Before we dive into the three types of depreciation, let’s do a brief summary of what depreciation is.
Depreciation is an accounting method that is used to allocate a cost to an item or asset as it ages through its useful life. Instead of claiming a single asset write off deduction, a deduction estimates how much of a tangible item has been used up.
Depreciation makes it possible for businesses to earn money from a tangible asset – such as a truck – whilst claiming the cost of that asset over time. Depreciation helps a company or owner reduce the amount of taxes they are paying at the end of the year.
There are three main types of depreciation:
- Straight-line depreciation
- Declining balance depreciation and
- Double declining
Let’s start by going over Straight-Line Depreciation, the most basic form of depreciation.
This is when equal parts of an asset are depreciated each year. Here’s an example:
If an appliance worth $10,000 is purchased and has a salvage value (or residual value) of $2,000, then the appliance has an $8,000 depreciable current book value. If we assume that the useful lifespan of the appliance is 8 years, using straight-line depreciation then $1,000 is the annual depreciation value for the asset.
The second form of depreciation is Declining Balance Depreciation. A declining balance depreciation method is a little more complex.
This is an accelerated form of depreciation which depreciates a piece of property at its straight-line depreciation percentage times its remaining depreciable amount each year
Declining Balance Depreciation = Current Book Value × Depreciation Rate
Let’s apply that to our previous example.
Year 1, with a current book value of $8,000, the depreciation rate is 12.5%. So, the amount claimed that year is $8,000 times 12.5% or $1,000.
Year 2, the current book value is now $7,000. When multiplied by 12.5% again the claimed amount for that year is $875
Year 3, our depreciable amount is only going to be $765.63
The amount gets smaller and smaller with each passing year.
The last form of depreciation is Double Declining Balance or DDB
This is another accelerated form of depreciation. This accounting method depreciates assets twice as quickly as the declining balance method.
The formula for DDB is
Depreciation=2 × Straight Line Depreciation Percent × Book Value at the beginning of the period
Okay let’s apply that to our same example.
The Straight-Line Depreciation Percent is 12.5% over the 8 years.
In year 1, the current book value is $8,000.
So, in year 1 we have 2 times 12.5% times $8,000 which equals $2,000.
In year 2, our book value is now $6,000, so our depreciation amount is $1,500
In year 3, with a book value now being $4,500, our depreciation amount is now only $1,125.
Depreciation is used for fixtures, fittings, and improvements to a piece of real property, however the land itself cannot be depreciated. It becomes most important for tax savings when an asset is being held as an investment property.