Types of depreciation

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Types of depreciation
The reduction in value of a tangible asset over the span of its useful life is called depreciation. (penny graph image by RT from Fotolia.com)

Depreciation is a term commonly use in accounting, finance, and economics and refers to the reduction in value of a tangible asset over the span of its useful life. Buildings, vehicles, and equipment are all assets for which the depreciation may be calculated. Depreciation is calculated using different methods depending on the nature of the asset and how the value of the asset is lost. There are five main types of depreciation: straight-line depreciation, units of production depreciation, sum of the years' digits depreciation, declining balance, and double-declining balance.

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Straight-Line Depreciation

Straight-line depreciation is the simplest form of depreciation and refers to a reduction in value that occurs at a constant rate. When charted on a graph, this depreciation is depicted as a straight downward-slanting line. For example, if an asset is bought for £650 and declines £65 a year over a 10-year period, the object has experienced straight-line depreciation.

Units of Production Depreciation

Units of production depreciation refers to a connection between a reduction in value and an asset's capacity to do work during its useful life. This method of depreciation does not take into account the age of the asset, but is determined by measurable units of use. The units can be miles travelled, hours used, or items produced. A common example of this type of depreciation is a vehicle, which depreciates depending on how many miles it is driven.

Sum of the Years' Depreciation

Sum of the years' digits depreciation refers to an accelerated depreciation rate where an asset loses most of its value during the beginning of its useful life. To calculate the sum of the years' digits depreciation, you add up the sum of all the years' digits, then divide the length of useful life by that sum and use that figure as your depreciation percentage. For example, if an asset has a useful life of 5 years, you take the sum of the years' digits (1+2+3+4+5=15), divide 5 (the length of useful life) by that figure (5/15=0.33) and use that number as your depreciation percentage for the first year (33%). The second year would see the original sum of the years' digits (15) divided by the remaining years (4) and so on until the end of the asset's useful life.

Declining Balance

Declining balance refers to an accelerated depreciation rate where, like sum of the years' depreciation, the asset loses most of its value during the beginning of its useful life. It is calculated the same way that straight-line depreciation is calculated, but at a rate of 1.5 times the depreciation for each year. For example, a £650 asset with a lifespan of 10 years and a straight-line depreciation of £65 per year, would have a declining balance depreciation of £97 the first year, £82.80 the second year, £70.40 the third year, and so on.

Double-Declining Balance

Double-declining balance functions the same way as declining balance depreciation, but at an even more accelerated rate of 2 times the straight-line depreciation rate. For example, a £650 asset with a lifespan of 10 years, and a straight-line depreciation rate of £65 per year, would have a double-declining balance depreciation of £130 the first year, £104 the second year, £83 the third year, and so on.

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