Define Depreciation and what are the key concepts used in its calculation: Depreciation is a way of understanding the loss of value of a capital asset over time. There are many methods, and the difference between them is in how time is managed as a factor. At the end of the life of a capital asset, there remains a salvage value which is equal to the price that the used or depleted asset can get on the market. A vehicle, for example, can still be sold for scrap metal after it can no longer run. This price which can be received on disposal is a benefit included in expectations and forecasts. With the acquisition or initial costs, one subtracts the salvage price and then divides the result among all of the useful years of the asset’s life. For many items and industries there are specific guidelines which must be followed in determining the depreciation method and the specifics of the approach.
Describe the Straight Line Method for calculating depreciation:
The straight-line method of depreciation is one approach based on assumptions about the asset and its performance, specifically that the asset will continue to perform at a consistent rate, producing consistent revenue or support, through its lifetime. Similarly the asset will depreciate and lose value at a constant rate. This method, by simplifying the understanding of depreciation, is very easy to apply. Rather than calculating real loss of use, the total cost is divided by the total length of the lifecycle of its productive use, taking into account the salvage value. The formula for annual depreciation value is therefore essentially the cost of acquiring the asset, minus the salvage value, divided by the years of useful life.
Describe the Declining Balance Method of calculating depreciation:
In the declining balance method of depreciation, the rate of depreciation is applied against the cost of the capital asset. This means that a different set of assumptions are employed in the technique, such as the idea that the asset will lose more value in early years than later years. This is reflected in actual use of assets, which tend to fall after purchase, but maintain their value as they age for as long as they continue to perform. The important difference from the straight line calculation is the rate of depreciation, and how that rate is determined to change over the lifecycle of the asset.
Is one method of depreciation “better” than the other?
With regard to methods of calculating depreciation, whether one is better than the other is contingent on the situation at hand and which method is more appropriate. One important factor is whether the revenue which the capital generates is consistent. Another important factor is whether depreciation will reduce the productive value of the asset. This could matter if the item itself became less productive after years of use or if the capital becomes obsolete by new disruptive technology. The straight-line method is simplest, but in assuming an equal value of depreciation assumptions are made which may not reflect reality. If the asset consistently performs throughout the lifecycle, and there are no complicating factors of the rate of depreciation, then the straight line method is easy to choose. In other cases, based on revenue that is related to the actual depreciation of an asset, the declining balance method is a better fit.
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