The two most common methods of depreciation are straight-line depreciation and accelerated depreciation. These two methods of depreciation are used for specific reasons. Accelerated or double declining depreciation is used for tax accounting purposes and straight line depreciation is used for financial accounting purposes. Assets that an organization owns that last for more than one year are considered fixed assets and will have a set amount of useful life. Every company must pay for the tool, equipment, building or any other capital expense in order to generate profit. These assets will not last forever and will depreciate over time. Unlike other expenses depreciation is a non-cash charge. Depreciation attempts to match the profit with the expense it took in order to achieve that profit. Depreciation is a term used in accounting to spread the cost of an asset over the course of the assets useful life. In both the accelerated or straight line depreciation methods the process involves an allocation of the cost of an asset to the years in which the benefits of the asset are expected to be received. Understanding why these two methods are used for different reporting purposes is an important concept in accounting.
Straight Line Depreciation
Straight Line Depreciation is the most widely used form of depreciation method for financial reporting. Straight Line Depreciation is used to show higher earning for their investments throughout the life span of the asset. In financial accounting this method is used to smooth earnings out over the useful life of the asset. For example, if an organization purchased a piece of equipment that cost $50,000 dollars and the useful life is 5 years then they will account for this using the straight-line depreciation method. This method estimates the salvage value of the asset at the end of the period which it used to generate revenue. Straight Line Depreciation will expense a portion of the original cost in equal proportions over the estimated life of the asset. The salvage value is the estimated value at the end of the assets useful life. If the salvage value is $5,000 dollars then the depreciation expense is as followed:
Depreciation Expense= $50,000-$5,000/5 years = $9000 or 20% for each year
The depreciation expense can now be seen on the financial statement and the user can determine how much of the cost has been recognized as expense since the tool was purchased.
Accelerated or Double Declining Depreciation
Another depreciation method that is used is the double declining balance and is a form of accelerated depreciation. In this method, the depreciation rate is doubled and in our example the rate is now 40% of the net book value for each year. Both methods use a constant percentage for each year to the declining balance of the net book value. Why do companies use different methods to account for depreciation? This method is often used for tax accounting purposes and will allow for greater deductions in early years of the assets useful life. This will allow the purchaser to deduct more in the first year and maximize deductions earlier. The reason most organization prefer this method to is claim more tax deductions today in order to maximize their returns. It is better to have a $100 dollars today rather than $100 dollars in 5 years. (without interest, of course). So now we can see why most organizations use these two depreciation methods for both financial and tax reporting. The straight-line method will smooth out earnings over the assets useful life and accelerated methods will help maximize tax deductions earlier.
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