Companies acquire physical resources and tangible assets to enhance their business value. Examples include vehicles, machinery, cash, inventory, equipment, and land. These assets have a finite lifespan during which they degrade. Companies must gauge this degradation and compute asset values as it influences their operations. This assessment process is termed “depreciation.” This article delves into the specifics of the “Sum of the Year’s Digits” depreciation method.

Understanding Depreciation and Its Varieties

The following methods are widely employed to compute depreciation:  

1. Straight-Line Method

This straightforward approach evenly distributes depreciation across an asset’s useful life. The formula deducts salvage value from the asset cost and divides it by the asset’s lifespan.  

2. Double Declining Balance Method

An accelerated method that doubles the depreciation rate of the declining balance method, resulting in higher early-year depreciation. 

3. Units of Production Method

This method calculates depreciation based on the asset’s production output rather than time-based usage. 

4. Sum of the Year’s Digits Method

A technique that frontloads higher depreciation in the initial years of asset use. This accelerated method considers the sum of years in the asset’s life.  

The sum of the Year’s Digits Depreciation Model Explained: 

Also known as the “sum of years method,” this model rapidly reduces an asset’s value. It permits larger deductions in the asset’s early years and smaller deductions in later years, emphasizing the asset’s economic utility rather than time of use. It computes depreciation expenses based on an asset’s useful life years.  

Considering Economic Utility 

This method aligns the cost of asset utilization with its overall economic usefulness across its lifespan. A significant advantage is that it acknowledges the asset’s declining performance over time, emphasizing higher depreciation in its productive early years. This approach accommodates higher early-year depreciation to counterbalance later years’ maintenance and repair costs.  

How it Operates

The sum of years method summarizes the digits for each year of an asset’s anticipated life to determine total depreciation expense. For instance, with a 5-year asset life, the sum is 5+4+3+2+1 = 15.  

Each number is then divided by this sum to derive the percentage depreciation for each year. This approach calculates the annual depreciation rate by considering the remaining years of useful life divided by the sum of the remaining years in each subsequent year.  

The sum of Years’ Digits Depreciation Method Formula  

An asset’s productivity is highest in its early years and gradually decreases over time. This approach results in higher depreciation charges during the initial years. 

To calculate it:  

Steps for Applying Sum of Years’ Digits Depreciation  

Step 1: Determine the depreciable amount by subtracting the salvage value from the total asset cost. Depreciable amount = asset cost – salvage value. 

Step 2: Find the sum of the useful years.  

Step 3: Calculate the depreciation factor for each year.  

Depreciation factor Formula

useful life/ sum of useful years.  

Step 4: Compute the depreciation for each year using the formula: (Number of useful years/totals of useful years) * depreciable amount.  

Step 5: Let’s consider a 4-year useful life. The sum of useful years = 4+3+2+1= 10. The factors for each year would be 4/10, 3/10, 2/10, and 1/10 for years 1 through 4.  

For a clearer grasp, refer to the example in the following section.  

Example and Calculation of Sum of Years’ Digits Depreciation 

Imagine ABC Technologies bought computers worth $4,000,000. We were assuming a 5-year useful life and a salvage value of $100,000, with $200,000 in transportation expenses. We’ll apply the Sum of Years’ Digits formula step by step. 

Step 1: Calculate Depreciable Amount  

Total asset cost = asset cost + transportation cost  

= $4,000,000 + $200,000  

= $4,200,000  

Salvage Value = $100,000  

Useful life = 5 years  

Depreciable amount = Total Cost – Salvage Value  

                 = $4,200,000 – $100,000  

                 = $4,100,000  

Step 2: Find the Sum of Useful Life  

Sum of useful life = 5+4+3+2+1 = 15  

Step 3: Compute Depreciation Factors  

The depreciation factors are:  

Step 4: Calculate Depreciation for Each Year  

Depreciation for the first year = $4,000,000 x 5/15  

= $1,333,333  

Remaining to be depreciated = $4,100,000 – $1,333,333 = $2,766,667  

Similarly, calculate depreciation for years 2, 3, and 4.  

In the 5th year, depreciated the remaining amount, which is $366,668.  

As seen from the example, initial years have the highest depreciation, gradually decreasing until obsolescence.  

Note that the final depreciation equals the salvage value.  

Benefits of Sum of Years’ Digits Depreciation Method 

Advantages:  

1. Aligns asset cost with yearly usage across its useful life, particularly beneficial for assets most productive in early years. 

2. Balances depreciation with other costs like maintenance, avoiding calculation issues. 

3. Acts as a tax advantage; reporting higher initial depreciation lowers net income and tax liability. 

4. Suits accelerated depreciation, maintaining earnings stability when assets peak early. 

5. Accepted by accounting standards like GAAP and IFRS for tax purposes.

Drawbacks:  

1. Early years’ higher depreciation lowers profits. 

2. May indirectly impact cash flows. 

When to Apply Sum of Years’ Digits Depreciation  

While all depreciation methods yield the same result, the timing of recognition varies. The sum of Years’ Digits is recommended when quick depreciation recognition is required. This method suits assets like cars, computers, and phones that rapidly become obsolete due to technological advancements.  

Journal Entries for Sum of Years’ Digits Depreciation  

In our example, there are five entries annually. The company debits depreciation expense and credits accumulated depreciation. Accumulated depreciation offsets the asset’s value, showing net asset worth in the balance sheet.  

Endnote

Depreciation is a technique used to evaluate an asset’s value reduction over its useful lifespan. When assets are utilized over their anticipated lifespan, they experience a decline due to various factors such as consistent use or obsolescence. Depreciation is employed for tangible assets, encompassing physical possessions that companies obtain to enhance productivity and overall business performance. Contrarily, intangible assets undergo amortization, like depreciation, but tailored to the unique attributes of such assets. Calculating depreciation expenses holds significance for accurate accounting records. Monily provides accounting and financial solutions to all size of businesses. If you are looking to simplify your company finances, contact one of our experts today or book a free consultation at https://monily.com/mfccalendly.  

Also Read: A Simple Guide To Double Declining Balance Depreciation Method

Wajiha Danish

Wajiha Danish is the Director at Monily, overseeing financial strategies and operations for small and medium businesses. She has over 18 years of experience, including her role as Controller at HOCHTIEF PPP Solutions North America. Wajiha's background includes significant roles at Pakistan Petroleum Limited and A.F. Ferguson & Co. (PwC Pakistan). She is a Chartered Certified Accountant (ACCA) and Certified General Accountant (CGA) with expertise in financial management and project finance.