Depreciation is the spreading of the cost of an asset over its expected life. There are several methods available to businesses when it comes to picking a depreciation method for their financial reporting. The straight-line method is the simplest one which assumes the cost of an asset is spread equally throughout the asset’s useful life. In contrast, more sophisticated methods such as declining balance front load the expenses, resulting in higher costs being reported in the earlier years the asset is used. It permits companies to adjust as the diminishing value of the asset is more accurately reflected during the early, high-use period.

 

Basic Depreciation Terms 

 

Before diving into specific depreciation methods, it’s essential to understand a few key terms:

 

• Salvage value is the estimated value of the asset at the end of its useful life. The term is the amount a business expects to receive if the asset is sold when it is no longer being depreciated. In many cases, the salvage value is assumed to be zero.

 

• Useful life (or recovery period) is the time taken for an asset to be used for tax purposes and accounting purposes, usually measured in years. It specifies a depreciation span.

 

• A portion of the cost of an asset is known as a depreciable basis which is eligible for depreciation. The depreciable basis of an asset is its purchase cost less any salvage value when it is first put into use. However, this basis gradually reduces each year since depreciation expenses are applied.

 

Two Main Depreciation Methods 

There are two primary ways to calculate depreciation: the declining balance method and the straight line method.

 

1. Straight-Line Depreciation

 

Straight-line depreciation is the easiest method of depreciation. Depreciation straight-line costs consist of dividing the depreciable basis of an asset by its recovery period. Say an asset has a depreciable basis of $5,000 and a useful life of 5 years, then one would depreciate $1,000 per year.

 

The depreciation rate is calculated by percentage by dividing 100% by the recovery period. Thus, if an asset had a five-year life, its annual depreciation rate would be 20%. However, this excludes the effect of depreciation, so this 20% applies to the asset’s original cost (its unadjusted basis).

 

Straight-line depreciation is easily the most consistent form of depreciation due to this. It is predictable and easy to plan for because businesses can claim the deduction every year. Companies that anticipate lower income from an asset’s early years can find this method especially appealing because, even while larger deductions are lost, later deductions remain available. Yet for long-term assets ranging from commercial buildings, it could take a long time to recover a sizable percentage of the cost of an asset, which may or may not fit their interests in obtaining as many tax benefits as quickly.

 

2. Declining Balance Depreciation

 

The declining balance method is an accelerated depreciation method in which the business takes larger deductions in the early years of an asset’s life. In particular, this method is useful when one wants to recover a greater part of the cost of the asset upfront. The depreciation for this method is higher than a straight line.

 

For instance, in the doubled declining balance method the depreciation is doubled. A five-year asset would have a rate of 40% (200% / 5). Here’s how it works:

 

• Calculated in the first year, depreciation is considered to be 40 per cent of the asset cost (called **adjusted basis**). Assuming the first year’s depreciation is $2,000, it would be a $5,000 asset.
• In the second year, you have a $3,000 adjusted basis ($5,000 less depreciation over that $2,000). In year two depreciation expense would be $1,200 (40% of $3,000)

 

However, this continues and the depreciation expense goes down with each year that the adjusted basis goes down. Businesses must eventually use the straight-line method, so long as it equals at least as much of a deduction as the declining balance method. 

 

The main advantage of this method is that we can claim bigger deductions in the early years of an asset’s life. Especially for businesses looking for more upfront tax relief, this can be very good. But it’s often the go-to for taxpayers looking for more deductions on the front end, so it’s a good choice in many cases.

 

Benefits of Each Method

 

The depreciation method is used to choose between, and it’s based on the type of asset being depreciated. If one wishes to keep accounting simple, the straight-line method is the simplest to apply and is thus the method of choice for businesses which want their accounting not to be too complex. The good news is that it spreads out the cost of the asset over time, so if the asset loses value over time, like furniture or real estate, it’s a good way to do that.

 

The declining balance method is more accurate for assets in which a great deal of value is lost in the first year. For instance, electronics like computers or smartphones depreciate within their first couple of years and the declining balance method is a better fit for recording that declining value.

 

The depreciation method chosen depends on whether the asset is of any special nature and how fast it depreciates. Besides, the financial strategy of a business should be considered in that a business may prefer to deduct larger sums in the early years like the declining balance or a consistent amount like a straight line.

 

Which Depreciation Method Should I Use?

 

For tax purposes, in the U.S. property is depreciated under the Modified Accelerated Cost Recovery System (MACRS). This system is detailed when it comes to depreciating different kens of assets. The IRS Publication 946, How to Depreciate Property, contains tables that show the correct depreciation rate for a recovery period, depreciation method, and date of put into service in case you want more information.

 

Some assets are eligible to be depreciated using the 150% or 200% declining balance method that permits the business to have larger deductions in the initial periods when they are owned. While it’s true that utilities — and other assets, like nonresidential and residential real estate — have to use the straight-line method to depreciate, otherwise the depreciation is not taken evenly over an asset’s useful life.

 

Taxpayers even have the option of using a more conservative depreciation method. Consider this, for example, if an asset qualifies for the 200% declining balance method of MACRS, the business can pick the 150% declining balance or even the straight-line method based on the company’s own financial strategy or tax planning.

 

If you want to compute the value of your assets, you can use this depreciation calculator and apply the methods above.