Answer by Peter Baskerville:
Depreciation is a recognition in the books of a business of the loss in value of its fixed assets that occurs over time due to obsolescence, wear n' tear and old age.
Now rather than write off all the asset value against the final accounting period where the asset is finally thrown out and replaced, the accounting system (supported by government tax departments) allows the business to write off the value of the asset gradually over the period where it was used to generate revenue.
In doing so, the accounting system is upholding an important principle in relation to reporting a fair view of the financial performance and position of the business. This principle is known as the 'matching principle' where the revenue for each accounting period should be matched against the costs incurred in earning that revenue and the loss in value of fixed assets (depreciation expenses) is one of those costs that should be included in each accounting period.
Because not all assets lose value at the same rate (i.e. computers vs buildings), various depreciation methods have been developed to write off the value of the assets in a fair an equitable way. But depreciation expense calculations have tax implications, so Governments usually only allow certain methods of depreciation to be adopted by businesses for tax purposes.
The most common depreciation method used by business and accepted by Governments is the Straight Line Method.
The Straight Line Method of depreciation calculates annual depreciation with the formula:
Depreciation Expenses = value of the asset (purchase price) / Useful Life of the Asset.
So if you purchased a truck for $20,000 and it had an estimated useful life of 10 years, then the annual depreciation expense would be calculated as = 20,000 / 10 = $2,000 depreciation expense per year.
Another adjustment to this formula occurs if the truck has some 'salvage value' at the end of its useful life. i.e. it could be sold for $2,000. In this scenario, the depreciation value would be first reduced by $2,000 in salvage value and then divided by the useful life. So the formula changes to: (20,000 – 2,000) = 18,000 / 10 = $1,800 depreciation expense per year.
Other methods of calculating depreciation expense are described well hereand include:
- Declining-balance: An accelerated method of depreciation, it results in higher depreciation expense in the earlier years of ownership.
- Sum-of-the-years’ digits: Compute depreciation expense by adding all years of the fixed asset’s expected useful life and factoring in which year you are currently in, as compared to the total number of years.
- Units-of-production: The total estimated number of units the fixed asset will produce over its expected useful life, as compared to the number of units produced in the current accounting period, is used to calculate depreciation expense.