Depreciation is the reduction in an asset's value over the passage of time due to wear and tear and abuse. Only items which lose useful value over time can be depreciated. It is used in accounting as a method of cost allocation. Generally the allocation of the cost of depreciation is based on a number of factors but it is always related to the estimated period of time that the product or assest can generate revenues for a/the company. The resulting depreciation expense is the amount of cost allocation (for depreciation) within an accounting period (Investopedia 2014).
Depreciation, then, refers to:
- the decrease in value of assets, as well as,
- the allocation of the decrease in value as a cost of assets to periods in which the assets (which depreciate) are used.
Part #1 affects the balance sheet of the business and Part #2 impacts the net income reported by the business (Wikipedia 2014). Several depreciation methods are available, depending on the country and so forth, for use in corporate book keeping. In this example model, three different depreciation methods are presented and compared.
- Straight Line Depreciation (Container "Straight_Line")
- Double Declining Balance Method (Container "Double_Declining")
- Modified Accelerated Cost Recovery System (Container "MACRS")
The calculations for each method and additional description of each method is provided in the associated container. The accounting period or the time over which to allocate the depreciation amount is set with the "Depreciation_Frequency" Data element. Thus, assets are depreciated at fixed intervals (i.e. accounting periods) as determined by "Depreciation_Frequency". The total period or lifetime of the asset over which it can be depreciated is specified using the "Recovery_Period" Data element.
The three methods can be compared using the result elements below under scenarios where the useful life of the asset ("Recovery_Period") varies, the purchase time of the asset ("Purchase_Time") varies, and the depreciation frequency ("Depreciation_Frequency") varies. Depreciation frequency can only be varied between annual and monthly. Of note, the Double Declining Balance method may not reduce the book value of the asset as far as the other two methods. In other words, this method does not necessarily reduce the book value to "Initial_Asset_Value" less the "Residual Value". However, the Double Declining Balance method does generally provide the fastest depreciation which results in relatively higher net present value (NPV) during the earlier portions of the asset useful life.