What is Depreciation?
Depreciation is an accounting method which spreads out the cost of a tangible asset over its useful life. This method recognizes the decline in the assets value usually due to usage or wear and tear. In simple terms, the more an asset is used, the lesser its value. This is done to ensure that the asset’s cost is equal to the revenue it generates. This method usually affects fixed assets such as buildings, office equipment, furniture, and machinery.
Importance of Depreciation
Depreciation is important in financial and tax accounting. It allows a company to allocate and spread out the cost of fixed assets over time for their financial reports. Since an asset will usually deteriorate and degrade with use over time, depreciation provides an accurate assessment of its value.
It is also important in tax accounting because companies can recover costs through depreciation over time instead of deducting the full cost of a capital expenditure in the year of purchase.
Under Section 179 of the Internal Revenue Code, a company can deduct the full or partial cost of qualifying assets in the year they are used (subject to specific limitations).
Methods of Calculating Depreciation
The method of calculating depreciation depends on the type of asset, financial reporting needs, and the tax strategy of the company. Here are some of the most common methods of calculating depreciation:
Straight-Line Depreciation
The simplest and most widely used method of calculation. In this method, the asset’s cost is evenly spread over its useful life which results in the same depreciation expense each year. It is best for assets like office furniture.
Units-of-Production Method
In this method, the depreciation depends on how much the asset is used. It is best for assets that wear out, such as manufacturing equipment and vehicles.
Double-Declining Balance
This is an accelerated method that applies higher depreciation costs in the early years of the asset’s useful life. It is mainly used for assets that lose value quickly such as computers.
Sum-of-the-Years’-Digits
This is another accelerated method. Similar to the double-declining method, it applies more depreciation in the early years of the asset’s life and less over time. It is used for assets that lose value quickly at the beginning of their life span.