The notion of depreciation is mainly used in finance in relation to fixed assets, like machinery and equipment, or assets that are purchased for a longer period of time. Depreciation is used to stretch the expense of a large acquisition across a longer time frame in order to match the asset’s anticipated lifespan.
The knowledge that fixed assets usually outlast a single accounting period forms the basis of this practice. When an asset depreciates, its value gradually declines over time as a result of use and wear. This is recognized and recorded. Specifically, an item that qualifies for depreciation must be purchased for more than $15,000 and must be intended to last for at least three years.
Linear depreciation and declining balance depreciation
Linear depreciation, also known as straight-line depreciation, involves reducing an asset‘s value by the same amount every year over its useful life. To calculate the annual depreciation, you subtract the salvage value (what you estimate the asset will be worth at the end of its use) from the asset’s initial cost, and then divide that number by the estimated number of years the asset will be in use. This method spreads the cost of the asset evenly across its life. This approach works well for assets like furniture and real estate whose value depreciates over time at a consistent rate.
Declining balance depreciation, on the other hand, is an accelerated technique that records higher depreciation costs in the early years of an asset’s useful life and lower depreciation in the later years. Under this approach, the depreciation is computed using a formula that takes the asset‘s current book value and depreciation rate into account. The decreasing balance method works well with assets whose value drops quickly over time or with items that lose more value early in life, such computers and cellphones.
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