It is an essential concept that is used to account for the wear and tear that an asset undergoes as it is used.
What is Depreciation?
Depreciation is a method used in accounting to allocate the cost of a physical or tangible asset over its useful lifespan. When a company purchases a tangible asset, such as a vehicle or machinery, it does not expense the entire cost in the year of purchase. Instead, it spreads the cost over the useful life of the asset, which is typically several years.
Why is Depreciation Important?
Depreciation is important for several reasons. First, it helps to match the cost of an asset with the revenue that it generates. For example, if a company purchases a piece of machinery for $100,000 that is expected to last for ten years, it would not be appropriate to expense the entire $100,000 in the year of purchase. Instead, the cost would be spread out over the ten-year life of the asset, with $10,000 being expensed each year. This helps to ensure that the cost of the asset is matched with the revenue that it generates.
Second, depreciation is important for tax purposes. In the United States, the Internal Revenue Service (IRS) allows businesses to deduct a portion of the cost of an asset each year as a depreciation expense. This helps to reduce the business's taxable income and, therefore, its tax liability.
Third, depreciation is important for financial reporting purposes. Generally accepted accounting principles (GAAP) require that companies report the value of their assets on their balance sheet at their net book value, which is the cost of the asset less any accumulated depreciation. Therefore, accurately calculating and reporting depreciation is crucial for companies to provide accurate financial statements to investors and other stakeholders.
How is Depreciation Calculated?
There are several methods that can be used to calculate depreciation. The most common methods are the straight-line method and the declining balance method.
Straight-Line Method - The straight-line method is the simplest and most commonly used method of depreciation. Under this method, the cost of an asset is spread out evenly over its useful life. To calculate the depreciation expense using the straight-line method, you divide the cost of the asset by its useful life. For example, if a company purchases a vehicle for $20,000 that has a useful life of five years, the annual depreciation expense would be $4,000 ($20,000 divided by five years).
Declining Balance Method - The declining balance method is an accelerated method of depreciation that is used to calculate higher depreciation expenses in the early years of an asset's life and lower expenses in later years. Under this method, a fixed percentage (known as the depreciation rate) is applied to the asset's net book value each year. The net book value is the asset's cost less any accumulated depreciation.
For example, if a company purchases a piece of machinery for $100,000 with a useful life of five years and a depreciation rate of 40%, the first year's depreciation expense would be $40,000 (40% of $100,000). The second year's depreciation expense would be $24,000 (40% of the remaining net book value of $60,000), and so on until the net book value reaches zero.
Other Methods of Depreciation
There are several other methods of depreciation that can be used, including the sum-of-the-years' digits method and the units-of-production method. These methods are typically used when the asset's usefulness or value is not expected to decline evenly over its useful life, or when the asset is not used equally in each year of its life.
The sum-of-the-years' digits method is an accelerated method of depreciation that assigns more of the asset's cost to the early years of its life. This method takes the sum of the digits of the useful life of the asset and assigns a percentage of the asset's cost to each year based on the year's digit. For example, if an asset has a useful life of five years, the sum of the digits is 15 (1+2+3+4+5). In the first year, 5/15 of the asset's cost would be expensed, in the second year 4/15, and so on until the asset's cost has been fully expensed.
The units-of-production method is used when an asset's usefulness is related to its output rather than its age. Under this method, depreciation is calculated based on the number of units that the asset is expected to produce over its useful life. For example, if a machine is expected to produce 100,000 units over its useful life and it cost $100,000, the depreciation expense per unit would be $1 ($100,000 divided by 100,000 units).
What is Accumulated Depreciation?
Accumulated depreciation is a contra asset account that is used to track the total amount of depreciation that has been expensed on an asset over its useful life. As the name suggests, accumulated depreciation is the sum of all the depreciation expenses that have been recorded to date. Accumulated depreciation is a credit balance, which means that it reduces the asset's book value on the balance sheet.
For example, if a company has a piece of machinery that cost $100,000 and has a useful life of ten years, the annual depreciation expense would be $10,000 per year. After five years, the accumulated depreciation on the machinery would be $50,000 ($10,000 per year for five years). The net book value of the machinery would be $50,000 ($100,000 cost less $50,000 accumulated depreciation).
What Assets Can be Depreciated?
Not all assets can be depreciated. In order for an asset to be depreciated, it must meet the following criteria:
- The asset must be owned by the business. Leased assets cannot be depreciated.
- The asset must have a determinable useful life. This means that the business must be able to estimate how long the asset will be useful before it needs to be replaced or disposed of.
- The asset must be used in the business's operations. Assets that are held for investment purposes, such as stocks or bonds, cannot be depreciated.
Amortization vs Depreciation