Assets held by a company will begin to lose value over time. Through usage, age and normal wear and tear the value of an asset will decline – this is known as depreciation. Examples of items that may depreciate are equipment, machinery or vehicles. Reflecting the lowering value of the asset is handled through a variety of reporting methods in the company accounting software and essentially writes off the asset’s depreciation over the length of its useful term. When calculating depreciation, the company must consider three factors. Factor one: the useful life – how long the item can realistically be used in a cost-efficient manner. Factor two: the salvage value – how much the company can recoup by selling the item. Factor three: the depreciation method – how accounting will handle the monetary value of the depreciating item.
There are two principles in accounting to handle depreciation: matching principle and cost principle. The matching principle divides the cost of an asset over the (estimated) length of the asset’s life. It then matches that amount up with the revenues earned through using the asset.
The cost of the asset is calculated using the cost principle. The cost principle makes sure that the original cost of the asset is used and is reported on the income statement. That original cost is, in essence, divided up and reported over the life of the asset, and matched with the revenues reported.
There are various methods of handling the depreciation of items, based on the potential life of the asset. The accelerated depreciation takes more depreciation during the initial few years, while straight line depreciation allows for the same amount of depreciation every year.
The main difference between the two types of distraction has to do with the timing of claiming the depreciation. Regardless of the type of depreciation done, the amount of the depreciation is the same, so the owner simply has to decide which a more effective tax strategy is.