What is the Sum of Years Digits Depreciation Method?
Sum of years Digits Methods or the sum of year depreciation method is an accelerated depreciation method whereby the method declines the value of the asset at an accelerated rate and therefore greater deductions are allowed in the starting life of the assets than in subsequent years mainly in case of those assets which are heavily used when they are new. Most of the depreciation of an asset is recognized in the first few years of useful life.
Although, the amount of depreciation remains the same whether the Company uses the straight-line depreciation method, double declining balance method, or the sum of year digits method. It is just that the amount of timing of the depreciation differs in all three approaches.
- With the Sum of the year’s digits method, it causes variability in the reported net income of the Company. The assets are depreciated at a higher rate in the early years, and thus, the net income is lower in the early life of the asset. But as the useful life of the asset increases, the reported net income increases.
- However, using this method can indirectly impact the cash flows of the CompanyCash Flows Of The CompanyCash Flow is the amount of cash or cash equivalent generated & consumed by a Company over a given period. It proves to be a prerequisite for analyzing the business’s strength, profitability, & scope for betterment. . Since the depreciation amount is higher in the initial years, the reported net income is lower, and hence, the tax implication is lower.
Steps to Sum of Years Digits Method
Below are the steps to sum of years digits method –
- First, calculate the depreciable amount, which is equal to assets total cost of acquisition minus the salvage valueSalvage ValueSalvage value or scrap value is the estimated value of an asset after its useful life is over. For example, if a company's machinery has a 5-year life and is only valued $5000 at the end of that time, the salvage value is $5000.. The acquisition cost is the CAPEXCAPEXCapex or Capital Expenditure is the expense of the company's total purchases of assets during a given period determined by adding the net increase in factory, property, equipment, and depreciation expense during a fiscal year.Capex or Capital Expenditure is the expense of the company's total purchases of assets during a given period determined by adding the net increase in factory, property, equipment, and depreciation expense during a fiscal year.Capex or Capital Expenditure is the expense of the company's total purchases of assets during a given period determined by adding the net increase in factory, property, equipment, and depreciation expense during a fiscal year. the company had made to acquire the asset. Depreciable amount = Total acquisition cost – Salvage Amount.
- Calculate the Sum of Useful Years of the Asset.
- The depreciation amount is multiplied by a depreciation factor each year. The depreciation factor is the useful life of the asset divided by the sum of the useful years of the asset.
- Thus, the Sum of years depreciation = Number of useful years/sum of useful years * (Depreciable amount)
- Let us say, the useful life of an asset is 3. Then, the sum of useful years = 3 + 2 + 1 = 6 Thus, the factors for each year will be 3/6, 2/6, 1/6 respectively for the 1st, 2nd and 3rd
Sum of Years Digits Method Example
Let us understand the concept with an example below:
A Computer Company has purchased some computers worth $ 5,000,000. It cost them $ 200,000 to transport the Computer to their location. The Company considers that the useful life of Computers is 5 years and they can expire the computers at a value of 100,000.
Now, considering the above example, let us try to create a depreciation schedule for the asset using the Sum of year depreciation method.
Step 1 – Calculate the Depreciable Amount
- Total Acquisition Cost = 5000000 + 200000 = 5200000
- Salvage Value = 100000
- Useful life of Computers = 5 years
- Depreciation Amount = Acquisition Cost – Salvage Value = 5200000 – 100000 = 5,100,000
Step 2 – Calculate the Sum of Useful Life
Sum of useful life = 5 + 4 + 3 + 2 + 1 = 15
Step 3 – Calculate Depreciation Factors
The depreciation factors are as follows
- Year 1 – 5/15
- Year 2 – 4/15
- Year 3 – 3/15
- Year 4 – 2/15
- Year 5 – 1/15
Step 4 – Calculate Depreciation for each year.
The depreciation expense of first year = $5,000,000 x 5/15 = $1,700,000
The amount left to be depreciated is calculated as $5,100,000 – $1,700,000 = $1,360,000
Likewise, we can calculate the depreciation expense for year 2, 3 and 4.
Year 5 depreciation is not calculated using the depreciation factor. As it is the last useful year, we depreciate the full amount that is left for depreciation. In this case, it is $340,000
As can be seen from the above depreciation schedule of the sum of the year depreciation method, the depreciation expense is highest in the early years and keeps decreasing as the asset life increases, and it becomes obsolete.
- The sum of years digits method is helpful in matching the cost of the asset and benefit of the asset, which provides over the useful life of an asset. The benefit of the asset declines as its useful life decreases, and the asset grows older. Thus, charging the asset’s cost higher in the early years and reducing the amount as years pass by reflects the economic condition and benefits from the asset.
- When the asset grows older and has been used for some good years, its repair and maintenance costs rise. The rising repair and maintenance costs can offset the low depreciation cost of the asset in the later period of its useful life. The repair costs are lower in initial years, and the depreciation amount is high and vice versa. If accelerated depreciation or sum of year depreciation method is not used, the earnings might be distorted and vary as they depreciation charge will be lower in the initial period and during the end of the useful life of an asset, the charges will rise due to repair costs thus decreasing the earnings.
- The sum of year digits method provides a tax shieldTax ShieldTax shield is the reduction in the taxable income by way of claiming the deduction allowed for the certain expense such as depreciation on the assets, interest on the debts etc. It is calculated by multiplying the deductible expense for the current year with the rate of taxation as applicable to the concerned person., especially during the initial years. Since the depreciation expense is high, the Company can report lower net income, thus decreasing the tax expense.
- The sum of the year depreciation method is useful for depreciating an asset that may become obsolete quickly. For e.g., Computers can become obsolete very fast due to technological advancements; thus, it makes sense to charge the expense in the early years of useful life.
The sum of years digits method is an accelerated depreciation method that can be used to depreciate the value of the asset over the useful life of the asset. The sum of the year depreciation method aims to depreciate the asset at an accelerated rate, i.e., higher depreciation expense in the early years and lower depreciation expense in later years. It is useful for deferring taxDeferring TaxDeferred Tax is the effect that occurs in a firm as a result of timing differences between the date when taxes are actually paid to tax authorities by the company and the date when such tax is accrued. Simply put, it is the difference in taxes that arises when taxes due in one of the accounting period are either not paid or overpaid. payments and especially used for assets that have a lower useful life and may become obsolete quickly.
Sum of Years Digits Method Video
This has been a guide to what is is the Sum of Years Digits Method of Depreciation. Here we discuss the steps to calculate the sum of years depreciation along with practical examples and advantages. You may learn more about accounting from the following articles –