Depreciation refers to two aspects of the same concept. The decrease in the value of assets and the allocation of the cost of assets in the period in which they are used.
The former affects the balance sheetem while the latter affects the net income. The cost is generally allocated as an expense during the periods in which the asset is expected to be used. This expense is recognized by businesses for their financial reporting and tax purposed.
The depreciation calculations may vary according to the different types of assets withing the same business and it may also vary for tax purposes. These calculations may even be specified by law or the accounting standards, that may vary by country. There are three main different methods of calculating depreciation.
These are known as the following:
- Units of activity.
- Straight line.
- Declining balance.
- Sum of the Year digits
Depreciation expenses normally begins as soon as the asset is placed in service.
Comparison of depreciation methods.
|Straight Line||Easy to calculate.Useful where the pattern of economic benefits are hard to determine with precision.
Suitable for depreciating assets that provide similar level of economic benefits throughout their lifetime.
|May not reflect the true pattern of asset’s economic benefits.|
|Reducing Balance||Appropriate where the usefulness of an asset declines over its lifetime.||The rate of depreciation selected is subject to bias.|
|Sum of the Year Digits||Easier to understand.The effect of decrease in depreciation expense compared to reducing balance method.||More difficult to calculate.|
|Units of Activity||Most accurately reflects the pattern of consumption of economic benefits.Suitable in case of fixed assets that depreciate in proportion to units of activity rather than just the passage of time.||Difficult to determine and measure a reasonable basis of activity.|