What Is Depreciation?
Depreciation is an accounting method of allocating the cost of a tangible fixed asset over its useful life. Companies use depreciation to account for declines in an asset’s value over time due to factors like wear and tear, age, and technological obsolescence. This practice allows businesses to match the expense of using the asset with the revenue it generates. In essence, depreciation spreads out the initial cost of an asset, financially, across multiple accounting periods, ensuring the matching principle of accounting is upheld. Depreciation is calculated and recorded periodically, usually annually, and it reflects as a non-cash expense on the financial statements.
Examples of Depreciation
Straight-Line Depreciation Example
A company purchases a delivery truck for $50,000. The truck is expected to have a useful life of 10 years, with a salvage value of $5,000 at the end of its useful life. Under the straight-line method:
- Depreciable amount = $50,000 (cost) - $5,000 (salvage value) = $45,000
- Annual depreciation expense = $45,000 / 10 years = $4,500
Declining Balance Depreciation Example
The same company decides to use a declining balance method with a rate of 20% for another asset that costs $15,000. Here’s how the calculation would look:
- Year 1: Depreciation = 20% of $15,000 = $3,000
- Year 2: Depreciation = 20% of ($15,000 - $3,000) = 20% of $12,000 = $2,400
Frequently Asked Questions (FAQs)
What are the different methods of calculating depreciation?
Common methods include:
- Straight-Line Depreciation: Spreads the cost of the asset evenly over its useful life.
- Declining Balance Depreciation: Applies a constant rate of depreciation to the decreasing book value of the asset each year.
- Units of Production Depreciation: Depreciates the asset based on its usage, work produced, or hours in operation.
- Sum-of-the-Years’-Digits Depreciation: Accelerates the depreciation process more than straight-line but less so than declining balance.
Can land be depreciated?
No, according to GAAP and IFRS, land is not subject to depreciation because it does not have a finite useful life and does not lose value through use.
Is depreciation a tax-deductible expense?
Yes, depreciation is a non-cash expense that can reduce taxable income, effectively lowering a business’s tax liabilities.
How do you account for depreciation in financial statements?
Depreciation is listed as an expense on the income statement and also reduces the book value of an asset on the balance sheet. It does not directly affect cash flow, though it can influence a company’s tax payments.
What is accumulated depreciation?
Accumulated depreciation is the total amount of depreciation expensed on an asset since it was put into use. It is recorded on the balance sheet and reduces the gross amount of tangible fixed assets.
Related Terms
- Amortization: Similar to depreciation but applies to intangible assets such as patents, trademarks, and goodwill.
- Salvage Value: The estimated residual value of an asset at the end of its useful life.
- Book Value: The value of an asset as shown on a company’s balance sheet, calculated as the cost of the asset minus accumulated depreciation.
- Useful Life: The period over which an asset is expected to be useful to the owner.
- Write-off: When an asset or part of an asset is expensed off fully because it is no longer useful or has lost its value.
Online References
- Investopedia - Depreciation
- IRS - Publication 946: How to Depreciate Property
- Accounting Coach - Depreciation
- GAAP vs. IFRS Depreciation Methods
Suggested Books for Further Studies
- Intermediate Accounting by Donald E. Kieso, Jerry J. Weygandt, and Terry D. Warfield
- Financial Accounting: An Introduction to Concepts, Methods and Uses by Roman L. Weil, Katherine Schipper, Jennifer Francis
- Principles of Accounting Volume 1 - Financial Accounting by Christine Jonick
- Depreciation and Amortization Guide by Deloitte
- Wiley GAAP 2021: Interpretation and Application of Generally Accepted Accounting Principles by Joanne M. Flood
Accounting Basics: “Depreciation” Fundamentals Quiz
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