What is depreciation

What is depreciation

Depreciation is a financial concept primarily applied to fixed assets, such as machinery and equipment, or assets acquired for extended ownership. The purpose of depreciation is to spread the cost of a significant purchase over an extended period, aligning with the asset’s expected lifespan.

This practice is rooted in the understanding that fixed assets typically outlast a single accounting period. Depreciating an asset involves recognizing and accounting for the gradual decrease in its value over time due to usage and wear. Notably, an asset eligible for depreciation should be acquired with the intent of lasting at least three years and having a cost exceeding $15,000.

Linear depreciation and declining balance depreciation

Linear depreciation, also known as the straight-line method, involves deducting the same amount of depreciation from the value of an asset for every year of its useful life. The annual depreciation is calculated by subtracting the salvage value from the cost basis of the asset and then dividing by the number of years of useful life. This method is suitable for assets whose value decreases steadily over time at around the same rate, such as real estate and furniture.

On the other hand, declining balance depreciation is an accelerated method that records larger depreciation expenses during the earlier years of an asset’s useful life while recording smaller depreciation during its later years. The depreciation under this method is calculated using a formula that involves the current book value of the asset and the depreciation rate. The declining balance method is useful for assets that lose more value early in their life, such as computers and smartphones, or for assets whose value decreases rapidly over time.