Assets lose value over time due to wear, tear and use, which is called depreciation. Companies use different methods to compute depreciation, which allows them to show the true book value of an asset on a financial statement. Shareholders of an organisation need the true value of an asset to correctly assess the value of an organisation.
The straight line method is the most popular type and the easiest to use. In order to calculate depreciation of an asset, take its purchase price, subtract the salvage value and then divide by the number of years you think the asset will produce an income for the company, called the useful life of the asset. The figure you get will be the annual depreciation expense for each year of the useful life of the asset.
Another method organisations use to calculate depreciation is called the sum-of-the-year's digits. To arrive at the depreciation expense, you first calculate the number of years the asset will be productive. Assuming the useful life of the asset is three years, you take, (3 + 2 +1) = 6, to get your total. Take the value of the asset minus the salvage value then you multiply it by the fraction 3/6, this will give you the first year of deprecation expense, which is subtracted from the value of the asset. The remaining value of the asset is multiplied by the fraction 2/6 to get the second year's deprecation expense, which is also subtracted from the remaining balance, and finally you take 1/6 for the third year depreciation expense, which is also subtracted from the remaining balance.
Double Declining Balance
With the double declining balance method you start your calculations by determining the percentage of depreciation expense of the asset using the straight line method. If that percentage is 20 per cent, then you double that percentage, which gives you 40 per cent. This percentage is multiplied by the purchase price minus the salvage value to get the first year of depreciation expense. You subtract the depreciation expense from the starting figure and then multiply the remaining balance by 40 per cent. You continue with this process until the depreciation figure from the double declining balance method is less than the figure from the straight line method, and then you use the straight line figure of depreciation for that year.
Once you start using one method of depreciation you have to use the same method for the entire useful life of the asset. Changing methods is not permitted.
An organisation will decide which method of depreciation to use based on the business type and its varied assets.