Reducing depreciation to build balance ensures that the company does not overvalue its assets.
Depreciation can be defined as the value that an asset or building loses over time due to unavoidable factors such as deterioration. Building depreciation can be calculated in a number of ways, including straight-line depreciation or using the reducing balance method. Straight-line building depreciation is calculated by estimating the value of the property at the end of its useful life and using its present value to subtract a certain percentage from its value each year. When the reducing balance method is used, a higher initial depreciation charge may be preferred, but subsequent losses become smaller each year.
Building depreciation can be determined as early as the planning stages.
Straight-line building depreciation is used most often as it is the least confusing method of calculating property loss in value. It may not be entirely accurate, but it gives company accountants a tangible number to enter on the income statement, which helps simplify annual accounts. It is not easy to determine how much a building will depreciate over a long period of time; each property is different, so the straight-line method may not be the best way to calculate the loss for this asset.
Suppose a company has a building currently valued at $300,000 US dollars (USD) and decides that the salvage value after five years will be $150,000. It will subtract the final value from the current cost and divide it by the number of years to live. In this case, $300,000 – $150,000 / 5 = $30,000 annual depreciation. So at the end of the first year, the building will be worth $300,000 – $30,000 = $270,000. In its final year, construction will begin with a value of $180,000 and will end with $150,000.
Reducing break-even building depreciation is more complex, but it gives a better idea of a property’s true value. This is calculated by multiplying the depreciation rate by the present value of the property. The rate is usually determined by doubling the estimated linear percentage.
In the example above, the fee is 10% and the fixed value of the building is $300,000. Using the building’s depreciation reduction from balance, the rate would be doubled to 20%. This means that the first year’s depreciation is 20% of $300,000 or $60,000, thus leaving the building’s value at the end of the first year of $240,000. Instead of using $300,000 as the amount for the second year, an initial amount of $240,000 is used.
At the end of the second year, the building would be worth $192,000 or $240,000 x 20%. The property value at the end of year five would be $93,804. While this may not be as high as the straight-line construction depreciation method, it does ensure that a company does not overvalue its assets. In the business world, it is often better to underestimate the value of assets to avoid unpleasant surprises in the future.