Companies purchase fixed assets, such as production equipment or vehicles, to use in the course of their business activities. When a company purchases a fixed asset, it capitalizes the full cost of the asset on its balance sheet. The company cannot expense this cost when purchasing the asset because it will benefit from the purchase for several years. Instead, the company records depreciation, or expenses a portion of the cost each year. Generally accepted accounting principles, or GAAP, provide specific rules for depreciating these assets.
Before calculating depreciation, the company must determine key amounts which it will use for calculating depreciation. These include the depreciable cost of the asset, the asset’s useful life and the estimated salvage value of the asset. The depreciable cost of the asset includes all costs necessary to acquire the asset and place it into service. These costs include the purchase price of the asset, installation charges, freight costs and legal fees. The asset’s useful life represents the number of years the company expects to use it. The estimated salvage value represents the amount of money the company expects to sell the asset for at the end of its useful life.
Companies choose one of three depreciation methods. These are the straight-line, units-of-production method and declining-balance methods. The straight-line method calculates a depreciable basis by subtracting the asset's estimated salvage value from its full cost. This is then divided by the number of years in the asset’s estimated useful life to determine the annual depreciation amount. The units-of-production method uses the same depreciable basis and divides it by the estimated production quantity of the asset. At the end of the year, the company multiplies this amount by the actual production quantity and records this amount as depreciation. The declining balance method is discussed below.
Accelerated Depreciation Method
The declining balance method accelerates the depreciation process and records a higher amount of depreciation earlier in the asset’s life. The company determines the straight-line rate by dividing 100 by the number of years in the asset’s useful life. The company doubles this rate and multiplies it by the full cost of the asset. This determines the depreciation for the first year. In future years, the company uses the full cost of the asset minus the depreciation already recorded and multiplies this by the same rate.
Companies maintain the same asset value in their accounting records as long as they own the asset. A company also maintains an accumulated depreciation account. Accumulated depreciation represents all of the depreciation recorded on an asset since the company first acquired it. Accumulated depreciation is a contra asset account and reduces the net book value of the asset.