Depreciation
The concept
Depreciation allocates the cost of a long-lived asset, less residual value, over its useful life. It is allocation, not valuation; book value rarely equals market value, and depreciation neither uses nor provides cash. Land is never depreciated. Methods: straight-line; units of production, where the rate is (cost minus salvage) divided by estimated units; double-declining balance, which applies twice the straight-line rate to beginning book value; and sum-of-the-years'-digits.
Traps
- Applying salvage value in double-declining balance before the final year, when book value is simply floored at salvage.
- Depreciating land, or an asset not yet placed in service.
- Crediting the asset account instead of Accumulated Depreciation.
- Skipping partial-year depreciation when the asset was bought mid-year.
- Treating a change in estimated life or salvage as retroactive; it is applied prospectively over the remaining life.
- Confusing accumulated depreciation with a fund of cash set aside.
Worked example
Machine: cost $10,000, salvage $1,000, five-year life. Straight-line = (10,000 − 1,000) ÷ 5 = $1,800 per year. Double-declining rate = 40%. Year 1: 40% × $10,000 = $4,000. Year 2: 40% × $6,000 = $2,400. Year 3: 40% × $3,600 = $1,440. Year 4 would give $864, but book value is capped at the $1,000 salvage, so only $1,160 remains to be taken.
Rule of thumb: straight-line rate = 1 ÷ life; double-declining rate = 2 ÷ life applied to beginning book value.