Depreciation is the decrease in asset value over time, with straight-line and declining balance being the most common methods. Depreciation expense and accumulated depreciation are important principles, and other methods include double-declining, activity, and unit-of-production.
Depreciation refers to the decrease in value that an asset incurs during the period of time that it is used. This is a vital accounting concept because businesses write off depreciation on their assets as an expense on tax returns, and various depreciation methods are used. The two most common methods of depreciation 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 asset’s balance of value. Other, more complex methods include double-declining depreciation, which combines the principles of straight-line and declining balance, activity depreciation, and similar unit-of-time methods.
Two important principles to understand, no matter which depreciation methods are used, are depreciation expense and accumulated depreciation. Depreciation expense is the amount of depreciation value in one year. Accumulated depreciation is the total amount of depreciation that the asset has suffered up to that point. For example, a business vehicle that depreciates in value to $400 US dollars (USD) per year would have an appreciation expense of $400 USD each year on the company’s balance sheet, but its accumulated depreciation would be $400 USD in the first year, $800 in the second, $1,200 in the third, and so on.
Straight-line depreciation is the simplest method of depreciation and allows the same amount of depreciation each year. For example, a computer costs $1,000 USD and must be used for five years. This means that $200 USD will depreciate each year, which is achieved by dividing $1,000 USD by five.
Declining balance depreciation allows businesses to spend a heavier purchase in the first year and then a decreasing amount each succeeding year. It does this by setting a depreciation percentage and applying it to the balance. Using the example above, if the depreciation rate for the computer were 50 percent, then $500 would depreciate in the first year, or 50 percent of $1,000, leaving a balance of $500, or $1,000. USD minus $500 USD. In the next year, the depreciation expense would be $250, or 50 percent of the $500 balance, and that process would continue until the balance reached the residual value of the computer.
The double-declining method of depreciation uses the straight-line method to establish the percentage, double it, and then apply the doubling percentage rate to the declining method. Activity depreciation bases depreciation expense on the amount an asset has been used rather than time, while the sum-of-years-digits method is achieved by multiplying the original depreciable cost of the asset by a series of fractions based in the sum of the digits of the years that the asset will be used. The units of production method is based on a formula that takes into account the amount of production produced by the asset, and a similar unit of time method applies this theory to natural resources that can be depleted over time.
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