What is the Depreciation Rate?
Depreciation is a periodic decrease in the value of a product due to wear and tear, damages that any object incurs over a period of time. In simpler words, when you buy any electronic device, its value decreases over a period of time.
This is due to many reasons such as technological advancement, damages during usage etc. This decrease in the value of a product is called depreciation. Depreciation is not just limited to electrical appliances but also many other objects like furniture, cars etc.
This rate is very important for tax purposes as this determines the true and accurate value of the asset that you have. In this article, we will find out how to calculate the depreciation of an AC through various methods.
There are 3 main methods to calculate depreciation, let’s see what these are:
1. Straight Line Method:
This is the easiest and simplest method of calculating depreciation. Here the salvageable value i.e. the value of the AC at the end of its productive life is obtained.
In this method, you can only find the total depreciation at the end of the productive life of the AC. This productive life is usually mentioned in years.
The general principle for calculating depreciation is;
Depreciation = Original cost of the product – the salvageable value
The formula for calculating straight-line depreciation is;
Annual depreciation = Cost of the asset – salvageable value/ number of years
Cost of asset: The purchase price of the AC
Salvageable Value: The price of the AC at the end of its productive life
Number of years: Productive life or years of usage or useful life of the AC
The main principle here is that the depreciation is distributed equally amongst all the useful years of the AC. This is the simplest method of calculating depreciation but it is not accurate in practical use. An electrical device in an AC will lose more value in the initial years due to technological advancement than the later years of its productive life.
For example, Let’s say an AC was purchased at Rs.45,000 and it worked for 10 years and now its value is 5000.
Here total depreciation is clearly Rs.40,000 (Rs.45,000 – Rs.5,000) and annual depreciation is,
40,000/10 = Rs.4000
Now the rate of depreciation = Annual depreciation/total depreciation
Which is;
Rs.4000/40,000 = 10% (0.1*100)
Advantages:
- This is an easy and simple method of calculating depreciation
- It is suitable for assets that have a long productive life and less value, to begin with
- The asset can be written off completely
Limitations:
- Not suitable for products such as an AC as these develop constantly. New and advanced products are coming to the market frequently.
- It wrongfully assumes that depreciation is the same each year
- Limited practical usability
2. Declining Balance Method:
The Declining Balance Method is the most commonly used method of calculating depreciation. It is also known as the Reducing Balance Method. Here the depreciation is higher in the initial years as lesser in the later years. This type of method is best suited for technological products like an AC or a car.
The formula for calculating Declining Balance Method is;
Declining Balance Method = (Net value of the asset – residual value) X rate of depreciation
The difference here is that the depreciation for each year is different;
Taking a similar example as above, let us find out the depreciation. We are given, AC was purchased at Rs.45,000 and it worked for 5 years and now its value is 5000. It has a rate of depreciation of 5%
Here, for the first year, the depreciation will be,
Depreciation = Rs.45,000 – Rs.5000 * 5% = Rs. 2000
For the next year, the net book value of the AC will become Rs.45000 – Rs.2000 = Rs. 43000, this is because the value of the AC has decreased by Rs.2000 in the first year itself, the value of the AC at the beginning of the second year is Rs.43,000.
For the second year, we will repeat this,
Depreciation = Rs.43000 – 5000*5% = 38000*5/100 = Rs.1900
For the second year, the value of the AC is decreased by Rs.1900 and the total value of the AC becomes Rs.43000-1900 = Rs.41,100
For the 3rd year,
Depreciation = Rs.41,100 – Rs.5000*5% = Rs. 1805
For the 4th year,
Value of AC = Rs.41,500 – 1805 = 39,295
Depreciation = Rs.39,295 – 5000*5% = 34,295*5% = Rs.1715 (approx.)
For the 5th and final year,
Value of AC = Rs.39,295 – 1715 = Rs.37,580
Depreciation = Rs.37,580 – 5000*5% = 32,580*5% = Rs.1629
Total depreciation here is,
Rs. 2000 + Rs.1900 + Rs.1805 + Rs.1715 = Rs.7420
As you can see the depreciation is much higher in the initial years as compared to the later years in the declining value method of depreciation.
Advantages:
- Is suitable for a large number of assets like AC, car etc.
- High practical usability
- This method charges greater depreciation in the initial period which is acceptable for income tax purposes.
Limitations:
- You cannot write off the asset with this method
- A high rate of depreciation needs to be charged for fixed assets
- It is difficult to calculate than the straight-line method
3. Sum Of The Year (SYD) Method:
Sum Of The Year method is an accelerated method of calculating depreciation which means that in this method, the depreciation is calculated more in the beginning periods of the useful life of the asset. As time passes, the depreciation of the asset decreases.
In this method, the rate of depreciation for each year is charged as the number of years remaining in the useful life of the asset divided by the sum of all the years of the useful life of the asset.
Let’s take an example to understand this,
If an AC was purchased at Rs.40000 and had a useful life of 4 years and has a salvageable value of Rs.4000, then the depreciation will be charged as follows;
The addition or the sum of the years of the useful life of the asset also called the depreciation base= 1+2+3+4 = 10
For the first year, the rate of depreciation will be,
Number of remaining useful life of the asset/ sum of the useful life of the asset
5/10 = ½ = 50%
For the 2nd year,
4/10 = ⅖ = 40%
For the 3rd year,
3/10 = 30%
For the 4th year and final year,
2/10 = ⅕ = 20%
The sum of all the percentages has to be 100%. As you can see, the rate of depreciation is much higher during the initial year as compared to the later years.
In the above example the useful life of the asset was 4 years, but what about when the useful life is 10 or 20 or 50 years? Finding the depreciation value or the sum of the years of the useful life of the asset by adding each number will be tedious. Therefore, we use a formula in those cases,
Depreciation value = Useful life/2 * (1+ useful life)
Let’s try this on the above example,
Depreciation value = 4/2 *(1+4) = 2*5 = 10
If we had to find out the depreciation value for each year, using the rate of depreciation that we found above, here is how we would do that,
First, we need to find out the depreciable value of the asset which is nothing but the purchase value of the asset minus the final salvageable value.
Depreciable value = Purchase value of the asset – salvageable value
Depreciable value = Rs.40,000 – Rs.4000 = Rs.36,000
Now for the 1st year depreciation will be,
50% of Rs.36000 = Rs.18,000
For2nd year,
40% of Rs.36000 = Rs.14,400
For the 3rd year,
30% of Rs.36000 = Rs.10,800
For the 4th and final year,
20% of Rs.36000 = Rs.7,200
Once an organization chooses a method of calculating depreciation, they generally stick to it forever. They can change the method of calculating depreciation later but that would require them to change the method of applying depreciation for all the years of operation before that as well. Therefore, it is important to understand the advantages and disadvantages of each of the above three methods.
Advantages:
- Depicts depreciation more accurately over the years
- High usability for a large number of assets including ACs
Limitations:
- Is complicated to calculate
Conclusion
Therefore for an AC, the most suitable method of depreciation will be either the declining balance method or the sum of the year method. This is because both these methods charge more depreciation in the beginning as compared to the later years of the productive life of the AC. This is an accurate way of charging depreciation as the AC will lose more value in the initial year of purchases due to technological advancement than compared to later years, where the AC will already be old and obsolete and will not have much value in the market.
It is important to choose the right mode of depreciation as you cannot change it later easily.
