Tuesday, 9 March 2010

IT Financial Management - Depreciation

Hardware and Software capital purchases are often accounted through depreciation (or amortization, as it is known in the context of software).  Depreciation mechanisms can be complex, or more straightforward - ranging from the simple "straight line" method to the more complex accelerated mechanisms like "sum of years" or "double depreciation method".  

Let's analyse the effectiveness of these 3 mechanisms in the context of IT Financial Management:

Straight Line Method
The most simple method, accounts for a monthly asset value reduction by a linear method whilst also factoring in any salvage value.  Can be easily applied and calculated according to the following formula:
Monthly Depreciation = (Capital Purchase Value - Salvage Value) / Depreciation Period

Sum of Years/Months Method
The first accelerated method, introduced to recognise the fact that greatest depreciation happens early in the depreciation period.  A common example of this would be buying a new car.  For IT Financial Management, accounting for costs on a monthly basis, this becomes the "sum of months" method and is calculated:
Montly Depreciation = (Capital Purchase Value - Salvage Value) * (Depreciation Period in Months - Current Month) / Sum ( Depreciation Period in Months)

For example, a server costing $10,000, no salvageable value and being depreciated over 36 months would have monthly depreciation according to this formula:
Montly Depreciation = $10000 * (36 - Current Month) / (36+35+34+33+...+1)

Double Depreciation Method
The second accelerated method, again a more complex method to recognise the fact that greatest depreciation happens early in the depreciation period. This gives greater depreciation in a first period of depreciation, then slows in a second period.  This is calculated according to the following:
Montly Depreciation = ( Current Value - Salvage Value ) / ( 2 * Depreciation Period in Months)
unless this value is less than ( Capital Purchase Value - Salvage Value ) / Depreciation Period in Months, in which case this value applies

The complexities of the accelerated methods mean that, unless you have a large number of assets, and close financial control is really important to you, then the straight line method will be most appropriate.  In practise, this is closely what we see.

The more complex accelerated methods may be appropriate if you might consider selling your assets before their depreciation periods, or if you consider the improved accuracy to be important.  

For benefit in implementing these depreciation models for IT Financial Management - visit our main webpage at www.limsol.com

No comments: