Depreciation of Fixed Assets
Fixed assets are assets that are expected to provide benefits over more than a single accounting period or to have lives exceeding one year. Examples of fixed assets include buildings, fixtures, furniture and equipment, and vehicles. Businesses use depreciation to allocate the cost of fixed assets to periods in which the asset is used to generate revenues.
The most common depreciation methods are the straight-line and accelerated methods. The straight-line method accounts for an equal amount of an asset’s cost in each period. The accelerated method takes larger amounts of depreciation in the earlier years and decreasing amounts in later years.
The straight-line depreciation method is the simplest and most commonly used method. It systematically recognizes a fixed dollar amount of depreciation each year over the life of the asset. To calculate the depreciation expense, the cost of the asset is deducted from the asset’s salvage value and spread out evenly over its service life. For example, a company purchases a machine costing $100,000 with a $10,000 salvage value. Using straight-line depreciation, the company records a total depreciation of $90,000 over the ten-year life of the machine. The annual depreciation expense is $9,000 (90,000 divided by 10 years).
The accelerated depreciation method relies on the theory that an asset’s value decreases more rapidly in the early years of its useful life than in the later years. The most common accelerated method is the sum-of-the-year’s digits depreciation method. Under this method, the numerator of the depreciation rate is equal to the number of years remaining in the asset’s useful life, and the denominator is the sum of the digits for each of those years. For example, a six-year useful life results in a depreciation rate of 6/21, 5/21, 4/21, 3/21, 2/21, and 1/21 in each of the six years of life.
Another accelerated method is the double-declining balance method. This is calculated by multiplying twice the straight-line depreciation rate, multiplied by the current book value of the asset. Since a declining balance is calculated every year, the dollar amount of depreciation is higher in the early stages of the asset’s life, resulting in accelerated depreciation.
Tax depreciation rules, which deduct a higher portion of the asset’s cost in the early years than in the later years, are allowed in many countries. Companies are allowed to either follow the tax rules or use straight-line depreciation for financial reporting and then use the tax-computed depreciation amount for tax computations.
Management uses depreciation to properly match expenses related to generating revenue with the revenue itself. Depreciation is established as an expense for the estimated useful life of an asset, thus allocating the cost of the asset over its life.
To summarize, depreciation of fixed assets is an important tool for businesses to allocate the cost of an asset over its service life. The most common depreciation methods are straight-line (equal amounts of depreciation over the life of an asset) and accelerated (higher amounts of depreciation in the early years). Companies should use depreciation to properly match expenses with revenue generated in a given period.
