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Simple English definitions for legal terms
depreciation method
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A quick definition of depreciation method:
A depreciation method is a way to estimate how much an asset will wear out or become obsolete over time. This is important for calculating how much of a tax deduction can be taken each year. There are different methods, such as the straight-line method, which spreads out the cost of the asset evenly over its useful life, and the double-declining method, which takes more deductions in the earlier years. Other methods include the annuity method, the units-of-output method, and the replacement-cost method. Each method has its own formula for calculating depreciation.
A more thorough explanation:
A depreciation method is a formula used to estimate the decrease in value of an asset over its useful life due to wear, tear, or obsolescence. This method is useful in calculating the allowable annual tax deduction for depreciation.
- Straight-line depreciation method: This method writes off the cost of the asset by deducting the expected salvage value from the initial cost of the capital asset, and dividing the difference by the asset's estimated useful life. For example, if a company buys a machine for $10,000 with an expected useful life of 5 years and a salvage value of $2,000, the annual depreciation expense would be $1,600 ($10,000 - $2,000 / 5).
- Double-declining depreciation method: This method spreads over time the initial cost of a capital asset by deducting in each period twice the percentage recognized by the straight-line method and applying that double percentage to the undepreciated balance existing at the start of each period. For example, if a company buys a machine for $10,000 with an expected useful life of 5 years and a salvage value of $2,000, the annual depreciation expense would be $3,200 in the first year (2 x 20% x $10,000) and $1,280 in the second year (2 x 20% x $6,800).
- Units-of-output depreciation method: This method allocates the cost of a depreciable asset, minus salvage value, to the accounting periods benefited based on output (as miles, hours, number of times used, and the like). For example, if a company buys a machine for $10,000 with an expected output of 100,000 units and a salvage value of $2,000, and produces 20,000 units in the first year, the depreciation expense would be $1,600 ($8,000 / 100,000 x 20,000).
These examples illustrate how different depreciation methods can be used to calculate the annual depreciation expense for an asset based on its expected useful life, salvage value, and productivity.