Rules for Depreciating
Depreciation is when an asset such as equipment or a building loses value over time as a result of wear and tear. When you are looking at depreciation, several factors must be considered. The categories that you must look at include the purchase price of the item to be depreciated, the number of years the asset will produce income (useful life) and the residual value of the asset. The amount of depreciation will also depend on which method of depreciation is used for the calculation.
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Straight-Line Method
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There are several methods, to be used in the calculation of depreciation, but the most popular is the straight-line method. Depreciation is computed by taking the cost of an asset and subtracting the salvage value and then dividing by the useful life of the asset. If you have equipment that costs $7,500 and has a residual value of $1,500 after three years, the depreciation expense for each year will be $2,000, ($7,500 - $1,500 = $6,000/3). The figure of $6,000 represents the depreciable base, and $1,500 is the salvage value, which cannot be depreciated.
Accumulated Depreciation
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The amount of depreciation that accrues at the end of each year is the accumulated depreciation expense. In year one, the amount of depreciation is $2,000, at the end of year two accumulated depreciation is $4,000, and it is $6,000 in the third and final year of the useful life of the equipment. Accumulated depreciation is recorded in each period as a depreciation expense as a debit for $2,000 and accumulated depreciation of $2,000 as a credit. This is done for each year for the amount that has accumulated. Finally, accumulated depreciation expense will be $6,000.
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Sum-of-the-Year's-Digits Method
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The depreciation expense of the equipment can build up faster in the early years if the sum-of-the-year's-digits method is used. This method will add the years of the useful life of the asset together to start the computation (3 + 2 + 1 = 6). Depreciation expense for the first year will be 3/6 times the depreciation base of $6,000, which equals $3,000. The second year yields a depreciation expense of $2,000 ($6,000 x 2/6 = $2,000). The third and final year of the useful life of the asset will yield a depreciation expense of $1,000, ($6,000 x 1/6 = $1,000).
Double-Declining Balance Method
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Companies also use the double-declining balance method of depreciation. You must first find out what the percentage of depreciation for the straight-line method of deprecation is, ($2,000/$6,000 = 33.33 percent); then you double it, which is 66.66 percent. You take the depreciation base of $6,000 and multiply it by 66.66 percent, which equals a depreciation of expense of $3,999.60. Subtract the depreciation expense from the depreciation base, and you arrive at $2,000.40. Multiply the remaining balance times 66.66 percent ($2,004 x 66.66 percent = $1,333.46). The second-year depreciation expense is $1,333.46. As soon as the depreciation expense for the double-declining balance method goes below the depreciation expense of the straight-line method, you stop using the double declining balance method and use the straight-line method. So you use $2,000 as the depreciation expense instead of $1,333.46.
Insight
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Even though there are different methods of calculating depreciation, the amount of depreciation that accumulates over the income-producing years or the useful life of an asset is the same regardless of which method is used.
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