Depreciation methods definition
/What are the Most Common Depreciation Methods?
Depreciation is used to gradually charge the book value of a fixed asset to expense. It is intended to approximately reflect the decline in value of an asset over time, due to wear and tear. There are several methods of depreciation, which can result in differing charges to expense in any given reporting period. The following are the general methods of depreciation available for use:
Straight-Line Depreciation
The straight-line method charges the same amount of depreciation to expense in every reporting period. This approach probably approximates the average usage pattern of most assets, and so is a reasonable way to match revenues to expenses. It is also the easiest depreciation method to calculate, which makes it by far the most commonly-used depreciation method. Using this approach makes it easier to close the books at the end of each month, since it is so simple to calculate.
Under the straight-line method of depreciation, recognize depreciation expense evenly over the estimated useful life of an asset. The straight-line calculation steps are:
Subtract the estimated salvage value of the asset from the amount at which it is recorded on the books.
Determine the estimated useful life of the asset. It is easiest to use a standard useful life for each class of assets.
Divide the estimated useful life (in years) into 1 to arrive at the straight-line depreciation rate.
Multiply the depreciation rate by the asset cost (less salvage value).
Example of Straight-Line Depreciation
Pensive Corporation purchases the Procrastinator Deluxe machine for $60,000. It has an estimated salvage value of $10,000 and a useful life of five years. Pensive calculates the annual straight-line depreciation for the machine as:
Purchase cost of $60,000 – Estimated salvage value of $10,000 = Depreciable asset cost of $50,000
1 ÷ 5-Year useful life = 20% Depreciation rate per year
20% Depreciation rate × $50,000 Depreciable asset cost = $10,000 Annual depreciation
Accelerated Depreciation
An accelerated depreciation method is designed to charge the bulk of the depreciable amount of a fixed asset to expense as soon as possible, with a rapidly-declining amount being charged to expense in later periods. Examples of this method are the double-declining balance method and the sum of the years' digits method. This approach is useful for depressing short-term profits in order to reduce the amount of taxable income. However, it is difficult to calculate, usually does not reflect the actual usage pattern of a fixed asset, and skews the reported results of a business.
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Usage-Based Depreciation
A usage-based depreciation method is designed to have a variable periodic depreciation expense that is based on the amount that a fixed asset is actually used. An example of this method is the units of production method. This is the most accurate of the depreciation methods in matching actual usage to the related depreciation expense, but suffers from an inordinate amount of record keeping to track usage levels. Given this problem, it is usually restricted to the more expensive fixed assets whose usage levels vary considerably over time.
Depreciation Best Practices
Of the methods of depreciation noted here, the most practical one is the straight-line method, since it requires minimal upkeep and is the easiest to understand. The only value of an accelerated method is in deferring the payment of income taxes. A usage-based method should not be used unless there is a demonstrable need for an increased level of depreciation accuracy, since it is a time-consuming approach.
Any method of depreciation is time-consuming over the lifespan of an asset, and so is not efficient. To improve the efficiency of the accounting staff, set a high capitalization threshold, below which all expenditures are charged to expense as incurred. Doing so can eliminate a large number of depreciation calculations.
From an auditing perspective, it is best to use the straight-line method, since these calculations are easiest for auditors to verify. This can reduce the annual audit fee charged to a business.