What Is Depreciation Expense in Accounting?
Understand how businesses systematically account for the decline in asset value, its critical impact on financial statements, and methods for accurate reporting.
Depreciation expense in accounting reflects the systematic allocation of a tangible asset’s cost over its useful life. This practice matches the expense of acquiring an asset with the revenue it helps generate. It provides a more accurate representation of a company’s financial performance by spreading the cost of significant purchases across multiple accounting periods.
Understanding Depreciation
Depreciation represents the decrease in an asset’s value over time, due to wear and tear, obsolescence, or usage. It is a non-cash expense, meaning no actual cash outflow occurs when recorded. This accounting convention is primarily for cost allocation, not for tracking market value fluctuations.
Assets subject to depreciation include tangible long-term assets such as machinery, buildings, vehicles, and furniture, used to generate revenue over an extended period. Land is generally not depreciated as it typically does not lose value. Intangible assets like patents or copyrights are amortized instead. Current assets, such as inventory or cash, are also not depreciated.
Elements for Calculation
Historical cost is the original amount paid to acquire an asset, including all costs to get it ready for its intended use (e.g., purchase price, shipping, installation). This figure forms the basis of depreciation.
Useful life is the estimated period an asset is expected to be productive. This estimate, expressed in years, units of production, or hours, requires professional judgment. For example, a delivery truck’s useful life might be in years, while a manufacturing machine’s could be tied to units produced.
Salvage value (or residual value) is the estimated amount a company expects to recover from disposing of an asset at the end of its useful life. This anticipated scrap or resale value is subtracted from the historical cost to determine the depreciable amount.
Common Depreciation Methods
Various depreciation methods exist, each suitable for different assets and business objectives. The choice depends on the asset’s usage pattern and company policies.
The straight-line method is widely used due to its simplicity. It allocates an equal amount of depreciation expense to each period over the asset’s useful life. The formula is: (Historical Cost – Salvage Value) / Useful Life. For example, a machine purchased for $100,000 with a $10,000 salvage value and a 5-year useful life would have an annual depreciation of ($100,000 – $10,000) / 5 = $18,000.
The declining balance method, particularly the double-declining balance method, is an accelerated depreciation method. It recognizes more expense in the earlier years of an asset’s life, beneficial for assets that lose value rapidly or are more productive initially. The formula involves multiplying a fixed rate (double the straight-line rate) by the asset’s book value at the beginning of the period.
For a 5-year useful life, the straight-line rate is 20% (1/5), making the double-declining rate 40%. A $100,000 asset would depreciate by $40,000 (40% of $100,000) in the first year. In the second year, with a book value of $60,000, depreciation would be $24,000 (40% of $60,000). Depreciation stops when book value reaches salvage value.
The units of production method suits assets with varying usage, like manufacturing equipment. It allocates depreciation based on actual output or usage. The calculation involves two steps: first, determine the depreciation cost per unit using (Historical Cost – Salvage Value) / Total Estimated Units of Production, then multiply this rate by actual units produced. For example, if a machine costs $50,000, has a $5,000 salvage value, and is expected to produce 90,000 units, the rate is ($50,000 – $5,000) / 90,000 units = $0.50 per unit. If 10,000 units are produced in a year, depreciation is $5,000 (10,000 units $0.50/unit).
Financial Statement Impact
Depreciation expense affects a company’s financial statements. On the income statement, it is reported as an operating expense, reducing net income and lowering taxable income.
On the balance sheet, depreciation impacts asset value through Accumulated Depreciation, a contra-asset account that reduces the asset’s original cost. The original cost minus accumulated depreciation yields the asset’s net book value, or carrying value. Accumulated depreciation increases over the asset’s useful life, steadily reducing its book value. These impacts align with the matching principle, ensuring expenses are recognized in the same period as related revenues.
Recording Depreciation
To recognize depreciation, a journal entry is made at regular intervals, typically monthly or annually. This entry debits the Depreciation Expense account and credits the Accumulated Depreciation account. For example, if annual depreciation for equipment is $18,000, the entry debits Depreciation Expense for $18,000 and credits Accumulated Depreciation for $18,000.