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Methods of Depreciation

There are three main methods of depreciating capital assets: straight-line, declining balance, and sum-of-the-years-digits. These methods are more prevalent than others because they are accept­able to most tax authorities.

 

Straight-line

This method is the simplest of the three. It takes the original cost of the asset less its expected salvage value (see above for the definition) and divides it by the number of years in its expected useful life. In the above example of the truck, if you purchased it for $27,000, the depreciable value would be $27,000 - $7,500, or $19,500. This amount would be divided by the useful life of five years to come to an annual depreciation amount of $3,900. Every year, you would take a $3,900 expense on your income statement to reflect the depreciation on the truck.

 

Declining balance

This method, as well as the sum-of-the-years-digits, is called an accelerated depreciation method because, by nature of its calculation, it allows more depreciation in earlier years and less in later years.

The declining balance method (sometimes called the double declining balance method, but meaning the same thing) applies a constant percentage to the declining book value of the asset.

Let's go back to the truck example above. If your depreciation rate is 20 percent, the depreciation over the five years that you own the truck would look like this:

 

 Year

Percentage

Book value

Depreciation

 1

20%

$27,000

$5,400

 2

20%

21,600

4,320

 3

20%

17,280

3,456

 4

20%

13,824

2,765

 5

20%

11,059

2,212

 

The book value at the end of the five years is $8,847. If you sell the vehicle for $7,500 at the end of the five years, you have a loss on sale because the book value is higher than the sale price. Remember that book value has no relationship to market value. If you sold the vehicle for $9,500, you would have taken too much depreciation over the years and would have a gain on sale. This is one area where tax treatment among countries differs significantly, so you should discuss this issue with your accountant. This session addresses only the general concepts of depreciation.

 
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