Cost basis methods determine how certain expenses and profits are accounted for. Depreciation is an accounting tool that is used to spread out the expense of a capital asset over its useful life. The types of depreciation methods include straight line, declining balance and sum-of-the-years' digit. Capital gains or losses from sales of assets or securities can be calculated using the cost basis methods of average cost-single, average cost-double, first-in first-out (FIFO) or specific identification.
The simplest form of depreciation is straight-line. The book value of the asset is divided by the amount of years it will be used. An asset's book value is equivalent to its purchase price. With straight-line depreciation, the amount that is being expensed is equal for each year the asset is in use.
Declining balance depreciation is another one of the common cost basis methods. It is also sometimes referred to as the double declining balance. The percentage amount that would be depreciated each year under the straight-line method is simply doubled and calculated by the remaining book value. For instance, if an asset has a useful life of five years, the straight-line percentage would be 20 percent and the declining balance percentage would be 40 percent.
The sum-of-the-years' digit depreciation technique involves the most calculation. It involves taking the sum of all the years of an asset's life. For example, a vehicle that is going to be depreciated over six years, would have a sum of 21, which is reached by adding together the digit for each year: 6+5+4+3+2+1 = 21. Each year's digit is then divided by 21 to get the percentage, which is multiplied by the asset's remaining book value. The first year's depreciation percentage would be 6 divided by 21, or 28.5 percent; the second year's would be 5/21 or 23.8 percent; and so on, for example.
Average cost-single and average cost-double are cost basis methods for capital gains. With the average cost methods, it is vital that detailed records of all stocks and securities are kept, along with purchase and selling prices. When stocks are sold, the average cost is determined by taking the price of the shares and dividing it by the number in the investor's portfolio. This average cost amount is then multiplied by the amount of shares that were liquidated.
With the average cost-double method, the costs are split between short-term and long-term securities. Average costs are calculated using the same cost basis methods used with average cost-single. The only difference is that each type of security gets its own separate calculation.
FIFO is a simple method of accounting for capital gains. The investor makes the assumption that stocks are liquidated in the order in which they were purchased. For example, shares that were purchased in the previous year would be sold before those purchased in the current. The cost is determined by taking the sale price minus the purchase price.
Specific identification is a method that gives the investor more flexibility than the FIFO method. The stocks that are being sold, along with their respective costs and capital gains are identified. Tight and detailed record keeping is a must when using this method.
