What Is Depreciation Expense and How Is It Calculated?
Master how businesses account for asset wear and tear. Understand depreciation expense, its calculation, methods, and financial statement impact.
Depreciation expense is an accounting method used by businesses to systematically allocate the cost of a tangible asset over its useful life. This process reflects how an asset’s economic benefits are utilized over time, rather than expensing its entire cost in the year of purchase. By spreading the cost, depreciation provides a more accurate representation of a company’s financial performance across multiple accounting periods.
Purpose of Depreciation
Recording depreciation serves several important purposes for a business. It primarily aligns with the matching principle of accounting, which requires that expenses be recognized in the same period as the revenues they help generate. For example, if a machine produces goods for five years, its cost should be spread over those five years to match the revenue earned from those goods. This provides a more accurate depiction of a company’s profitability and financial position.
Depreciation also reflects the declining value of assets over time. Assets naturally lose value due to usage, age, and technological advancements. By accounting for this reduction, businesses can present a truer picture of the asset’s remaining value on their financial statements. This practice helps in financial planning, including decisions about asset replacement.
Depreciation offers tax advantages. For many businesses, depreciation is a tax-deductible expense. By deducting depreciation, a company can reduce its taxable income, which in turn lowers its tax payments. The Internal Revenue Service (IRS) provides specific guidelines and methods for calculating depreciation for tax purposes, such as the Modified Accelerated Cost Recovery System (MACRS).
Assets That Depreciate
Not all assets are subject to depreciation. For an asset to be depreciable, it must meet specific criteria. First, it must be tangible property, such as machinery, vehicles, buildings, or office equipment. Second, the asset must be owned by the business and used in its trade or business, or for income-producing activities.
Third, the asset must have a determinable useful life, meaning it is expected to lose value over time. This useful life must also be longer than one year. Examples of common depreciable assets include computers, delivery trucks, manufacturing equipment, and furniture.
Certain assets are not depreciated. Land is an example because it has an unlimited useful life and does not wear out or become obsolete. Intangible assets, such as patents, copyrights, and trademarks, are amortized, which is a similar process of allocating cost over time. Inventory and assets held for personal use or investment purposes are also not depreciable.
Methods of Depreciation Calculation
Businesses can choose from several methods to calculate depreciation, each allocating the asset’s cost differently over its useful life. The most commonly used and straightforward method is the straight-line method. This approach allocates an equal amount of depreciation expense to each period over the asset’s useful life.
To calculate straight-line depreciation, the asset’s estimated salvage value (what it is expected to be worth at the end of its useful life) is subtracted from its original cost. This depreciable amount is then divided by the asset’s estimated useful life in years. For instance, an asset costing $10,000 with a $1,000 salvage value and a 5-year useful life would have an annual depreciation expense of $1,800 (($10,000 – $1,000) / 5).
Other methods include accelerated depreciation techniques, such as the declining balance method. These methods recognize a larger depreciation expense in the earlier years of an asset’s life and smaller amounts in later years. Another method is the units of production method, which depreciates an asset based on its actual usage or output rather than the passage of time.
Financial Statement Impact
Depreciation expense significantly impacts a company’s financial statements. On the income statement, it is recorded as an operating expense. This reduces the company’s reported net income, as expenses are subtracted from revenue to determine profit. The inclusion of depreciation helps match the cost of using an asset with the revenue it generates.
On the balance sheet, depreciation affects the reported value of assets. While the original cost of a tangible asset remains on the books, a contra-asset account called accumulated depreciation is used. Accumulated depreciation represents the total amount of depreciation recorded for an asset since its acquisition. This cumulative amount is subtracted from the asset’s original cost to arrive at its net book value, reflecting its declining value over time.
It is important to note that depreciation is a non-cash expense. This means it does not involve an actual outflow of cash in the period it is recorded. The cash outflow for the asset generally occurred when it was initially purchased. Therefore, while depreciation reduces net income, it does not directly reduce the cash available to the business. This distinction is crucial for analyzing a company’s cash flow.