Introduction to Depreciation
Depreciation refers to two very different but related concepts:
- the decrease in value of assets (fair value depreciation), and
- the allocation of the cost of assets to periods in which the assets are used (depreciation with the matching principle).
The former affects values of businesses and entities. The latter affects net income. Generally the cost is allocated, as depreciation expense, among the periods in which the asset is expected to be used. Such expense is recognized by businesses for financial reporting and tax purposes.
Depreciation is the method of allocating costs to the appropriate period. Note
depreciation isnít part of the whole equation for figuring the fair market value, which is the amount of money the company may fetch when it sells any of the assets.
Methods of computing depreciation may vary by asset for the same business. Methods and lives may be specified in accounting and/or tax rules in a country. Several standard methods of computing depreciation expense may be used, including fixed percentage, straight line, and declining balance methods.
. Here’s a brief explanation of each:
- Straight-line: This method spreads the cost of the fixed asset evenly over its useful life.
- Declining-balance: An accelerated method of depreciation, it results in higher depreciation expense in the earlier years of ownership.
- Sum-of-the-years’ digits: Compute depreciation expense by adding all years of the fixed assetís expected useful life and factoring in which year you are currently in, as compared to the total number of years.
- Units-of-production: The total estimated number of units the fixed asset will produce over its expected useful life, as compared to the number of units produced in the current accounting period, is used to calculate depreciation expense
Depreciation expense generally begins when the asset is placed in service. Example: a depreciation expense of 100 per year for 5 years may be recognized for an asset costing 500.
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