How To Select The Most Appropriate Depreciation Method

I just join a newly set up company. Now I need to choose a depreciation method whether it should be on a straight-line basis(SL), unit of production basis, declining/reducing balance basis or sum of digit (SD) methods? So how do I go about doing it?

Answer:

Based on your Capital Budget you should able to know what are the fixed assets concerned.

Based on certain assumption like life span and salvage value if any, compute a projected table of annual depreciation charge based on the various depreciation methodologies.

A simplified of yearly depreciation is appended below for illustration:-

The general principle of providing depreciation is based on the matching concept. Hence, we need to understand the impact of each methodology re: matching the income generated from the fixed assets against it expense ( in this case the yearly depreciation amount)

Based on the above:

• If the asset is expected to generate income evenly overran extended period of time, the straight-line method is preferred
• If the asset to produce a different number of units each year, or if the machine may wear out early, the units-of-production methods is better as it is based on usage rather than time
• If the asset is able to generate high income in its early years, the sum of digits method is the choice as it will be able to generate greater depreciation expense in its earlier years to match with the early period’s higher revenue.

Of course, bear in mind that like choosing the best stock valuation method, the choice of selecting the correct depreciation methods varies with many other factors like for example your company’s nature of business, its industry trend, changes in technologies, etc.

For example say an equipment that has a very high level of obsolescence because of changes in technology/fashion might even require a double declining balance depreciation methodology which might suitable when you are recording early years of high sales generated from the fixed asset.

Check out other related articles:

Reason for depreciating fixed assets

Various methods of depreciating fixed assets

How to compute depreciation for assets bought or sold during an accounting period