When a business purchases a new fixed asset, the business cannot expense out all of the cost of the asset in the year of purchase. This is due to the matching concept which states that expenses should be matched to the year in which revenues are earned from them. Fixed assets help a business generate revenue for a business over many years, therefore, to match these revenues to the cost of the asset, depreciation is used.
Depreciation is the method of allocating the cost of a fixed asset based on its useful life or life expectancy. It demonstrates how much the asset has been used to help generate revenues for a period. This helps businesses and stakeholders of the business understand the true impact of the fixed asset used.
Furthermore, once an asset is depreciated, the depreciation is accumulated and deducted from the cost of the asset to reach its carrying value or book value. This helps stakeholders of the business understand the true value of the assets and the business’ financial position.
Types of Depreciation
There are different types of depreciation that are widely used in businesses. The decision about the type of depreciation to use lies with the business. A business can also use different types of depreciation for different classes of assets but the depreciation type for all assets within a class of assets must remain the same.
There are two main types of depreciation that are used commonly, as follows:
- Straight-line method
- Declining balance method
The straight-line method of the depreciation depreciates the value of an asset over its useful life. The useful life of the asset is the life the asset is expected to have returns for the business. For example, an asset the costs $20,000 depreciated over a useful life of 5 years will have a depreciation of $4,000 per year. If the asset has any residual value, the residual value is subtracted from the cost before depreciating it.
Declining balance method
The declining balance method of depreciation depreciates the carrying value of an asset using a percentage. This is different to straight-line method as it considers the carrying value of the asset rather than its cost. This method produces higher depreciation in the early years of the asset’s life and lower depreciation in the later. For example, an asset purchased for $10,000 and having a depreciation rate of 10% will have a depreciation of $1,000 in the first year while the carrying value of the asset would be $9,000 at the end of first year. For second year, the asset will have a depreciation of $900 ($9,000 x 10%), for third $810 (($9,000 – $900) x 10%) and so on.
Other types of depreciation
There are other types of depreciation as well such as the double-declining method, the units of production method and the sum-of-the-year’s-digits method. These methods are not widely used among businesses.There are other types of depreciation as well such as the double-declining method, the units of production method and the sum-of-the-year’s-digits method. These methods are not widely used among businesses.
Depreciation is the process of allocating the cost of an asset over its life expectancy or useful life. It exists to conform with the rules of the matching concept. A business can choose from different types of depreciation such as the straight-line method or declining balance method etc. for a class of assets. Each of these types will give different results.