Understanding the Straight Line and Accelerated Depreciation Methods

Depreciation is a way to account for the reduction of an asset’s value as a result of using the asset over time. Depreciation generally applies to an entity’s owned fixed assets or to its right-of-use assets arising from finance leases for lessees. Accumulated DepreciationThe accumulated depreciation of an asset is the amount of cumulative depreciation charged on the asset from its purchase date until the reporting date. It is a contra-account, the difference between the asset’s purchase price and its carrying value on the balance sheet. From year 1 to 3, ABC Limited has recognized accumulated depreciation of $9800.Since the Machinery has a residual value of $2500, depreciation expense is limited to $10000 ($12500-$2500). As such, the depreciation in year four will be $200 ($10000-$9800) rather than $1080, as computed above. Also, for Year 5, depreciation expense will be $0 as the assets are already fully depreciated.

With liberal accounting choices, revenues tend to be recognized sooner and expenses tend to be recognized later. This increases your current revenues and decreases your current expenses. With conservative accounting choices, revenues tend to be recognized later and expenses tend to be recognized sooner. This decreases your current revenues and increases your current expenses. The concept and relevance of allocating the portion of the original cost of an asset „used up“ in a period to generate revenue as an expense of the period is clear. In many practical cases, however, the proportion of cost to be allocated as an expense of a particular accounting period can only be estimated.

Taxes

This method is less commonly used as it can result in large swings in depreciation expense from year to year. However, it is often https://simple-accounting.org/ used for tax purposes as it results in a higher deduction in the early years when the company is likely in a higher tax bracket.

It is the rate of recognition that will be effected by this method and not the overall amount to be recognized as an expense. Accelerated depreciation requires additional depreciation calculations and record keeping, so some companies avoid it for that reason . Companies may also ignore it if they are not consistently earning taxable income, which takes away the primary reason for using it.

DEPRECIATION AND TAXES

For weak form finance leases where the lessor retains ownership of the asset at the end of the lease term, the asset is depreciated over the shorter of the useful life or the lease term. Because this method is the most universally used, we will present a full example of how to account for straight-line depreciation expense on a finance lease later in our article. There are several methods for calculating depreciation, generally based on either the passage of time or the level of activity or use of the asset. You have to keep an accurate record of how many items the equipment has produced. Because production will likely vary from month to month, you’ll need to manually enter this depreciation expense into your accounting software every month. The entry can’t be automated, as it can with straight-line depreciation. When you go through the financial statements, quickly check what type of accounting method is used.

• Salvage valueThe estimated value of an asset at the end of its useful life.
• Therefore, the accelerated methods of depreciation skew the profits of the company and reveal lower profit in the earlier years of the asset’s acquisition.
• Under the straight-line method, depreciation expense is recognized evenly over the asset’s useful life.
• The expense is an income statement line item recognized throughout the life of the asset as a “non-cash” expense.

However, the rate at which the depreciation is recognized over the life of the asset is dictated by the depreciation method chosen. Unlike the other methods, the units of production depreciation method does not depreciate the asset solely based on time passed, but on the units the asset produced throughout the period. Sum-of-years‘ digits is a depreciation method an accelerated depreciation method recognizes that results in a more accelerated write-off than straight line, but less than the declining-balance method. Under this method, annual depreciation is determined by multiplying the depreciable cost by a schedule of fractions. The simplest and most commonly used method of depreciation is the straight line method or straight line accelerated depreciation method.