Depreciation

Depreciation generally refers to the decline in value of assets, the cost of this is known as depreciation expense, which means allocating the cost of the assets among the periods in which the asset is expected to be used. There are two different theories to how companies have to go about this, and within those two theories there are different ways of allocating the cost. First we have book depreciation, which is the depreciation expense recorded on the books and reported on the financial statements. Then we have tax depreciation, this depreciation expense is recorded on the company’s income tax return and it needs to follow the rules of the Internal Revenue Service (IRS).

There are four types of book depreciation: straight line, declining balance, sum-of-year's digits, and the units-of-production methods. In some cases the double declining balance method is combined with the straight line method to match the book value of the asset with its salvage value at the end of its depreciable life. The book value of the asset in any given period is the difference between its cost basis and the cumulative depreciation of the asset up to that period. The declining balance and sum-of-year's digits methods are also known as the accelerated methods, because the rate of depreciation with these methods is higher than with the straight line method.

The straight line method is one of the simpler ones and probably the most used method. This method works by estimating the salvage value of a particular asset at the end of its useful life and expensing a portion of the original cost in equal amounts over the asset’s useful life. The declining balance method is one of the two accelerated methods of depreciation. In some cases it may be better for a company to write off its expenses on an asset at a faster rate than allowed by the straight line method. With a higher fraction of the cost written off during the early years the company will have more cash, which will lead to...