DepreciationDefined along with Formulas & How to Calculate
Depreciation describes the accounting principle for spreading the cost of an asset over its expected useful life.
This helps organizations to record the cost of an asset over the periods in which it is used and understand how much of its value has been used.
This basic accounting method can have a considerable impact on an organization’s recorded profits and tax burden.
There are several distinct ways to calculate depreciation, including accelerated depreciation and the most well-known method, “straight-line depreciation.”
Let’s take a look at what these methods are trying to achieve and the different ways that you can calculate them.
Physical assets are often costly but provide returns over a number of years.
Instead of accounting for an asset all at once, it can be a better measurement of the value of an asset to instead spread this cost out over the period in which it generates revenue.
This concept is called depreciation, and this allows an organization to record an asset’s cost and then allocate it over its entire estimated life.
Whenever an asset is purchased, it is recorded on the balance sheet as a debit to a specific asset account, and a corresponding credit is also made either to the cash account or to accounts payable, depending on how the asset was paid for.
At this point, all changes are made to the balance sheet, not to the income statement, as the asset has not been expensed.
From here on out, the asset will be “depreciated” at the end of every accounting period with a debit to the depreciation expense account, which will move to the income statement and with a credit to the accumulated depreciation account on the balance sheet.
Over time this will reduce the “carrying value” of the asset, which is the difference between the starting value of the asset and the accumulated depreciation.
Accounting for depreciation offers several advantages both for accounting purposes and for taxes.
By accounting for depreciation, the Internal Revenue Service (IRS) allows organizations to receive a tax deduction for the cost of the asset.
However, in order to do this, the IRS requires assets to be depreciated on a particular schedule which is provided for a variety of asset classes depreciation schedules which the IRS provides.
Additionally, the IRS has particular procedures that must be followed in order to claim a deduction.
Considerations When Calculating for Depreciation
Many people find accounting for depreciation confusing due to the lack of actual cash flow.
Often the actual cash outlay is entirely paid for when the asset is acquired.
However, the expense is recorded in increments spread out over the life of the asset.
Regardless of the lack of an actual cash charge, the depreciation expense will still reduce the earnings a company records and affect the taxes a company will be responsible for.
This concept also follows the matching principle, which is a core part of Generally Accepted Accounting Principles (GAAP).
This principle states that expenses should always be matched to the period in which they help generate revenue.
Not only does this help to keep your accounting in line with GAAP, which is required in many cases, but it will help the user to see how the cost of the asset aligns with the revenue it generates as well as the remaining value of an asset.
The amount that an asset depreciates every year will be represented as a percentage which is referred to as the depreciation rate.
This rate is an important calculation in several methods of calculating depreciation; as an example of how it works, consider an asset with $50,000 to depreciate over its useful life with an annual depreciation of $10,000.
Under these assumptions, the depreciation rate would be 20%.
When To Depreciate an Asset
Organizations may set their own thresholds for when to depreciate fixed assets or property, plant, and equipment instead of directly expensing it all at once.
Often this depends on the size of an organization as what may be a significant expense for one purchaser may be small for another.
The IRS suggests two possible thresholds of $2,500 or $5,000; however, this is not a requirement, only a suggestion.
What is required is that this threshold is consistent between an organization’s thresholds for accounting purposes and tax purposes.
As an asset is depreciated, this amount is placed into the accumulated depreciation account.
This account is a “contra asset account,” which means that it will have a natural balance of zero or a credit balance that will reduce net asset value.
This account can accumulate on any given asset up to a certain point where all of the asset’s value has been spent except for its salvage value which is often known as scrap value.
An asset’s salvage value is what the asset can be sold for after its useful life has passed, and this can be an important figure for calculating depreciation.
Notably, carrying value which is often referenced when considering the value of an organization’s assets, is the difference between the accumulated depreciation and an asset’s cost and provides owners an idea of what the current asset’s value is and what remains to be depreciated.
Different Types of Depreciation
The most general calculation for depreciation is:
The total cost of an asset – the salvage value ÷ the number of years of the asset’s useful life.
However, there are several different means to calculate depreciation, each with its own formulas.
Let’s look at them and how to calculate each method.
Straight Line Depreciation
Straight-line depreciation is the easiest and most straightforward way to account for depreciation.
In this method, depreciation will be recorded in equal increments from start to finish throughout the useful life of the asset until it reaches its salvage value.
For example, consider a company that purchases equipment costing $10,000 with an estimated salvage value of $2,000 and a useful life of four years.
Using these assumptions, the amount that could be depreciated would be $8,000, the difference between the cost of $10,000 minus the $2,000 salvage cost.
Next, the annual depreciation would be found by taking the depreciable amount and dividing it by the number of years over which it will be depreciated.
In our example, the annual depreciation will be $2,000 ($8,000 depreciable amount ÷ 4).
Now we can find the depreciation rate by dividing our annual depreciation rate by the depreciable amount, which in our case results in a depreciation rate of 25% ($2,000 ÷ $8,000).
Declining Balance Depreciation
The declining balance method, also known as the reducing balance method, tags the straight-line depreciation percentage and then multiplies it by the remaining depreciable amount every year.
This results in an accelerated rate of depreciation with a larger amount depreciated in the earlier years of an asset’s life and a less astute asset becoming older.
Often this is a better depiction of the value of an asset for assets that decline in value quickly, such as computer equipment.
Taking the same example which we used for straight-line depreciation, the machine had an initial cost of $10,000, a salvage value of $2,000, a useful life of four years, and a depreciation rate of 25%.
Using the declining balance method, we would take the depreciable amount of $8,000 and multiply it by the depreciation rate of 25% for the first year for $2,000 in depreciation ($8,000 * 25%).
$1,500 for the second year ($6,000 * 25%), and $1,125 in the third ($4,500 * 25%).
This would continue through the useful life of the asset.
Double Declining Balance (DDB)
The double-declining balance method of depreciation also uses accelerated depreciation.
To calculate depreciation using this method, the reciprocal of the asset’s useful life is doubled and multiplied by the depreciable base.
This is done for the entire life of the asset.
An example of this would be a company that has some equipment that has a useful life of ten years.
To use the double-declining balance method, the reciprocal of ten would be used to calculate the depreciation rate of 10%.
Then the book value of the asset from the beginning of the period would be multiplied by twice the depreciation rate, which would be 20%.
This value would then be subtracted from the beginning period book value.
This will continue for each period until the asset is fully depreciated.
The sum-of-the-year’s-digits (SYD) is a method of depreciation that allows a business to allocate more of the depreciation expense in the initial years of the asset’s useful life.
To use the method, all of the digits of the asset’s useful life are added together.
For example, for a desk with a seven-year life, the years are added together, so 1+2+3+4+5+6+7 = 28.
Then, for the first year of depreciation, the base would be multiplied by 7/15 to calculate the depreciation expense for the year.
In the second year, the base would be multiplied by 6/28 to obtain the depreciation expense.
This would continue for all seven years.
If the desk were $14,000, it would work as below:
Year 1 depreciation expense = $14,000 * 7/28 = $3,500
Year 2 depreciation expense = $14,000 * 6/28 = $3,000
Year 3 depreciation expense = $14,000 * 5/28 = $2,500
Year 4 depreciation expense = $14,000 * 4/28 = $2,000
Year 5 depreciation expense = $14,000 * 3/28 = $1,500
Year 6 depreciation expense = $14,000 * 2/28 = $1,000
Year 7 depreciation expense = $14,000 * 1/28 = $500
At this point, the desk is fully depreciated.
Units of Production Depreciation
Units of production depreciation allow depreciation to be calculated based on an asset’s usage, which is often useful for machinery.
However, this method of depreciation can only be used when an estimate can be made of the total number of units an asset can produce over the course of its useful life.
To calculate the depreciation rate per unit, the depreciable amount is calculated, which is the cost of an asset minus its salvage value and then divided by the total number of units the asset will produce over its useful life.
This will give you the units of production rate, which is then multiplied by the actual units produced in a given year.
Many businesses find depreciation useful due to the fact that it allows them to expense the cost of an asset over time rather than entirely in the year of purchase.
Doing this increases the net income in the year of purchase.
If a business bought some office furniture for $28,000, they could expense it all in the year of the purchase or write it off over the next seven years for a depreciation expense of $4,000 a year.
Typically, a business would prefer to expense the furniture over time so as to boost its income in the year of purchase.
If the business plans to sell the furniture at the end of its useful life, it will need to subtract the salvage value from the cost of the asset before determining the yearly depreciation expense.
If the furniture had a salvage value of $7,000, this would be subtracted from the cost of $28,000, leaving a depreciable amount of $21,000.
The $21,000 would then be divided by the useful life of the furniture of seven years ($21,000/7 years = $3,000).
This would mean a yearly depreciation expense of $3,000 for seven years, at which point the asset would reach its salvage value.
This example uses straight-line depreciation.
Why Are Assets Depreciated Over a Period of Time?
Assets are depreciated over time to reflect the fact that they decrease in value over time.
Depreciation is used in accounting to record monetary value that an asset loses through wear and tear over its useful life or through inflation or new products or models being released.
How Are Assets Depreciated for Tax Purposes?
An asset is depreciated by taking its cost and allocating it over the life expectancy or useful life of the asset.
This process helps to match the expense of the asset with the revenue it generates.
There are different methods of depreciation that can be used, such as straight-line, sum-of-the-year’s digits, and declining- balance.
Many businesses choose to make an accounting depreciation schedule that can be used when they are preparing taxes since the depreciation on a business’s assets is a deductible business expense.
Although it is essential to follow IRS rules when using the deduction.
What Is the Difference Between Amortization and Depreciation?
Amortization and depreciation differ in what they are used to depreciate.
Amortization is used to depreciate interest or intangible assets, including trademarks or franchise agreements.
In contrast, depreciation is used for property or physical assets, such as office equipment or machinery.
How Are Depreciation Expense and Accumulated Depreciation Different?
Both depreciation expense and accumulated depreciation help keep track of the wear and tear on assets such as machinery or equipment over time.
This is essential when filing taxes or if a business is being sold since an accurate valuation of all assets is necessary.
The main difference between depreciation expense and accumulated depreciation is where they are recorded.
Depreciation expense is recorded on the income statement; whereas, accumulated depreciation is recorded as a contra asset on a business’s balance sheet.
Accumulated depreciation and depreciation expense should both appear on quarterly reports and yearly reports.
However, this is more common with depreciation expense as it is used for tax deductions, thus potentially lowering a business’s taxes.
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IRS.gov "Publication 946 (2020), How To Depreciate Property" Page 1. November 8, 2021
IRS.gov "Topic No. 704 Depreciation" Page 1. November 8, 2021
IRS.gov "Depreciation FAQ's" Page 1 - 6. November 8, 2021