Straight-Line Vs. Declining Depreciation
Depreciation is the practice of dividing the cost of an asset to spread it over several accounting periods. The term is only applicable to tangible assets that create profits; when the same action is taken with intangible assets, it is referred to as amortization. Inventory items may not be depreciated. The practice of depreciating assets allows accountants to match the cost of an asset with the revenue that it generates.
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Straight-Line Depreciation
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Straight-line depreciation is the simplest depreciation method. First, the accountant must determine the useful life of the asset. This is the period over which it helps the firm to generate profits, or the time between its purchase and the time when it is replaced or worn out. If the asset will be resold, the accountant must subtract the estimated resale value, called salvage value, from the purchase price to obtain the depreciable amount. He divides this figure by the number of periods, usually years, in the useful life. Each period, he reports the resulting number as a cost on the firm's balance sheet. For example, a $1,000 asset with a $100 salvage value and a useful life of 10 years would be reported as a cost of $90 each year for those 10 years.
Declining Balance Depreciation
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Declining balance depreciation is one method of declining depreciation. It is also known as accelerated depreciation, because the asset depreciates more in earlier periods than in later periods. To calculate this depreciation, the accountant must find the depreciation rate, which is the percentage of the value that would have been depreciated using the straight-line method multiplied by an accelerator. An accelerator of 200 percent is most often used, and the resulting method is known as the double declining balance method. For example, if the useful life of an asset is 10 years, then the asset would depreciate 10 percent per year with the straight-line method, so the depreciation rate for the double declining balance method is 20 percent. The depreciation for the first year is the purchase price multiplied by the depreciation rate, so if the asset cost $1,000, then it would depreciate $200 in the first year. The difference of $800 is called the depreciable basis. The depreciation for each year is found by multiplying the depreciation rate by the depreciable basis left over from the last year, so the depreciation for the second year would be $160. The depreciable basis may never be below salvage value, so sometimes the depreciation in the last period must be lower than the formula indicates.
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Sum of the Years' Digits Depreciation
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This is the second method of declining depreciation. It is calculated by multiplying the depreciable amount, or the purchase price minus the salvage value, by a fraction that depends on the year of the depreciation. If a $1,000 asset has a $100 salvage value, then the depreciable amount is $900. The denominator of the fraction is the sum of the years in the useful life of the asset, so if the asset has a 10-year useful life, then the denominator is 1+2+3+4+5+6+7+8+9+10=55. The numerator starts out at the highest number and counts down, so the fraction for the first year is 10/55, and the fraction for the second year is 9/55. This means that the depreciation in the first year would be $900*10/55=$173.64. The depreciation for the second year would be $900*9/55=$147.27.
Comparisons
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The purpose of depreciation is to create an accurate report of the profitability of a company by matching the costs that it expends with the revenues generated from those costs. Thus, the method of depreciation that is most suitable depends on the nature of the asset. If it generates more benefits from the firm in earlier years than in later years, then a declining depreciation method would be appropriate. If an asset generates roughly the same level of profits in each year of its useful life, then it makes sense to use the straight-line method.
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