Depreciation is an accounting term that’s used to describe an asset’s loss of value over time. It’s is used for valuable assets with a long lifespan.
Depreciation is necessary for expensive assets that have long lifespans, such as machinery, vehicles, buildings and other equipment. This is because the asset’s value decreases over time, and the accounts should be updated to reflect this.
These assets are called fixed assets
Why is depreciation necessary?
These fixed assets outlast a single accounting period, which is from one fiscal year to the next. Since your accounts should reflect what your business actually owns, you have to use depreciation to reduce their value over time.
If you purchase a car one year, you’ll probably still have it next year—and the next accounting period—but it won’t have the same value due to wear and tear.
Usually, fixed assets must be purchased for a specific amount and intended to last for a specific number of years—but the amount and the number of years can vary from country to country.
The linear and declining-balance method
There are two types of depreciation: linear, also known as straight-line, and declining balance.
Linear depreciation means reducing an asset‘s value by the same amount every year over its lifespan. 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 at a consistent rate.
Declining balance, on the other hand, is an accelerated technique that records higher depreciation costs in the early years of an asset’s lifespan. With this approach, the depreciation is calculated using a formula that takes the asset‘s current value and rate of decline into account. The decreasing balance method works well for assets whose value drops quickly over time or with items that lose more value early on, such as computers and mobile phones.
If you need help with depreciation, we recommend speaking to an accountant.