You aren’t alone; many people are confused by depreciation.  However, it may be simpler than commonly believed.  Let’s discuss it in a manner that won’t have non-accountants nodding off – or running in the other direction.

 

The standard definition of depreciation is as follows:  the portion of the cost that reflects the use of a fixed asset during an accounting period.  Let say, for example, that a company purchased a piece of equipment for $10,000 and the determined (estimated, guessed, etc.) that it had a useful life of seven years.  For a one-year accounting period, using the straight-line method of depreciation, the portion of the $10,000 cost of the asset to be depreciated would be one-seventh (one for the accounting period; seven for the estimated life of the asset) of $10,000 (the cost or purchase price) or $1,428.57.

 

That wasn’t too hard to understand, was it?  Everything else (regarding depreciation) is just specifics or nuances of the above.  When we look back at our example, we’ll see key pieces of information that you must have in all cases when considering depreciation.  For the purposes of our example we made some assumptions, if the actual conditions differ, it’s just details.  The same principals apply.  First, what is the nature of the item?  Equipment.  When was the item placed into service?  January 1 (hence our full year of depreciation).  What was the useful life of the asset?  Seven years.  What method of depreciation will be used?  Straight-line.

 

There!  That’s it in a nutshell.  Simply repeat and substituted the specific details for specific assets.  It’s not that hard.   The first three conditions are fairly simple and straightforward.  The useful life is a little more complicated, BUT you’ve got to use the Internal Revenue Service (IRS) version of reality.  For instance, take a laptop.  Some individuals (and businesses) still have the very first one they purchased and it still works fine.  Others upgrade frequently, needing (or wanting) the very latest technological advancements and capabilities.  Clearly, “service life” for laptops is subjective.  But the IRS comes to the rescue.  It has guidance (IRS Publication 946) that provides the officially sanctioned useful life of different assets.  Use that – always.  Even if the useful life of your particular asset doesn’t match.    

 

The last condition is the method of depreciation.  You have to decide which you want to use.  We’ve already discussed straight-line (which is very straight forward) and there’s also another method, which “accelerates” the rate of depreciation:  double-declining balance.  The concept behind this (and it’s very logical for some assets) is that when an assets is first purchased, it will get more “used up” in the earlier years of its useful life.  The double-declining balance is an attempt to more closely match reality for some assets.  Consider a person al example:  Say you buy a new car and keep your old one.  And say also that vehicles have an estimated service life of ten years.  You have two cars sitting in your driveway.  One is eight years old; the other brand new.  Which one are you going to use the most? 

 

The computations for double-declining balance are only slightly more complicated than for straight-line, but you don’t even have to do them anymore, thanks to the IRS.  Yep, they provide guidance.  But just to show you how to do the computation, you start out EXACTLY like you do with straight-line.  For the first year, you multiply the computed (by the straight-line method) amount by 2 (hence double) for the first year.  For the second year, you subtract the first year’s depreciation from the cost of the asset (use the accumulated amount for following years).  You take that figure and divide it the useful life of the asset and multiply that result by 2, and repeat the process for each remaining year.