Last Updated on December 17, 2020
Depreciation is a word used for tax and accounting functions that describes the method a company uses to account for the declining value of its assets. It is a methodical allocation the cost of a fixed asset more than its valuable life. It is a means of matching the cost of a fixed asset with the revenue (or other economic benefits) it produces over its useful life.
Without depreciation accounting, the entire cost of a fixed asset will be known in the year of its purchase or acquire for. The company is not spending funds as a consequence of assets depreciation; it just wouldn’t be merit as a lot should the company be liquidated.
Types of Depreciation
1. Depreciation Accounting
In the United States, businesses can able to take a deduction for depreciation. Depreciation is the reduction in an asset’s cost caused by the passage of time because of use or abuse, wear and tear.
Depreciation is a method of cost allocation. The cost allocation can be based on a number of aspects, but it is generally connected to the estimated period of time the product can produce revenues for the company, also known as the asset’s economic life.
Depreciation cost is the sum of cost allocation within an accounting period. Only items that lose useful worth over time can be depreciated. Depreciation can be calculated in more than one way.
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2. Straight-line Depreciation
The simplest and the most commonly used method, straight-line depreciation is calculated by taking the purchase or acquisition price of an asset, subtracting the salvage value (value at which it can be sold once the corporation no longer wants it) and dividing by the total productive years for which the asset can rationally be expected to benefit the company (or its useful life).
However, In this method depreciation is worked out on the purchase price of the asset and the same amount is claimed each year.
3. Unit-of-Production Depreciation
The unit of production method of depreciation is based on an asset’s usage, activity, or parts formed as an alternative of the passage of time. Under the units of production method, depreciation during a given year will be very high when numerous units are formed, and it will be very low when only a few units are formed.
This method provides for depreciation by means of a fixed rate per unit of production. Under this method, one is required to first find out the cost per one production unit and then multiply that cost per unit with the total number of units the company or franchise produced within an accounting period to find out its depreciation expense.
4. Depreciation Expense
Depreciation Expense are accounts similar to depletion Expense and Amortization Expense, as all three involve allocating the rate of a long-term asset to an expense over the useful life of the asset. There is no money involved.
5. Hours-of-Service Depreciation
Hours-of-Service Depreciation is the same concept as unit of the production depreciation except for that the depreciation expense is a purpose of total hours of service used throughout an accounting period.
6. Accelerated Depreciation
Accelerated depreciation allows companies to write off their assets quicker in past years than the straight-line depreciation method and to write down a lesser amount in the later years.
Normally, this method allows greater deductions in the earlier years of an asset and is used to lessen taxable income. The main benefit of using this method is the tax shield it offers.
Companies with a large tax load might want to apply the accelerated-depreciation method, even if it decreases the income shown on the financial statement.
This depreciation method is well-known for writing off equipment that might be return before the end of its useful life if it becomes obsolete (for example, computers or cars). Companies that have used accelerated depreciation will state smaller amount earnings in the beginning years and will look more beneficial in the later years.
Companies that will be raising financing are more likely to use accelerated depreciation in the initial years of process and lift financing in the later years to make the illusion of improved profitability (and as a result of higher valuation).
When a company uses an accelerated depreciation method, it lowers the cost of its total assets on its balance sheet previous in the days of those assets. Many companies employ accelerated depreciation methods when they have assets that they look forward to be more useful in their untimely years.
7. Diminishing Value Method
In this technique, depreciation is worked out on the adjusted tax value of the asset (the purchase price, less any depreciation already claimed in earlier years). Diminishing value has higher deductions in the initial few years than in the straight line depreciation and these deductions reduce each year.
8. Annuity Method
Annuity depreciation methods are based on the level of the Annuity and not on the time. This could be miles driven by a motor vehicle, or a cycle count for the machine. When the asset is attained, its life is estimated in terms of this point of activity.
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9. Revaluation Method
With this method of depreciation, we revaluate the fixed asset at the point of closing of accounts in every year. Dissimilarity among opening balance of fixed asset and current value of asset at the end of year will be the depreciation.
If there is excess of current value of asset in excess of the opening balance of asset, after that this will be the percentage increase in the asset.
10. Sum-of-the-Years’ Digit Method
The sum of the years’ digits method, also known as SYD, is a type of accelerated depreciation. The total of the years’ digits method will result in greater depreciation in the earlier years of an asset’s useful life and less in the later years.
Though, the total amount of depreciation in excess of an asset’s useful life should be the similar despite of the depreciation method used. The difference is in the timing of the sum or the total depreciation.
Note: Always enlist the help of a certified accountant, tax advisor, or lawyer for advice related to asset depreciation.