When a business purchases a long-term asset, the full price of the item is not deducted from earnings at the time of purchase. Instead, the item becomes an asset on the company's general ledger and is gradually depreciated over time. Multiple methods of calculating depreciation exist – two of the most common are straight-line and declining-balance depreciation.
Straight-line and declining-balance depreciation both rely on a few basics to determine the annual depreciation on an item. The cost of the asset is the purchase price paid by your business; the residual value is the salvage value, meaning what the asset is worth at the end of its life. For example, even a fleet car that no longer runs has a value in scrap metal at the end of its life. The useful life of an asset, also known as its service life, refers to the expected time the asset will remain in service.
In straight-line depreciation, the value of the asset depreciates at a steady rate over its service life. Determine the annual depreciation amount by subtracting the scrap value of the item from the purchase price of the asset. Divide the difference by the service life to find the annual deduction. For example, a $22,000 asset with a $2,000 scrap value and a 10-year service life depreciates by $2,000 per year. The $22,000 cost minus $2,000 in scrap equals $20,000. The $20,000 difference divided by 10 years equals $2,000.
With declining-balance depreciation, the value of the asset declines by a specific percentage every year instead of a set dollar amount. For example, in double-declining balance depreciation, the percentage equivalent of the straight-line depreciation amount is doubled. An asset purchased with a 10-year service life depreciates at 10 percent per year, since 100 percent divided by 10 years equals 10. Using the double-declining balance method, 10 percent doubles to 20 percent. Twenty percent of the asset's value is deducted per year until the scrap value is reached. Should the final year's depreciation total reduce the asset's value to less than the scrap value, only the portion up to the scrap value can be claimed. For example, if the scrap value of an item with a 10-year service life is $5,000 and its depreciation amount of $2,000 in the 10th year would reduce the value of the item to $4,000, only $1,000 of the depreciation can be claimed to preserve the $5,000 scrap value.
Declining-balance depreciation allows a business to claim larger amounts of depreciation in the first few years an asset is placed into service, while straight-line depreciation maintains a consistency. The regularity of straight-line depreciation makes it ideal for steady assets such as real estate and vehicles. Declining-balance works best for assets that become obsolete faster, such as software, tablet computers, smartphones, desktop PCs and laptops.
Different Balance Sheet and Tax Effects
Each type of depreciation affects a company's balance sheet differently. Straight-line depreciation allows an asset to retain more value for longer, which can make a business appear stronger, whereas with the declining-balance method, larger depreciation in the first years of service life leads to an asset losing more value in the beginning, which reduces a company's total assets on the balance sheet. However, this rapid depreciation in value provides a business with maximum savings on income taxes.
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