Depreciation is intended to reflect change in the value of the asset over time.
Assets such as specialized machinery are physical assets that will lose value as they are used. At certain point they will become worthless because they will serve their useful life or have no market value.
There are different ways to depreciate an asset. You must choose a method that best represents the use of that asset. The two most common methods are:
1. Straightline: Breaks the value of an asset into equal parts.
Asset is purchased for $50,000 and useful life is 10 years. This asset will be depreciated at $10,000 (i.e. $50,000/10) per year.
2. Declining Balance: Subtracts equal percentage amount from the balance of the previous year.
Asset is purchased for $50,000. Because this asset is most valuable when its new, most of the depreciation will happen in the early years and gradually decrease over time. Declining balance determined at 20%.
Year 1: Depreciation $50,000*20% = $10,000
Year 2: Depreciation ($50,000 - $10,000)*20% = $8,000
Year 3: Depreciation ($40,000 - $8,000)*20 = $6,400