What Is Depreciation?

Depreciation is the process by which a company allocates an asset's cost over the duration of its useful life. Each time a company prepares its financial statements, it records a depreciation expense to allocate a portion of the cost of the buildings, machines or equipment it has purchased to the current fiscal year. The purpose of recording depreciation as an expense is to spread the initial price of the asset over its useful life. For intangible assets - such as brands and intellectual property - this process of allocating costs over time is called amortization. For natural resources such as minerals, timber and oil reserves - its called depletion. (For a background on reading financial statements check out What You Need to Know about Financial Statements.) A study of various asset management frameworks developed by the public ... This provides a consistent view of the organization's, Data management Developing an assets register; systems breakdown structures; asset data selection criteria; Understanding and Using Asset Valuation and Depreciation Methods. How to Choose a Depreciation Method Depreciation methods vary by how decline in value is calculated. Depreciation is a method of accounting for the value that real property loses over time. As property ages and wears out, you can calculate the depreciation of the property and use this as a tax write-off. Accountants use different methods to calculate depreciation of assets, and will account for the loss in value over time until the assets can no longer be claimed on tax forms. The depreciation method you choose is most often dependent on when you will need tax writeoffs. Define Methods of Depreciation 1 Consider the straight line depreciation method. According to AccountingInfo.com, this is a standard method of depreciating property that is calculated using the formula "Depreciation = (Cost - Residual value) / Useful life." For instance, if an asset cost $11,000, will last for five years and will have a residual value of $1,000, the depreciation you would claim as a tax writeoff each year would be $2,000. 2 Choose the double declining balance method to get a larger tax write-off in earlier years of depreciation. To use this method, double the rate of depreciation used in the straight line method. In our example above, the asset will lose 20 percent of its original value (minus residual value) every year. Use a depreciation rate double this rate in the formula "Depreciation = (Original cost

- Residual value - Last year's depreciation) * Depreciation rate." Depreciation stops once the residual value is reached. 3 Compare the sum of years method to the other two methods. This method also allows you to get a larger write-off in the early years of depreciation. The formula for this method is, "Depreciation expense = (Cost - Residual value) x Fraction," according to AccountingInfo.com. The fraction in this formula is the remaining number of years the asset will be depreciated over the sum of the total years that the asset will be depreciated. In our example of property with a five-year useful life, the fraction for the first year of depreciation would be 5 / (1+2+3+4+5) or 1/3. This would allow you to claim a $3,333 tax write-off in the first year.

In accounting terms depreciation is the distribution of an assets cost over its useful life. In other words when a firm purchases an asset it has to make the decision if the asset will economically benefit the organization for more than a year. If the answer is yes than the firm would add this asset as a non current asset on its balance sheet, and would commence depreciating this asset over its useful life. In depreciating the asset the firm is subtracting the value (or the original cost) of the asset that was originally booked when the asset was purchased (under the non current asset section of the firms balance sheet) and is then expensing (the calculated accounting period depreciation amount) from the firms revenues earned in the same accounting period. The firm is in essence matching the cost (or value in terms of assets) against the revenues earned by the asset use. Many methods exist to calculate depreciation but I am going to focus on two of the more popular methods: Straight Line and Double Declining Balance.

Straight Line:

In the straight line depreciation method the total cost of the depreciable asset is subtracted from the salvage value of the asset. This number is then divided by the useful life of an asset (in years) to determine the amount will be depreciated from this asset each year. An example of this would be if a firm where to purchase a piece of equipment that cost $5,000 and the salvage value of the asset is calculated at $500 ; the amount to be depreciated would be $4,500 ($5,000$500=$4,500). The useful life of this piece of equipment for this example is 4 years. Using this data we would calculate the yearly depreciation of this asset to be $1,125 (which would represent a depreciation percentage of 25% per year).

Double Declining Balance:

Under double declining balance depreciation an asset is depreciated using the yearly percentage that would be calculated to be depreciated in straight line depreciation and doubles that percentage, and depreciates the asset by that percentage each year multiplied by the assets remaining book value. For example if you are depreciating the same $5,000 asset (in the straight line depreciation example) over 4 years, under straight line depreciation you would deprecate the asset by 25% per year; under double declining you would deprecate the asset by 50% per year. The first year the asset would be deprecated by $2,500 ($5,000 X 50%=$2,500), and in year 2 the asset would be deprecated by $1,250 ($5,000 original cost-$2,500 amount deprecated in year 1= $2,500 X 50%= $1,250). By using the same calculation the depreciation expense in year 3 would be $625. From year one to year three we have depreciated at total of $4,375 of the depreciable value of the asset, so in year 4 (the last year of the assets useful life) we would only need to depreciate the reaming $125 left on the $4,500 we previously determined to be depreciated on this asset ($2,500+$1,250+$625+$125=$4,500). So in essence you are increasing the deprecation amount of the asset in the earlier years and decreasing the deprecation in the later years.

Firms often will choose different methods for reporting the depreciation of their assets (which is allowable under the current tax code). What this means is that an organization could choose straight line depreciation on all of their financial statements released to the public, but it may choose for tax purposes to depreciate its assets using the double declining balance method. Why would an organization want to do this? The answer is really quite simple, it looks better depending on your perspective. What this means is that all firms want to inherently look good to potential investors, and also to minimize their tax liability. The way this is accomplished for example is if an asset is deprecated using straight line depreciation for reporting financial statements the straight line method will not show as much depreciation as would the double declining balance method. So in using the straight line method for depreciating assets a firm can use the least amount of depreciation expensed through the firms income statement; thus the firm is not reducing revenues as much as it would under the double declining balance method. The reverse is also true that using the double declining balance method will allow the firm to depreciate more of the asset than the straight line method. So in essence using the double declining balance method a firm has increased the amount depreciated from the asset (in the early years) and also the amount that the firm can deduct from its tax liability because depreciation is tax deductible. In summary reporting a higher depreciation number for tax purposes may in effect lower a firms tax liability and on the other hand by showing a lower

depreciation amount on the firms financial statements will show depreciation to have a lower impact thus not reducing the firms net income as much.