Depreciation

What depreciation means

Depreciation is the way businesses spread the cost of a long-lived asset over time. When you buy equipment, a vehicle, or a building, you do not record the whole cost as an expense the day you buy it. Instead you record part of the cost each year. That part is the depreciation expense.

Depreciation helps match the cost of the asset with the revenue the asset helps produce. It also shows how the asset loses value over time.

Key terms

• Cost: what you paid for the asset, including taxes and shipping.
• Useful life: how long you expect to use the asset.
• Salvage value: the expected value at the end of the asset's life.
• Accumulated depreciation: the total depreciation recorded so far.
• Book value: cost minus accumulated depreciation.
• Depreciation expense: the amount recorded as expense for a period.

Why depreciation matters

• It spreads a large cost over many periods.
• It matches expense to revenue in the same periods.
• It affects profit and taxes.
• It shows the remaining value of assets on the balance sheet.

Main depreciation methods

1. Straight-line

   • Formula: (Cost - Salvage) / Useful life
   • Same expense every year
   • Simple and common

2. Declining balance

   • Accelerated method. More expense early, less later.
   • Double-declining balance example:
     • Rate = 2 / Useful life
     • Depreciation = Rate * Book value at start of year
     • Stop when book value equals salvage

3. Units of production

   • Based on actual use.
   • Formula: (Cost - Salvage) * (Units used / Total estimated units)
   • Good for machines that wear based on hours or output

4. Sum-of-years-digits

   • Another accelerated method.
   • Fraction uses remaining life over sum of years 1 to n.
   • Produces larger expense early on.

Simple examples

Straight-line example:

• Cost: $10,000
• Salvage: $1,000
• Useful life: 5 years
• Annual depreciation = (10,000 - 1,000) / 5 = $1,800
• After 3 years, accumulated depreciation = 3 * 1,800 = $5,400
• Book value after 3 years = 10,000 - 5,400 = $4,600

Double-declining example:

• Cost: $10,000
• Salvage: $1,000
• Useful life: 5 years
• Rate = 2 / 5 = 40%
• Year 1 depreciation = 40% * 10,000 = $4,000
• Book value end of year 1 = 10,000 - 4,000 = $6,000
• Year 2 depreciation = 40% * 6,000 = $2,400
• Continue until you reach salvage value

Units of production example:

• Cost: $50,000
• Salvage: $5,000
• Total estimated units: 100,000 hours
• Used this year: 10,000 hours
• Depreciation = (50,000 - 5,000) * (10,000 / 100,000) = 4,500

How to record depreciation

Journal entry each period:

• Debit Depreciation Expense
• Credit Accumulated Depreciation

Accumulated depreciation is a contra asset account. It reduces the gross asset on the balance sheet. Depreciation expense shows on the income statement.

Disposal or sale of an asset

When you sell or dispose of an asset:

• Remove the asset cost from books.
• Remove accumulated depreciation for that asset.
• Compare sale proceeds to book value.
  • If proceeds are higher than book value, record a gain.
  • If proceeds are lower, record a loss.

Example:

• Asset cost $10,000, accumulated depreciation $7,000, book value $3,000.
• Sold for $4,000.
• Gain = 4,000 - 3,000 = 1,000.

Accounting depreciation vs tax depreciation

• Financial accounting aims to match expenses with revenues.
• Tax rules decide how you deduct costs for tax purposes.
• In the US, MACRS and bonus depreciation can accelerate tax deductions.
• Companies often have two sets of records: book depreciation and tax depreciation.
• The difference creates deferred tax items on the balance sheet.

Common mistakes

• Treating repairs as depreciation. Repairs are expenses. Improvements are capitalized and depreciated.
• Ignoring salvage value or using unrealistic useful life.
• Letting depreciation go to zero when asset still in use.
• Forgetting accumulated depreciation when selling assets.

How to choose a method

• Use straight-line for simplicity and even expense.
• Use accelerated methods when asset loses value fast early on.
• Use units of production when wear depends on use.
• Consider tax rules and company policy.

Quick checklist for accountants

• Record cost correctly at acquisition.
• Choose method and useful life.
• Calculate and record depreciation each period.
• Update accumulated depreciation.
• Adjust at disposal or sale.
• Revisit estimates if use or life changes.

Short FAQ

• Does depreciation mean cash leaves the business? No. Depreciation is a noncash expense.
• Is land depreciable? No. Land usually does not depreciate.
• Can you change the method later? Changing methods for accounting requires justification and disclosure. Tax rules may restrict changes.

Depreciation is simple in idea and important in practice. It tells you how cost moves from the balance sheet to the income statement over time. Get the inputs right and the rest follows.