What is depreciation?
The term depreciation refers to an accounting method used to allocate the cost of a tangible or physical assetactivethroughout its useful life. Depreciation represents how much of an asset's value has been used up. It allows companies to earn revenue from the assets they own by paying for them over a certain period of time.
As companies do not need to fully account for assets in the year they are acquired, the direct cost of ownership is greatly reduced. Not accounting for depreciation can greatly affect thebenefits. Companies may also depreciate long-term assets for tax and accounting purposes.
Depreciation can be compared toamortization, which represents the change in value over time of intangible assets.
- Depreciation relates the cost of using a tangible asset to the benefit obtained over its useful life.
- There are many types of depreciation, including straight-line depreciation and various forms of accelerated depreciation.
- Accumulated depreciation refers to the sum of all depreciation recorded on an asset at a given date.
- The book value of an asset on the balance sheet is its historical cost less any accumulated depreciation.
- The book value of an asset after depreciation is known as its salvage value.
Assets such as machinery and equipment are expensive. Rather than realizing the full cost of an asset in the first year, companies can use depreciation to spread the cost and equate the depreciation expense with the related income in the same reporting period. This allows a company to amortize the value of an asset over a period of time, primarily its useful life.
Companies depreciate regularly so that they can transfer the cost of their assets from their ownbalanceson its ownincome statements. When a company buys an asset, it records the transaction as a debit to increase an asset account on the balance sheet and a credit to decrease cash (or increase accounts payable), which is also on the balance sheet. None of the accounting entries affect the income statement, where income and expenses are reported.
At the end of an accounting period, an accountant records the depreciation of all capitalized assets that are not fully depreciated. Hecalendarthe entry consists of:
- Demandon depreciation expense, which flows through the income statement
- Creditin accumulated depreciation, which appears on the balance sheet
As noted above, companies can benefit from depreciation both fortaxand accounting purposes. This means they can take a tax deduction for the cost of the asset, reducing the taxable amount. ButIRS(IRS) states that when depreciating assets, companies must spread the cost over time. The IRS also has rules about when companies can obtain asubtraction.
Depreciation is considered a non-cash charge because it does not represent ato withdraw. Any cash outlay may be paid initially when an asset is purchased, but the outlay is recorded over time for financial reporting purposes. This is because assets provide benefits to the company over a long period of time. But depreciation rates still reduce a company's profitability.profits, which is useful for tax purposes.
The correspondence principle underGenerally Accepted Accounting Principles(GAAP) is aprecision accountinga concept that determines that expenses must coincide with the same period in which the respective revenues are generated. Depreciation helps link the cost of an asset to the benefit of using it over time. That is, the additional cost associated with the use of the asset is also recorded for the asset that is put into use each year and createsincome.
The total amount depreciated each year, expressed as a percentage, is called the depreciation rate. For example, if a company has $100,000 in totaldevaluationover the expected life of the asset and the annual depreciation was $15,000. This means that the rate will be 15% per annum.
Buildings and structures can be depreciated, but land is not eligible for depreciation.
Different companies may set their own limits for when depreciation starts a period.fixed assetOProperty, plant and equipment(PP&E). For example, a small business might set a threshold of $500, above which it depreciates an asset. On the other hand, a larger company might set a threshold of $10,000, below which all purchases are immediately counted.
Accumulated depreciationit is aagainst an asset account, that is, your physical balance is a credit that reduces the total value of your equity. The cumulative depreciation of any asset is its cumulative depreciation up to a single point in its life.
As mentioned above, the book value is the net of the asset account and accumulated depreciation. Heransom valueIt is the carrying amount that remains on the balance sheet after which all depreciation is accounted for until the asset is disposed of or sold.
It is based on what a company expects to receive in exchange for the asset at the end of its useful life. The estimated residual value of an asset is an important factor in calculating depreciation.
The IRS publishes depreciation schedules that outline the number of years an asset can depreciate for tax purposes, based on various asset classes.
There are several methods that accountants often use to depreciate capital assets and other income generating assets. These are Straight Line, Declining Balance, Double Declining Balance, Sum of Years Digits, and Unit of Production. We highlight some of the key principles of each below.
using herlinear methodIt is the most basic way to record depreciation. It reports equal depreciation expense each year over the asset's useful life until the entire asset is depreciated to its salvage value.
Suppose a company purchases a machine at a cost of $5,000. The company decides on a salvage value of $1,000 and alifespanfive years old. Based on these assumptions, the depreciable amount is $4,000 ($5,000 cost - $1,000 salvage value).
Annual depreciation using the straight-line method is calculated by dividing the depreciable amount by the total number of years. In this case, it amounts to $800 per year ($4,000 / 5). This results in a depreciation rate of 20% ($800 / $4,000).
Hedeclining balance methodIt is a fast amortization method. This method depreciates the machine at its constant rate of depreciation multiplied by its remaining depreciable value each year. As the book value of an asset is higher in prior years, the same rate results in a higher amount of depreciation expense in prior years, which is reduced each year.
Reduced Balance Depreciation = (Net Book Value - Recovery Value) x (1 / Useful Life) x Depreciation Rate
Using the simple example above, the machine costs $5,000, has a salvage value of $1,000, has a useful life of five years, and is depreciated by 20% each year, so the expense is $800 in the first year ($4,000 depreciable value x 20%), $640 in the second year ($4,000 - $800) x 20%), and so on.
Double Declining Balance (DDB)
Hereduced double balance(DDB) is another accelerated depreciation method. After taking the inverse of the asset's useful life and doubling it, this rate is applied on the depreciation basis -value in books— for the remainder of the expected life of the asset. So it's essentially double the diminishing balance method.
DDB = (Net Book Value - Recoverable Value) x (2 / Useful Life) x Depreciation Rate
For example, an asset with a useful life of five years would have a mutual value of 1/5 or 20%. Double the rate, or 40%, is applied to the asset's current book value for depreciation. Although the interest rate remains constant, the value of the dollar will decrease over time because the interest rate is multiplied by a smaller amortization base for each period.
Sum of Digits of Years (SYD)
Hesum of years digits(SYD) also allows for quick amortization. Start by adding up all the digits of the asset's expected life.
For example, an asset with a useful life of five years would be based on the sum of the digits one through five, or 1 + 2 + 3 + 4 + 5 = 15. In the first year of depreciation, 5/15 of the depreciable base would be depreciated. In the second year, only 4/15 of the depreciable base would be depreciated. This continues until the fifth year has written off the remaining 1/15th of the base.
The depreciation factor is used in both declining balance and double balance calculations.
This method requires an estimate of the total units an asset will produce over its useful life. Depreciation expense is then calculated per year based on the number of units produced. This method also calculates the depreciation cost based on the depreciable amount.
example of depreciation
Here is a hypothetical example to show how depreciation works. However, keep in mind that some types of accounting allow for different forms of depreciation. Assume that if a company buys equipment for $50,000, it can either spend its entire cost in the first year or amortize the value of the asset over its 10-year useful life. That's why business people like depreciation. Most business owners prefer to spend only a portion of the cost, which can add upbig income.
The company can also dispose of the equipment for $10,000 at the end of its useful life, which means it has a salvage value of $10,000. Using these variables, thegiftedIt calculates depreciation expense as the difference between the cost of the asset and its residual value, divided by its useful life. The calculation in this example is ($50,000 - $10,000) / 10. This results in a total depreciation expense of $4,000 per year.
Therefore, the company's accountant does not have to spend all of the $50,000 in the first year, even though the company paid that amount in cash. Instead, the company only needs to spend $4,000 against net income. The company spends another $4,000 the next year, and another $4,000 the next year, and so on, until the asset reaches its salvage value of $10,000 in 10 years.
Why do assets depreciate over time?
New assets are often more valuable than old ones. Depreciation measures the value an asset loses over time, directly from continued use due to wear and tear and indirectly from the introduction of new product models and factors such as inflation.
How are assets depreciated for tax purposes?
Depreciation is often what people are talking about when they refer to accounting depreciation. It is the process of allocating the cost of an asset over its useful life in order to align its expenses with the generation of revenues.
Companies also create accounting depreciation schedules with tax benefits in mind because asset depreciation is deductible as a business expense under IRS rules.
Payback schedules can range from a simple straight line to accelerated or unit rates.
How does amortization differ from amortization?
Depreciation refers only to physical or real estate assets. Amortization is an accounting term that essentially depreciates intangible assets such as intellectual property or loan interest over time.
What is the difference between depreciation expense and accumulated depreciation?
The main difference between depreciation expense and accumulated depreciation is that one appears as an expense on the income statement, while the other is a counter asset reported on the balance sheet.
Both relate to the wear and tear of equipment, machinery or other assets and help determine their true value, which is important to consider when making year-end tax deductions and when a business is sold and assets need of a correct assessment.
While both depreciation entries must be included in quarterly and year-end reports, depreciation expense is the more common of the two due to its application in relation to discounts and can help reduce a company's tax liability. Accumulated depreciation is commonly used to forecast the useful life of an item or to track depreciation from year to year.
Is depreciation considered an expense?
Depreciation is considered an expense for accounting purposes as it results in a cost of doing business. As assets such as machinery are used, they wear out and lose value over their useful lives. Depreciation is recorded as an expense on the income statement.