7 2 Calculate and compare depreciation expense using straight-line, reducing-balance and units-of-activity methods. Accounting Business and Society

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. Let us understand the units-of-activity method of depreciation by taking an example. Activity-Based Depreciation expense is suitable for the assets which produce countable output. It is very popular for the plant and machinery in manufacturing as they are easily linked with production.

Instead of appearing as a sharp jump in the accounting books, this can be smoothed by expensing the asset over its useful life. The modified accelerated cost recovery system (MACRS) is a standard way to depreciate assets for tax purposes. For tax purposes in Australia, reducing-balance at twice the straight-line rate is often used and referred to as the ‘double declining balance’ method.

Summary and comparison of depreciation methods

In our hypothetical scenario, the company is projected to have $10mm in revenue in the first year of the forecast, 2021. The revenue growth rate will decrease by 1.0% each year until reaching 3.0% in 2025. Under this approach, the average remaining useful life for existing PP&E and useful life assumptions by management (or a rough approximation) is necessary for projecting new CapEx.

• There are various depreciation methodologies, but the most common type is called “straight-line” depreciation.
• Notice that in the 5th year, the remaining carrying amount of $15606 was not multiplied by 30%.
• Below is a short video tutorial that goes through the four types of depreciation outlined in this guide.
• The annual depreciation charge is calculated by applying this rate to the number of units produced during an accounting period.
• But in the absence of such data, the number of assumptions required based on approximations rather than internal company information makes the method ultimately be less credible.
• As the name suggests, the main component in calculating depreciation under this method is the units of production.
• In other words, this method focuses on the real use of the asset in production process rather than just the passage of time.

In addition to straight line depreciation, there are also other methods of calculating depreciation of an asset. Different methods of asset depreciation are used to more accurately reflect the depreciation and current value of an asset. A company may elect to use one depreciation method over another in order to gain tax or cash flow advantages. The unit-of-activity method is a little different method for calculating depreciation. What it does is, it takes a total number of units a plant or asset is expected to produce during its lifetime for the depreciation purpose.

Unit of Production vs. MACRS Methods

Harold Averkamp (CPA, MBA) has worked as a university accounting instructor, accountant, and consultant for more than 25 years.

• Straight-line depreciation is a very common, and the simplest, method of calculating depreciation expense.
• Note that for purposes of simplicity, we are only projecting the incremental new capex.
• Below is the summary of all four depreciation methods from the examples above.
• The profitability levels fluctuate with different levels of the activities too.
• Assume that a company acquires a robot that is expected to be useful for performing a simple operation on 100,000 units of product.
• Then the depreciation for a year is calculated by applying the depletion rate per unit to the total quantity extracted during that year.
• The other type of depreciation such as straight line and declining is depending on the time.

Usually, the manufacturing and processing businesses will prefer the unit of production depreciation method. The estimated total output from the asset/machinery can be taken from the historical records for the same asset. The units produced will be for the calculation of depreciation cost period, usually on yearly basis. This method calculates the depreciation expense on an asset considering the actual usage of the asset, which makes it the most accurate metric for charging depreciation. Units of production depreciation allow businesses to charge more depreciation during the periods when there is more asset usage and vice-versa. For specific assets, the newer they are, the faster they depreciate in value.

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Activities Based Depreciation allows the management to match between revenue and depreciation expense. Once repeated for all five years, the “Total Depreciation” line item sums up the depreciation amount for the current year and all previous periods to date. For example, the total depreciation for 2023 is comprised of the $60k of depreciation from Year 1, $61k of depreciation from Year 2, and then $62k of depreciation from Year 3 – which comes out to $184k in total.

Second, over an asset’s life, an entity cannot record more total depreciation than the asset’s depreciable cost. Notice that in the 5th year, the remaining carrying amount of $15606 was not multiplied by 30%. Lastly, the depreciation rate is applied to the carrying amount of the asset. In this example, the first year’s reducing-balance depreciation expense would be $65000 × 30%, or $19500. Note that we ignore the residual value when calculating the depreciation expense. For the remaining years, the reducing balance percentage is multiplied by the remaining carrying amount of the asset.

Definition of Units-of-Activity Depreciation

It is important to note that just because a business uses one method for taxation does not mean it has to use that method in its financial statements. While the straight-line depreciation is efficient in accounting for assets used consistently over their lifetime, what about assets that are used with less regularity? The units-of-activity depreciation method bases depreciation on the actual usage of the asset, which is more appropriate https://www.bookstime.com/articles/units-of-production-method when an asset’s life is a function of usage instead of time. For example, this method could account for depreciation of a truck for which the depreciable base is $50000 (as in the straight-line method), but now the number of kilometres the van is driven is important. Because units-of-activity relies on an estimate of an asset’s lifetime activity, the method is limited to assets whose units-of-activity can be measured.

And then calculate the cost per unit of output which is simply the purchase price less scrap value and divided by total output. Then we can get the depreciation expense per year by multiplying the output during the year with the cost per unit of output. The units-of-activity depreciation is unique among the common methods of depreciation in that the useful life of the asset being depreciated is not expressed or calculated based on the passage of time (such as years).