreciation amount/total depreciation amount)*100 =
(1000/8000)*100 = 12.5%
• Depreciation account of the balance sheet will look like below over the 8 years of the machine’s life:
• Double Declining Method Example
• Suppose a business has bought a machine for $ 100,000. They have estimated the useful life of the
machine to be 8 years with a salvage value of $ 11,000.
• Now, as per the straight-line method of depreciation:
• Cost of the asset = $ 100,000
• Salvage Value = $ 11,000
• The useful life of the asset = 8 years
• Depreciation rate = 1/useful life *100 = (1/8) * 100 = 12.5%
• Double-declining balance formula = 2 X Cost of the asset X Depreciation rate
• Here, it will be 2 x 12.5% = 25%
• Year 1 Depreciation = $100000 X 25% = $25,000
• Year 2 Depreciation = $75,000 x 25% = $18,750
• Depreciation account of the balance sheet will look like below over the 8 years of the machine’s life:
• In the above table it can be seen:
• In the double declining balance formula, depreciation rate remains the same and is applied to the ending
value of the last year
• The double declining balance depreciation value keeps decreasing over the life of the asset
• The final double declining balance depreciation expense was $ 2348 which is less than the actual $3,338
(25% of $13,348 ). It was done to keep the salvage value as estimated
• Units of production example

• The following example shows an example application of this method. Again, the first step is the calculation
of a rate by dividing the depreciable basis by the expected number of hours of operation. The example
uses the same asset seen in the above example:

• In this case, the rate is $3 per hour ($105,000 / 35,000 hours).

• Sum of the years units example:
• The Monster company purchased a machine on January 1, 2015. The relevant information is given below:
• Cost of the machine: $250,000
• Expected useful life of machine: 5 years
• Salvage value: $25,000
• Required: Prepare a schedule showing the depreciation expense of each year of the useful life of the
machine using sum of years’ digits method.

• Solution:
• Depreciable cost (depreciable base): $250,000 – $25,000 = $225,000
• Depreciation expense at the end of the first year: $225,000 × (5/15) = $75,000
• Book value at the end of the first year: $250,000 – $75,000 = $175,000
• Notice that as the remaining life of the machine decreases, the depreciation expense also decreases.
Sources:

• https://www.accountingformanagement.org/sum-of-the-years-digits
-method/
• https://www.playaccounting.com/explanation/exp-oa/units-of-prod
uction-method-depreciation/
• https://www.wallstreetmojo.com