What Is Depreciation Expense & How Is It Calculated?
Understand depreciation expense: its accounting purpose, how assets are valued over time, and its impact on financial statements.
Depreciation is a fundamental accounting practice that impacts a company’s financial health. It provides a structured way to account for the reduction in value of tangible assets over time. Understanding depreciation helps in evaluating a company’s financial performance and asset management strategies.
Understanding Depreciation Expense
Depreciation expense represents the systematic allocation of the cost of a tangible asset over its useful life. This accounting process recognizes that physical assets, such as machinery or buildings, lose value due to wear and tear, obsolescence, or usage. Its core purpose is to match the expense of using an asset with the revenue it helps generate over time, adhering to the matching principle in accounting. By spreading the cost, businesses avoid recording a large expense in the year of purchase, which would distort profitability.
Depreciation is considered a non-cash expense, meaning it reduces a company’s reported profit without involving an actual outflow of cash. This distinction is significant because it impacts net income but not the immediate cash position of the business. Companies often calculate depreciation differently for financial reporting (accounting depreciation) and tax purposes (tax depreciation). Accounting depreciation aims to present an accurate financial position, whereas tax depreciation often seeks to optimize tax deductions, with rules set by bodies like the IRS.
Elements of Depreciation Calculation
To calculate depreciation, specific elements must be determined for the asset. The cost of the asset includes not only the purchase price but also all necessary expenditures to get the asset ready for its intended use. This can encompass costs such as shipping, installation, and testing fees.
The useful life of the asset is an estimate of the period it is expected to be productive for the business. This estimate is based on factors like expected usage, anticipated wear and tear, and technological obsolescence. The useful life can be expressed in years, units produced, or hours of operation, depending on the nature of the asset.
The salvage value, also known as residual value, is the estimated amount a company expects to receive from selling or disposing of the asset at the end of its useful life. This value is subtracted from the asset’s cost to determine the total depreciable amount. If an asset is expected to have no residual value, its salvage value is considered zero.
Common Methods of Depreciation
Several methods exist to calculate depreciation. The most commonly used and straightforward approach is the straight-line method. This method allocates an equal amount of depreciation expense to each period over the asset’s useful life. It is calculated by subtracting the salvage value from the asset’s cost and then dividing that result by the estimated useful life in years.
Another approach is the declining balance method, which is an accelerated depreciation method that records more depreciation expense in the earlier years of an asset’s life. A common variant is the double-declining balance method, which depreciates assets at twice the straight-line rate. This method is often chosen for assets that lose value quickly or become obsolete more rapidly, such as certain types of technology.
The units of production method is distinct because it bases depreciation on the asset’s actual usage or output, rather than time. This method is suitable for assets where wear and tear are directly related to the volume of goods produced or services rendered, like manufacturing machinery or vehicles. Depreciation expense under this method fluctuates each period, being higher in periods of greater usage and lower when the asset is used less.
How Depreciation Appears in Financial Reporting
Depreciation expense has a direct impact on a company’s financial statements, specifically the income statement and the balance sheet. On the income statement, depreciation is recorded as an operating expense. This reduces the company’s reported net income, which reflects its profitability for a given period.
On the balance sheet, depreciation is accounted for through a contra-asset account called “accumulated depreciation”. This account holds the total amount of depreciation that has been recorded for a specific asset since its acquisition. Accumulated depreciation reduces the asset’s original cost to arrive at its “net book value” or “carrying value” on the balance sheet. The net book value represents the asset’s remaining recorded value after accounting for the portion of its cost that has been expensed.