What is Depreciation and Why Depreciate? An Easy to Understand Illustration - Straight Line and Diminishing Value

Depreciation is a weird concept isn’t it?

It’s meant to decrease the value of something you own. Why? Well in most cases, when you own something, say a computer, over time:

1) Wear and tear occurs just from normal usage
2) The market for second-hand is different from buying a computer at retail

So that value of your computer shouldn’t be shown in your financial reports at the amount that your originally bought it at because your assets (what you own) should be shown at their realistic value and your computer’s realistic value is likely to be lower than what you bought it at.

That’s where depreciation comes in.

You ‘depreciate’, meaning reduce the value of your computer by an amount to show a new figure that would represent the ‘realistic’ value of your computer.

There are two types of depreciation: Straight Line and Diminishing Value

  • Straight Line Depreciation is where depreciation is that same amount every year until the value of the asset is NIL. For example, if $100,000 is allocated from your asset as depreciable at a rate of 50%, in the first year you’d depreciate $50,000 and the second year, you’d depreciate $50,000 and that would be it (there are guides from the Australian Tax Office of appropriate depreciation rates you can use).
  • Diminishing Value Depreciation is where the first year amount is 50% and then you’d apply 50% to the remaining balance until it gradually gets smaller and smaller. Reducing balance means that asset stays longer on your books than straight line. So using the example above, let’s apply diminishing value depreciation:
    • 1st year: $100,000 x 50% = $50,000 depreciation. Therefore, the remaining value of the asset is $100,000 - $50,000 = $50,000

    • 2nd year: $50,000 (new balance) x 50% = $25,000 depreciation. Remaining value/new balance is now: $50,000 - $25,000 = $25,000
    • 3rd year: $25,000 x 50% = $12,500 depreciation. New balance is now: $25,000 - $12,500 = $12,500
    • 4th year: $12,500 x 50% = $6250 depreciation. New balance = $6250.
    • 5th year: $6250 x 50% = $3125 depreciation…. and you get the drift…

Depreciation is used for both an accounting and tax reasons, that’s another reason why you’ve got to do it.

Next: What is Net Assets? An Illustrated Example

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