In accounting terms, depreciation is defined as the reduction of recorded cost of a fixed asset in a systematic manner until the value of the asset becomes zero or negligible. The fixed assets include the following: buildings, furniture, office equipment, machinery and many more. A land is the only exception which cannot be depreciated as the value of land appreciates with time.
When you run a small business, depreciating your equipment can help offset the purchase costs through tax savings. Depreciation allows a portion of the cost of a fixed asset to the revenue generated by the fixed asset. This is mandatory under the matching principle as revenues are recorded with their associated expenses in the accounting period when the asset is in use.
When handling the depreciation for your property, you get to choose which method you want to use. Depending on your business structure and your preference, one method may be the best choice for your situation. Below are the sample depreciation methods you can use:
Straight-line
Straight-line is the most commonly used method for determining the depreciation for reporting. Under this method, depreciation amount remains same each year for the entire life of the asset.
Accelerated
Under this method, an asset is considered depreciate more in the early years than the later. Hence, more depreciation is reported in the initial years of the life of the asset and less in the later years. As a result, the accelerated method lowers the net income in the initial years and increases it in the later years as compared to the straight-line method.
Double-declining balance
Another method of depreciation is the double-declining balance approach. This approach is a type of accelerated depreciation method that results in bigger depreciation in the first few years of the asset and smaller amounts in the later years. With this option, you choose a percentage to depreciate the property by each year.
Unit of production
This is a two-step process, unlike straight line method. Here, equal expense rates are assigned to each unit produced. This assignment makes the method very useful in assembly for production lines. Hence, the calculation is based on output capability of the asset rather than the number of years.
Sum of the years’ digits
Under this method, a fraction is computed by dividing the remaining useful life of the asset on a particular date by the sum of the year’s digits. This fraction is applied to the depreciable cost of the asset to compute the depreciation expense for the period. Sum of years’ digits method attempts to charge a higher depreciation expense in early years of the useful life of the asset because the asset is most productive in early years of its life.
Diminishing value method
The diminishing value (DV) method works out depreciation on the adjusted tax value of an asset. To work out the adjusted tax value of an asset, subtract any depreciation claimed from the cost price. Depreciation claimed is higher at the start, but reduces each year.
Considerations
When choosing a depreciation method for your business, you have to consider the tax implications. If you would rather have a bigger tax deduction in the near-term, using a double-declining balance method or the sum of the year’s method might make more sense. If you would rather just spread out the tax deduction evenly, it makes sense to use the straight-line depreciation method. You could even use one method on certain items and another on different items.
