What is depreciation?
Depreciation is an accounting method for allocating the cost of a tangible or physical asset over its useful life or its life expectancy. Depreciation represents the part of the value of an asset that has been used. Depreciation of assets helps businesses earn income from an asset while accounting for a portion of its cost each year the asset is used. If not taken into account, it can significantly affect profits.
Businesses can amortize long-lived assets for tax and accounting purposes. For example, businesses may benefit from a tax deduction for the cost of the asset, which means it reduces taxable income. However, the Internal Revenue Service (IRS) states that when depreciating assets, companies must spread the cost over time. The IRS also has rules for when businesses can take a deduction.
Key points to remember
- According to the accounting correspondence principle, depreciation links the cost of using a tangible asset to the advantage 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 specific date.
- The carrying amount of an asset on the balance sheet corresponds to its historical cost less accumulated depreciation.
- The carrying amount of an asset after full depreciation is called its salvage value.
Amortization is an accounting policy that allows a business to write off the value of an asset over a period of time, typically the useful life of the asset. Assets such as machinery and equipment are expensive. Instead of realizing the entire cost of the asset during the first year, depreciation of the asset allows companies to spread this cost and generate income.
Amortization is used to account for decreases in book value over time. The book value represents the difference between the original cost and the accumulated depreciation for years.
Each company can set its own thresholds as to when to start depreciating an item of property, plant and equipment. For example, a small business may set a threshold of $ 500, above which it depreciates an asset. On the other hand, a large business can set a threshold of $ 10,000, below which all purchases are expensed immediately.
For tax purposes, the IRS publishes depreciation tables detailing the number of years during which an asset can be depreciated, based on different asset classes.
All cash expenses can be paid initially when purchasing an asset, but the expenses are recorded incrementally for financial reporting purposes because the assets provide a benefit to the business over a long period of time. Therefore, depreciation is considered a non-monetary expense as it does not represent an actual cash outflow. However, depreciation charges always reduce a company’s profits, which is useful for tax purposes.
The principle of matching according to generally accepted accounting principles (GAAP) is an accrual accounting concept which dictates that expenses must be matched in the same period during which the related revenues are generated. Depreciation makes it possible to link the cost of an asset to the benefit of its use over time. In other words, each year the asset is put into service and generates income, the additional expenses associated with the use of the asset are also recorded.
The total amount amortized each year, represented as a percentage, is called the depreciation rate. For example, if a business had $ 100,000 in total depreciation over the expected life of the asset and the annual depreciation was $ 15,000; the rate would be 15% per year.
When an asset is purchased, it is recorded as a debit to increase an asset account, which then appears on the balance sheet, and as 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 income and expenses are reported. In order to shift the cost of the asset from the balance sheet to the income statement, depreciation is taken regularly.
At the end of an accounting period, an accountant will record depreciation for all fixed assets that are not fully depreciated. The journal entry for this depreciation consists of a debit to the depreciation charge, which goes through the income statement, and a credit to the accumulated depreciation, which is carried over to the balance sheet. Accumulated depreciation is a counter-asset account, which means that its natural balance is a credit that reduces the net asset value. The accumulated depreciation on a given asset corresponds to its accumulated depreciation up to a single point in its life.
As indicated above, the book value is net of the asset account and accumulated depreciation. The salvage value is the book value that remains on the balance sheet after all depreciation has been taken until the asset is sold or otherwise disposed of. It is based on what a company expects to receive in exchange for the asset at the end of its useful life. As such, the estimated salvage value of an asset is an important element in calculating depreciation.
If a business purchases a piece of equipment for $ 50,000, it could cost the entire cost of the asset in the first year or write off the value of the asset over its 10-year useful life. This is why business owners love depreciation. Most business owners prefer to spend only part of the cost, which increases net income.
In addition, the company can abandon the equipment for $ 10,000 at the end of its useful life, which means that it has a salvage value of $ 10,000. Using these variables, the accountant calculates the 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 equals $ 4,000 of depreciation per year.
This means that the business accountant does not have to spend all of the $ 50,000 in the first year, even if the business paid this amount in cash. Instead, the company only has to shell out $ 4,000 for its bottom line. The company is spending another $ 4,000 next year and $ 4,000 the following year, and so on until the asset reaches its recovery value of $ 10,000 in ten years.
Depreciation of assets using the straight-line method is generally the easiest way to record depreciation. It has an equal depreciation charge each year for the entire useful life until the entire asset is depreciated at its salvage value. The example above uses straight-line depreciation.
Suppose, for another example, that a company purchases 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. Under these assumptions, the depreciable amount is $ 4,000 (cost of $ 5,000 – salvage value of $ 1,000) and the annual depreciation using the straight-line method is $ 4,000 depreciable amount / 5 years, or $ 800 per year. Therefore, the depreciation rate is 20% ($ 800 / $ 4,000). The depreciation rate is used in the declining balance and double declining balance calculations.
The declining balance method is an accelerated amortization method. This method depreciates the machine according to its percentage of linear depreciation multiplied by the depreciable amount remaining each year. Since the book value of an asset is higher in previous years, the same percentage results in a higher depreciation charge in previous years, which decreases each year.
Using the linear example above, the machine costs $ 5,000, has a salvage value of $ 1,000, a service life of 5 years, and is amortized at 20% each year, so the expense is $ 800 the first year (depreciable amount of $ 4,000 * 20%), $ 640 the second year (($ 4,000 – $ 800) * 20%), etc.
Double declining balance (DDB)
Another method of accelerated depreciation is the double declining balance method (DDB). After taking the inverse of the useful life of the asset and doubling it, this rate is applied to the depreciable base, the book value, for the remainder of the expected life of the asset. 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 current carrying amount of the asset for depreciation. Although the rate remains constant, the dollar value will decrease over time because the rate is multiplied by a smaller depreciable base in each period.
Figures for the sum of the year (SYD)
The sum of the year figures (SYD) method also allows accelerated depreciation. To get started, combine all the numbers for the asset’s expected life. For example, an asset with a useful life of five years would have a base of the sum of the digits from one to five, or 1+ 2 + 3 + 4 + 5 = 15. In the first year of depreciation, 5 / 15 of the basic depreciation would be depreciated. In the second year, only 4/15 of the depreciable base would be depreciated. This continues until the fifth year depreciates the remaining 1/15 of the base.
This method requires an estimate of the total number of units that an asset will produce during its useful life. The depreciation charge is then calculated per year based on the number of units produced. This method also calculates depreciation based on the depreciable amount.