There are several methods of calculating depreciation of fixed assets, but all of them can be reduced to one of two common methods, straight line and declining balance. No fixed asset lasts forever, and every one has what is referred to as a useful economic life. The IRS maintains guidelines indicating acceptable terms in years of the useful life of any fixed asset of a business. A computer may have a useful life of three years, but a building may have a useful life of 25 or 30 years. Depreciation is based on the assumption that all fixed assets decline in value over time. Though real property may increase in market value over time, facilities housing business activities suffer wear and occasionally need maintenance or restoration that can be quite costly. Depreciation of fixed assets provides a means of accounting for businesses’ consumption of those fixed assets over the course of their useful life.
In the straight line method, depreciation charge is calculated on the basis of equal amounts of value being depreciated each year of the fixed asset’s useful life. The straight line depreciation equation is:
D = (C- R)/ N
Where D = depreciation
C = original cost of the fixed asset
R = the fixed asset’s residual value
N = the number of years of the fixed asset’s useful economic life.
Thus a fixed asset that costs $17,000, has a useful economic life of five years and can be sold at the end of those five years for a residual value of $2,000 provides $3,000 in depreciation for each of the five years of its useful life. The equation reads ($17,000 – $2,000) / 5 years = $3,000 each year.
The declining balance method of depreciating fixed assets often is referred to as the double declining balance method. It allows the business to take a double depreciation charge in the first year. The book value of the asset then is reduced by the amount of the depreciation charge. That resulting book value is subject to the same double percentage the following year and each year of the fixed asset’s useful life.
The total amount allowed in depreciation is the same with both methods. The primary difference is that the declining balance method allows the business to take the greatest depreciation charge in the first year of the asset’s use. The straight line method is simpler, but may not always yield any first year advantages for the organization. Whichever method the organization chooses to use to depreciate fixed assets, that method should be used for the entire terms of the fixed asset’s useful life.
