What Is Depreciation, and How Is It Calculated?

What Is Depreciation?

The term depreciation refers to an accounting method used to allocate the cost of a tangible or physical asset over its useful life. Depreciation represents how much of an asset’s value has been used. It allows companies to earn revenue from their assets by paying for them over a certain period.

Because companies don’t have to account for them entirely in the year the assets are purchased, the immediate cost of ownership is significantly reduced. Not accounting for depreciation can greatly affect a company’s profits. Companies can also depreciate long-term assets for both tax and accounting purposes.

Depreciation can be compared with amortization, which accounts for the change in value over time of intangible assets.

KEY TAKEAWAYS

Depreciation ties the cost of using a tangible asset with the benefit gained over its useful life.
There are many types of depreciation, including straight-line and various forms of accelerated depreciation.
Accumulated depreciation is the sum of all depreciation recorded on an asset to a specific date.
The carrying value of an asset on the balance sheet is its historical cost minus all accumulated depreciation.
The carrying value of an asset after all depreciation has been taken is referred to as its salvage value.

Understanding Depreciation

Assets such as machinery and equipment are expensive. Instead of realizing the entire cost of an asset in year one, companies can use depreciation to spread out the price and match depreciation expenses to related revenues in the same reporting period. This allows a company to write off an asset’s value over time, notably its helpful life.

Companies take depreciation regularly to move their assets’ costs from their balance sheets to their income statements. When a company buys an asset, it records the transaction as a debit to increase an asset account on the balance sheet and a credit to reduce cash (or increase accounts payable), which is also on the balance sheet. Neither journal entry affects the income statement, where revenues and expenses are reported.1

At the end of an accounting period, an accountant books depreciation for all capitalized assets that are not fully depreciated. The journal entry consists of a:

Debit to depreciation expense, which flows through to the income statement
Credit to accumulated depreciation, which is reported on the balance sheet

As noted above, businesses can use depreciation for tax and accounting purposes. This means they can take a tax deduction for the asset’s cost, reducing taxable income. But the Internal Revenue Service (IRS) states that companies must spread the cost out over time when depreciating assets. The IRS also has rules for when companies can take a deduction.2

Special Considerations

Depreciation is considered a non-cash charge because it doesn’t represent an actual cash outflow. The entire cash outlay might be paid initially when an asset is purchased, but the expense is recorded incrementally for financial reporting purposes. That’s because assets benefit the company over a lengthy period. But the depreciation charges still reduce a company’s earnings, which is helpful for tax purposes.3

Under generally accepted accounting principles (GAAP), the matching principle is an accrual accounting concept that dictates that expenses must be matched to the same period in which the related revenue is generated. Depreciation helps to tie an asset’s cost with its user’s benefit over time. In other words, the incremental expense associated with using up the asset is also recorded for the asset used each year and generates revenue.

The total amount depreciated each year, which is represented as a percentage, is called the depreciation rate. For example, if a company had $100,000 in total depreciation over the asset’s expected life, and the annual depreciation was $15,000. This means the rate would be 15% per year.

Fast Fact

Buildings and structures can be depreciated, but the land is not eligible for depreciation.

Threshold Amounts

Different companies may set their threshold amounts for when to begin depreciating a fixed asset or property, plant, and equipment (PP&E). For example, a small company may set a $500 threshold over which it depreciates an asset. On the other hand, a larger company may set a $10,000 threshold, under which all purchases are expensed immediately.

Accumulated Depreciation

Accumulated depreciation is a contra-asset account, meaning its natural balance is a credit that reduces its overall asset value. Accumulated depreciation on any given asset is its cumulative depreciation up to a single point in its life.

As stated earlier, carrying value is the net of the asset account and the accumulated depreciation. The salvage value is the carrying value that remains on the balance sheet, after which all depreciation is accounted for until the asset is disposed of or sold.

It is based on what a company expects to receive in exchange for the asset at the end of its useful life. An asset’s estimated salvage value is an essential component in calculating depreciation.

KEY TAKEAWAYS

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Types of Depreciation

There are several methods that accountants commonly use to depreciate capital assets and other revenue-generating assets. These are straight-line, declining balance, double-declining balance, sum-of-the-years’ digits, and production unit. We’ve highlighted some of the basic principles of each below.

Straight-Line

Using the straight-line method is the most basic way to record depreciation. It reports an equal depreciation expense each year throughout the entire useful life of the asset until the whole asset is depreciated to its salvage value.

Let’s assume that a company buys a machine for $5,000. The company decides on a salvage value of $1,000 and a useful life of five years. Based on these assumptions, the depreciable amount is $4,000 ($5,000 cost – $1,000 salvage value).

The straight-line method calculates annual depreciation by dividing the depreciable amount by the total number of years. In this case, it amounts to $800 annually ($4,000 / 5). This results in a depreciation rate of 20% ($800 / $4,000).

Declining Balance

The declining balance method is an accelerated depreciation method. This method depreciates the machine at its straight-line depreciation percentage times its remaining depreciable amount each year. Because an asset’s carrying value is higher in earlier years, the same percentage causes a larger depreciation expense amount in earlier years, declining each year.

Using the straight-line example above, the machine costs $5,000, has a salvage value of $1,000, a five-year life, and is depreciated at 20% each year, so the expense is $800 in the first year ($4,000 depreciable amount x 20%), $640 in the second year (($4,000 – $800) x 20%), and so on.

Double-Declining Balance (DDB)

The double-declining balance (DDB) method is another accelerated depreciation method. After taking the reciprocal of the asset’s useful life and doubling it, this rate is applied to the depreciable base—its book value—for the remainder of the asset’s expected life. Thus, it is essentially twice as fast as the declining balance method.

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 asset’s current book value for depreciation. Although the rate remains constant, the dollar value will decrease over time because the rate is multiplied by a smaller depreciable base for each period.

Sum-of-the-Years Digits (SYD)

The sum-of-the-years’ digits (SYD) method also allows for accelerated depreciation. Start by combining all the digits of the expected life of the asset.

For example, an asset with a five-year life would have a base of the sum of the digits one through five, or 1 + 2 + 3 + 4 + 5 = 15. In the first depreciation year, 5/15 of the depreciable base would be depreciated. Only 4/15 of the depreciable base would be depreciated in the second year. This continues until year five depreciates the remaining 1/15 of the base.

The depreciation rate is used in declining and double-declining balance calculations.

Units of Production

This method requires estimating the total units an asset will produce over its useful life. Depreciation expense is calculated per year based on the number of units produced. This method also calculates depreciation expenses based on the depreciable amount.

Example of Depreciation

Here’s a hypothetical example to show how depreciation works. Remember, though, that certain types of accounting allow for different means of depreciation. Let’s assume that if a company buys equipment for $50,000, it may expense its entire cost in year one or write the asset’s value off throughout its 10-year useful life. This is why business owners like depreciation. Most business owners prefer to expense only a portion of the cost, which can boost net income.

The company can also scrap the equipment for $10,000 at the end of its useful life, which means it has a salvage value of $10,000. Using these variables, the accountant calculates depreciation expense as the difference between the asset’s cost and salvage value, divided by its useful life. The calculation in this example is ($50,000 – $10,000) / 10. This results in a total of $4,000 of depreciation expenses per year.

As such, the company’s accountant does not have to expense the entire $50,000 in year one, even though the company paid out that amount in cash. Instead, the company only has to expense $4,000 against net income. The company expenses another $4,000 next year and another $4,000 the year after that, and so on, until the asset reaches its $10,000 salvage value in 10 years.

Why Are Assets Depreciated Over Time?

New assets are typically more valuable than older ones. Depreciation measures the value an asset loses over time—directly from ongoing usage through wear and tear and indirectly from introducing new product models and factors like inflation.

How Are Assets Depreciated for Tax Purposes?

Depreciation is often what people talk about when they refer to accounting depreciation. This is allocating an asset’s cost throughout its useful life to align its expenses with revenue generation.

Businesses also create accounting depreciation schedules with tax benefits in mind because depreciation on assets is deductible as a business expense following IRS rules.

Depreciation schedules can range from simple straight-line to accelerated or per-unit measures.2

How Does Depreciation Differ From Amortization?

Depreciation refers only to physical assets or property. Amortization is an accounting term that essentially depreciates intangible assets such as intellectual property or loan interest over time.

What Is the Difference Between Depreciation Expense and Accumulated Depreciation?

The primary difference between depreciation expense and accumulated depreciation is that one appears as an expense on the income statement. At the same time, the other is a contra asset reported on the balance sheet.

Both pertain to the wearing out of equipment, machinery, or another asset and help state its value. This is an important consideration when making year-end tax deductions and when a company is sold. The assets need a proper valuation.

Although both of these depreciation entries should be listed on year-end and quarterly reports, depreciation expense is the more common due to its application regarding deductions. It can help lower a company’s tax liability. Accumulated depreciation is commonly used to forecast an item’s lifetime or keep track of depreciation year-over-year.2

Is Depreciation Considered to Be an Expense?

Depreciation is considered an expense for accounting purposes, resulting in business costs. As assets like machines are used, they experience wear and tear and decline in value over their useful lives. Depreciation is recorded as an expense on the income statement.