What Is Depreciation?

Depreciation is an accounting method of allocating the cost of a tangible or physical asset over its useful life or life expectancy. Depreciation represents how much of an asset's value has been used up. Depreciating assets helps companies earn revenue from an asset while expensing a portion of its cost each year the asset is in use. If not taken into account, it can greatly affect profits.

Businesses can depreciate long-term assets for both tax and accounting purposes. For example, companies can take a tax deduction for the cost of the asset, meaning it reduces taxable income. However, the Internal Revenue Service (IRS) states that when depreciating assets, companies must spread the cost out over time. The IRS also has rules for when companies can take a deduction.

Key Takeaways

  • Per the matching principle of accounting, depreciation ties the cost of using a tangible asset with the benefit gained over its useful life.
  • There are many types of depreciation, including straight-line and various forms of accelerated depreciation.
  • Accumulated depreciation refers to the sum of all depreciation recorded on an asset to a specific date.
  • The carrying value of an asset on the balance sheet is its historical cost minus all accumulated depreciation.
  • The carrying value of an asset after all depreciation has been taken is referred to as its salvage value.
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Depreciation

Understanding Depreciation

Depreciation is an accounting convention that allows a company to write off an asset's value over a period of time, commonly the asset's useful life. Assets such as machinery and equipment are expensive. Instead of realizing the entire cost of the asset in year one, depreciating the asset allows companies to spread out that cost and generate revenue from it.

Depreciation is used to account for declines in the carrying value over time. Carrying value represents the difference between the original cost and the accumulated depreciation of the years.

Each company might set its own threshold amounts for when to begin depreciating a fixed asset–or property, plant, and equipment. For example, a small company may set a $500 threshold, over which it depreciates an asset. On the other hand, a larger company may set a $10,000 threshold, under which all purchases are expensed immediately.

For tax purposes, the IRS publishes depreciation schedules detailing the number of years an asset can be depreciated, based on various asset classes.

The entire cash outlay might be paid initially when an asset is purchased, but the expense is recorded incrementally for financial reporting purposes because assets provide a benefit to the company over a lengthy period of time. Therefore, depreciation is considered a non-cash charge since it doesn't represent an actual cash outflow. However, the depreciation charges still reduce a company's earnings, which is helpful for tax purposes.

The matching principle under generally accepted accounting principles (GAAP) is an accrual accounting concept that dictates that expenses must be matched to the same period in which the related revenue is generated. Depreciation helps to tie the cost of an asset with the benefit of its use over time. In other words, each year, the asset is put to use and generates revenue, the incremental expense associated with using up the asset is also recorded.

The total amount that's depreciated each year, represented as a percentage, is called the depreciation rate. For example, if a company had $100,000 in total depreciation over the asset's expected life, and the annual depreciation was $15,000; the rate would 15% per year.

Recording Depreciation

When an asset is purchased, it is recorded as a debit to increase an asset account, which then appears on the balance sheet, and a credit to reduce cash or increase accounts payable, which also appears on the balance sheet. Neither side of this journal entry affects the income statement, where revenues and expenses are reported. In order to move the cost of the asset from the balance sheet to the income statement, depreciation is taken on a regular basis.

At the end of an accounting period, an accountant will book depreciation for all capitalized assets that are not fully depreciated. The journal entry for this depreciation consists of a debit to depreciation expense, which flows through to the income statement, and a credit to accumulated depreciation, which is reported on the balance sheet. Accumulated depreciation is a contra asset account, meaning its natural balance is a credit which reduces the net asset value. Accumulated depreciation on any given asset is its cumulative depreciation up to a single point in its life.

As stated earlier, carrying value is the net of the asset account and accumulated depreciation. The salvage value is the carrying value that remains on the balance sheet after all depreciation has been taken until the asset is sold or otherwise disposed. It is based on what a company expects to receive in exchange for the asset at the end of its useful life. As such, an asset’s estimated salvage value is an important component in the calculation of depreciation.

Example of Depreciation

If a company buys a piece of equipment for $50,000, it could expense the entire cost of the asset in year one or write the value of the asset off over the asset's 10-year useful life. This is why business owners like depreciation. Most business owners prefer to expense only a portion of the cost, which boosts net income.

In addition, the company can scrap 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, the accountant calculates depreciation expense as the difference between the cost of the asset and its salvage value, divided by the useful life of the asset. The calculation in this example is ($50,000 - $10,000) / 10, which is $4,000 of depreciation expense per year.

This means the company's accountant does not have to expense the entire $50,000 in year one, even though the company paid out that amount in cash. Instead, the company only has to expense $4,000 against net income. The company expenses another $4,000 next year and another $4,000 the year after that, and so on until the asset reaches its $10,000 salvage value in ten years.

Types of Depreciation

Straight-Line

Depreciating assets using the straight-line method is typically the most basic way to record depreciation. It reports equal depreciation expense each year throughout the entire useful life until the entire asset is depreciated to its salvage value. The example above used straight-line depreciation.

Assume, for another example, that a company buys a machine at a cost of $5,000. The company decides on a salvage value of $1,000 and a useful life of five years. Based on these assumptions, the depreciable amount is $4,000 ($5,000 cost - $1,000 salvage value) and the annual depreciation using the straight-line method is: $4,000 depreciable amount / 5 years, or $800 per year. As a result, the depreciation rate is 20% ($800/$4,000). The depreciation rate is used in both the declining balance and double-declining balance calculations.

Declining Balance

The declining balance method is an accelerated depreciation method. This method depreciates the machine at its straight-line depreciation percentage times its remaining depreciable amount each year. Because an asset's carrying value is higher in earlier years, the same percentage causes a larger depreciation expense amount in earlier years, declining each year.

Using the straight-line example above, the machine costs $5,000, has a salvage value of $1,000, a 5-year life, and is depreciated at 20% each year, so the expense is $800 in the first year ($4,000 depreciable amount * 20%), $640 in the second year (($4,000 - $800) * 20%), and so on.

Double Declining Balance (DDB)

The double-declining balance (DDB) method is another accelerated depreciation method. After taking the reciprocal of the useful life of the asset and doubling it, this rate is applied to the depreciable base, book value, for the remainder of the asset’s expected life. For example, an asset with a useful life of five years would have a reciprocal value of 1/5 or 20%. Double the rate, or 40%, is applied to the asset's current book value for depreciation. Although the rate remains constant, the dollar value will decrease over time because the rate is multiplied by a smaller depreciable base each period.

Sum-of-the-Year's-Digits (SYD)

The sum-of-the-year’s-digits (SYD) method also allows for accelerated depreciation. To start, combine all the digits of the expected life of the asset. For example, an asset with a five-year life would have a base of the sum of the digits one through five, or 1+ 2 + 3 + 4 + 5 = 15. In the first depreciation year, 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 year five depreciates the remaining 1/15 of the base.

Units of Production

This method requires an estimate for 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 depreciation expenses based on the depreciable amount.