Depreciation

Depreciation

Depreciation is a method of allocating cost of an asset over the asset useful life. The key concept that is used for calculating depreciation is matching the expense to the revenues, which are produced by the asset as required by the generally accepted accounting principle. The cost will include the purchase price and other costs like delivery or the sales tax and less the estimated salvage value of the asset. The salvage value the amount of money that the firm will expect to get when the asset gets disposed. When the cost is determined, the estimated useful life of the asset should be determined. Several methods can be used in finding the asset useful life like the guidance from the manufacturer, industry standards, and tax consideration. Depreciation is usually calculated so as to try to match the expense of the asset to the income that the company will earn from the asset.


Straight line method

Depreciation can be calculated using different methods. One of these methods is the straight line method. This is one of the simplest methods used, and it is also commonly used. In the straight line method, calculation of depreciation is done by evenly spreading the asset cost over the life of that asset. This method assumes that the asset will generate revenue at a rate that is constant over its useful life. The straight line method for calculating depreciation is normally calculated by using the asset purchase price and subtracting the salvage value then the amount is divided by the useful life of the asset. The standard formula for this method is

Purchase price of asset- Salvage value = Depreciation

Estimated useful life of the asset


Declining balance method

The declining method of depreciation is a type of accelerated depreciation where the amount of depreciation charged on an asset tends to decline over time. With this method, more depreciation is charged at the start of a life time, and less is charged at the end. The reason why more depreciation is charged at the beginning is because the asset is more productive when new and its productivity declines with time. In this method, instead of the asset cost being spread evenly over time, it expenses the asset at a constant rate. Therefore, this result in a declining depreciation charged every period. When calculating the declining balance depreciation, the depreciation basis of the asset is multiplied by a factor. The factor is the asset percentage that would be depreciated every year. The formulae for this calculation is

Depreciation= depreciation rate * book value of asset

Depreciation rate is given by

Depreciation rate= straight line rate * accelerator.


Appropriate method

The better method to be used will depend on which method appropriately reflects the expenses against the revenue generated. When using the straight line method, it assumes that the value of the asset is equal all through the useful years. In the declining balance method, it assumes that the asset lose more value in the early years of its useful life as it assumes that the asset loses equal percentage of its value each year. The better method will be determined by the expected generated revenue. The straight line method is better if the asset will generate revenue at a rate that is constant every year of its life. The declining balance method is better if the asset will generate more revenue early during its useful life.


 

Excel Spreadsheet for Straight Line Depreciation

Period

Book Value at Beginning of Year

Depreciation Expense for Period

Book Value at End of Year

year 1

$725.00

$225.00

$500.00

year 2

$500.00

$225.00

$275.00

year 3

$275.00

$225.00

$50.00

 


Reference

“A brief overview of depreciation” Accessed on 14th November 2012





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