Depreciation allocates the cost of a long-lived asset over its useful life. There are several methods; the two most common are straight-line and declining balance.
Key terms:
- Cost: what the business paid for the asset
- Salvage value (residual value): the estimated value at the end of its useful life
- Depreciable base: cost minus salvage value
- Useful life: how long the business expects to use the asset
Straight-line depreciation The simplest method — equal expense each period.
Formula: (Cost - Salvage Value) / Useful Life
Example: A machine costs 5,000, and a useful life of 10 years. Annual depreciation = (5,000) / 10 = $4,500 per year.
The journal entry each year:
| Account | Debit | Credit |
|---|---|---|
| Depreciation Expense | $4,500 | |
| Accumulated Depreciation | $4,500 |
After 3 years, accumulated depreciation is 50,000 - 36,500.
Double-declining balance depreciation An accelerated method — higher expense in early years, lower in later years.
Formula: (2 / Useful Life) × Book Value at Beginning of Year
Same machine: Rate = 2/10 = 20%.
- Year 1: 20% × 10,000 (book value drops to $40,000)
- Year 2: 20% × 8,000 (book value drops to $32,000)
- Year 3: 20% × 6,400 (book value drops to $25,600)
- Continue until book value reaches salvage value, then stop depreciating.
Note: double-declining balance uses the full cost (not the depreciable base) in its calculation, and ignores salvage value until the end when the book value can’t drop below salvage.
When to use which: Straight-line is simpler and spreads cost evenly. Accelerated methods make sense when an asset loses most of its productive capacity early (vehicles, technology). Tax rules may require or incentivize a specific method — in the US, businesses often use MACRS (modified accelerated cost recovery system) for tax purposes and straight-line for financial reporting [citation needed].