Depreciation is the decrease in value of an asset over time, with straight-line and declining balance being common methods. Depreciation expense is the yearly amount, while accumulated depreciation is the total. Other methods include double-declining, asset, sum-of-years-digits, production units, and analogous time units.
Depreciation refers to the decrease in value that an asset suffers over the period of time it is used. This is a vital accounting concept because businesses write off the depreciation of their assets as an expense on their tax returns, and different depreciation methods are used. The two most common depreciation methods are straight-line depreciation, in which the value decreases by the same amount each year, and declining balance depreciation, which calculates depreciation as a percentage of the balance of the asset’s value. Other more complex methods include double-declining depreciation, which combines the principles of straight and declining balance, asset depreciation, and similar time unit methods.
Two important principles to understand regardless of the depreciation methods you use are depreciation expenses and accumulated depreciation. The depreciation expense is the amount of the depreciation value in one year. Accumulated depreciation is the total amount of depreciation the asset has incurred to date. For example, a company vehicle depreciating in value at $400 USD (USD) per year would have an appreciation expense of $400 USD each year on the company balance sheet, but its accumulated depreciation would be $400 USD in the first year, $800 USD in the second, $1200 USD in the third, and so on.
Straight line depreciation is the simplest of the depreciation methods and allows for the same amount of depreciation each year. For example, a computer costs $1,000 USD and needs to be used for five years. This means that it will depreciate $200 USD each year, which is achieved by dividing $1,000 USD by five.
Diminishing balance depreciation allows businesses to spend a heavier purchase in the first year and then a declining amount each year thereafter. It does this by establishing an amortization percentage rate and applying it to the balance. Using the example above, if the computer’s depreciation rate was 50 percent, it would depreciate by $500 USD or 50 percent of $1,000 USD in the first year, leaving a balance of $500 USD or $1,000 USD minus $500 USD. The following year, the depreciation expense would be $250 USD, or 50 percent of the $500 USD balance, and that process would continue until the balance reached the computer’s salvage value.
The double declining depreciation method uses the straight line method to determine the percentage, double it, and then apply the doubled percentage rate to the declining method. Asset depreciation bases depreciation expense on the amount an asset has been used over time, while the sum-of-years-digits method is obtained by multiplying the original depreciable cost of the asset by a series of fractions based on the sum the figures for the years in which the asset will be used. The production units method is based on a formula that takes into account the quantity of output produced by the good and the analogous time units method applies this theory to natural resources that can become depleted over time.
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