Depreciation is an accounting method used to allocate the cost of a tangible asset over its useful life. Rather than expensing the entire purchase price of a vehicle, machinery, or building in the year it is acquired, businesses write off a portion of the asset's value each year. This matches the cost of the asset with the revenue it generates, providing a more accurate picture of business profitability.
Straight-line depreciation is the simplest and most common method. It distributes the cost of the asset evenly across its useful life. To calculate it, you subtract the salvage value (residual scrap value) from the original purchase cost, and divide by the number of years of useful life: \[Annual\ Expense = \frac{Asset\ Cost - Salvage\ Value}{Useful\ Life}\] For example, if a machine costs $11,000, has a salvage value of $1,000, and a useful life of 5 years, the annual depreciation is: \(\frac{11,000 - 1,000}{5} = \$2,000\text{ per year}\).
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The declining balance method is an accelerated depreciation technique that records higher depreciation expenses during the early years of an asset's life and lower expenses in later years. This is useful for assets that lose value quickly, such as computers or vehicles. The Double Declining Balance (DDB) method is a common variation that depreciates the asset at twice the straight-line rate applied to the remaining book value.
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Sum-of-the-Years' Digits is another accelerated depreciation method. The depreciation rate is a fraction where the numerator is the remaining years of useful life, and the denominator is the sum of the digits of the total useful life. For a 5-year asset, the sum of the digits is \(5 + 4 + 3 + 2 + 1 = 15\). In year one, the depreciation rate is \(\frac{5}{15}\) of the depreciable base, declining to \(\frac{1}{15}\) in the final year.
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Depreciation reduces a company's taxable income, thereby lowering its tax liability. Because depreciation is a non-cash expense (no cash actually leaves the business), it improves cash flow. For tax purposes in the US, businesses often use the Modified Accelerated Cost Recovery System (MACRS) to calculate depreciation deductions.
The book value of an asset is its original purchase cost minus its accumulated depreciation. As depreciation is recorded each year, the book value of the asset declines until it reaches the estimated salvage value.
Salvage value is the estimated resale value of the asset at the end of its useful life. This is a prediction, which may differ from the actual market value when the asset is sold. If you sell the asset for more than its book value, you must record a taxable gain on the sale.