Understanding Depreciation
Businesses acquire fixed assets to use in their operations. The business capitalizes the cost of these assets at the time of purchase then reduces the net value of the assets and recognizes depreciation expense each period. Business owners need to understand how various depreciation methods work in order to choose the best method for their business.
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Fixed Assets
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Companies acquire fixed assets for use in their operations. Examples of fixed assets include equipment, buildings, furnishings or vehicles. When the company purchases the fixed assets, it determines a cost for each asset. This cost includes purchase price, freight charges, installation charges and any legal costs incurred to acquire the asset. After acquiring each asset, the company estimates a salvage value and the useful life of the asset. The salvage value refers to the amount the company can sell the asset for when the company no longer needs it. The useful life refers to the number of years the company will use the asset. The company uses the cost of the asset, the estimated salvage value and the estimated useful life of the asset to calculate depreciation.
Why Depreciate: The Matching Principle
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Companies capitalize the total cost of the asset on the balance sheet when they acquire it. The matching principle requires the company to recognize the expense for the asset throughout the time frame when the company receives its benefit. The company receives the benefit of using the asset over its entire useful life, so it recognizes a portion of the expense each period during the asset's useful life. This expense is called depreciation.
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Depreciation Method: Straight-line
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Companies choose between several different methods for calculating and recognizing depreciation expense. The easiest method is called straight-line depreciation. Straight-line depreciation takes the total cost of the asset, subtracts the salvage value and divides this amount by the number of periods in the asset's useful life. The company recognizes this amount of depreciation each period.
Accelerated Depreciation Methods
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Companies sometimes choose to depreciate a higher amount of the asset's cost in the early years of its useful life. Accelerated depreciation methods include double-declining balance and sum-of-the-years digits. The double-declining balance starts by calculating the straight-line rate of depreciation. The company calculates this rate by dividing 100 percent by the number of years in the asset's useful life. The double-declining balance method multiplies this rate by 200 percent to calculate a depreciation rate. The company then takes the total cost, subtracts the salvage value and multiplies this amount by the depreciation rate. In subsequent periods, the company takes the total cost of the asset, subtracts the salvage value and the depreciation already recognized, and multiplies this amount by the depreciation rate. To calculate the sum-of-the-years digits depreciation, the company lists the numbers for each year of the asset's life. An asset with a three-year life would use the numbers one, two and three. The company adds these numbers together for a grand total. The depreciation rate changes every year. Each year, the depreciation rate equals the number of years left in the asset's useful life divided by the grand total already calculated. The company takes the total cost of the asset less the salvage value and multiplies it by the depreciation rate for the appropriate year.
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