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Depreciation Rate

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Fundamentals of the Depreciation Rate

To understand the depreciation rate one must have an idea of what depreciation is and what it entails. Simply put depreciation is the process of allocating an assets value often set at cost price over its useful life less its scrap value. This yields a depreciation expense which is then allocated to the respective fiscal years on the assets ranging from buildings, machines to equipment. For intangible assets such as intellectual property and brands the term used in place of depreciation is amortization and depletion for the case of natural resources such as gas and oil. All these are equivalent terms and should be taken as to convey the same basic meaning.

There are various methods used to calculate depreciations all with their own advantages and disadvantages, and are based on different assumptions. It is the duty of the finance function of any company to choose a method that best captures the economic reality of the company and should consider the following three factors:

 

 

  • Method and rate of depreciation
  • The assets useful life
  • The assets scrap value i.e. the value of the asset remaining after the end of its useful life.

An individual has a number of choices for calculating depreciation rate available to him. The most common methods used are straight line method and accelerated method, depending on the choice of the individual. These methods are explained below;

Straight Line Method

The basic idea around which the straight line method operates is to subtract the scrap value of an asset from its original cost. This is then divided by the expected useful life of the asset in years expensing the same amount of depreciation every year. Although the method thrives on its apparent simplicity and straight forwardness, it is not reflective of reality as assets are more useful in the early years when they are bought and decrease gradually through the years, allocating the same rate of depreciation over the years does not do justice to this fact.

Accelerated Method For Calculating Depreciation Rate

A good thing about this method is that they tend to write off depreciation faster than the straight line method. A fact that minimizes taxable income, a popular method of calculation is the double declining rate which, in its basic form, doubles the rate of the straight line method.

The choice of method chosen to calculate the depreciation rate totally depends on the person doing the calculation and the environment under which the firm operates. However one should be careful in order to include all possible aspects of depreciation thus forming a basis on which one can determine which method of calculating depreciation rate best reflects the company’s financial situation.

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