Post on Tuesday, May 1st, 2018 in Accounting
Before we start explaining what is asset depreciation and what are the best depreciation methods, let’s first define the “fixed asset” term.
Fixed assets, or capital assets, are long-term tangible pieces of property that a company owns, such as cars, computers, buildings, furniture, equipment, etc. Fixed assets are not expected to be consumed or converted into cash within a year, but a company uses them in its operations to generate income. Over time, fixed assets become “worn out” and thus lose their value. A business should record such value loss at the end of each accounting period until the value becomes zero. This process is called depreciation of assets.
Depreciation allows adding a portion of the fixed asset cost to the revenue that is generated by the fixed asset. Such revenues and their associated expenses are recorded within the accounting period when the asset is in use. It helps to get a complete picture of the revenue generation transaction.
There are several types of depreciations. Let’s take a look at each of them.
The most widely used depreciation method is straight-line depreciation. This type of depreciation is also the simplest one. The formula is as follows:
Annual Depreciation Expense = Asset Cost – Salvage Value / Asset Life Cycle
The only drawback of straight-line depreciation is that it may not reflect the real pattern of the asset’s economic benefits.
This type of depreciation is based on output capability of the asset rather than the number of years. The calculation involves the following two steps:
Units-of-activity is an appropriate depreciation method to use when assembling the production lines, because equal expense rates are assigned to each unit produced. This method most accurately reflects the usage of economic benefits. However, at the same time it is hard to determine a reasonable basis of activity by using the units-of-activity method.
The accelerated depreciation method is also known under the names of “reducing balance” or “double-declining-balance” method. Both the straight-line depreciation method and the double-declining-balance depreciation method are most commonly used by companies.
Here is the formula:
Depreciation = 2 * Straight-Line Depreciation Percentage * Book Value at the Beginning of the Accounting Period
Book Value = Fixed Asset Cost – Accumulated Depreciation (total depreciation of the fixed asset, which is accumulated up to a specified time).
A benefit of using an accelerated depreciation method is that it is appropriate where the usefulness of an asset declines over its life cycle, like computers. A drawback is a biased selection of the depreciation rate.
Sum of the years’ digits belongs to the depreciation types that involve complicated calculation. However, at the same time it is quite easy to understand. The calculation consists of these steps:
Undepreciated Life Cycle (Step 3) / Sum of the Years’ Digits (Step 1) x Depreciable Amount (Step 2)
One of the questions that may arise after reading this article – Is it appropriate to calculate depreciation using two different methods?
Yes, companies can use two depreciation methods. For example, a business can use the straight-line method to depreciate asset on its financial statements and an accelerated method on its income tax return.
Adam is the Assistant Director of Operations at Dynamic Inventory. He has experience working with retailers in various industries including sporting goods, automotive parts, outdoor equipment, and more. His background is in e-commerce internet marketing and he has helped design the requirements for many features in Dynamic Inventory based on his expertise managing and marketing products online.
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