What Is Depreciation in Business and How Does It Work?
Explore the fundamental accounting process businesses use to spread out the cost of major purchases over their useful life.
Depreciation is an accounting practice that spreads the cost of a tangible asset over its useful life. This method reflects the gradual decline in an asset’s value due to wear and tear, decay, or obsolescence. Its primary purpose is to align the expense of using an asset with the revenue it generates, providing a more accurate representation of a company’s financial performance over time.
Understanding Depreciable Assets
For an asset to be depreciable, it must meet specific criteria. It must be owned by the business and used in its operations or for income-producing activities. It must also possess a determinable useful life, meaning it is expected to wear out, decay, become obsolete, or be consumed over time. The asset must also be expected to last for more than one year.
Common examples of depreciable assets include machinery, equipment, vehicles, buildings, and furniture. These physical assets lose value as they are used or as technology advances. In contrast, certain assets are not depreciable. Land, for instance, has an unlimited useful life and does not wear out. Inventory held for sale, intangible assets like goodwill, or assets not used for business purposes are also not depreciable.
Core Elements of Depreciation Calculation
Before applying any depreciation method, three core elements are essential for calculation. The first is the cost basis of the asset, which includes the original purchase price plus any additional expenditures necessary to get the asset ready for its intended use, such as shipping, installation, and setup fees.
The second element is the asset’s useful life. This is the estimated period, in years or units of production, over which the business expects to use the asset to generate revenue. It is an estimation and does not always correspond to the asset’s physical lifespan.
Finally, salvage value, also known as residual value, is the estimated resale value of the asset at the end of its useful life. This is the amount the business expects to recover when it disposes of the asset. The depreciable amount of an asset is its cost basis minus its salvage value, representing the total amount expensed over its useful life.
Standard Depreciation Methods
Businesses employ various methods to calculate depreciation, with the choice often depending on the asset’s nature and the company’s accounting objectives. The straight-line method is widely used due to its simplicity and consistent expense allocation. This method distributes an equal amount of depreciation expense to each accounting period over the asset’s useful life.
The formula for straight-line depreciation is (Cost Basis – Salvage Value) / Useful Life. For example, an asset costing $100,000 with a $10,000 salvage value and a 5-year useful life results in an annual depreciation of $18,000 ([$100,000 – $10,000] / 5 years). This method assumes the asset provides equal economic benefits throughout its operational period.
Other methods, known as accelerated depreciation, allocate a larger portion of the asset’s cost to the earlier years of its useful life. This approach can be beneficial for assets that lose value more quickly in their initial years or for businesses seeking higher deductions sooner. Common examples include the Double-Declining Balance Method and the Sum-of-the-Years’ Digits Method. These methods apply a constant rate to a declining book value, leading to higher depreciation in early years.
How Depreciation Impacts Financial Statements
Depreciation influences a company’s financial statements, providing a more accurate picture of its financial health and performance. On the income statement, depreciation is recorded as an operating expense. This expense reduces the company’s reported net income, which lowers its taxable income.
On the balance sheet, depreciation affects the reported value of assets. Accumulated depreciation is a contra-asset account, meaning it reduces the asset’s book value over time. The original cost of the asset remains on the balance sheet, but accumulated depreciation is subtracted to show the asset’s net book value. Depreciation is a non-cash expense; it does not involve a cash outflow. While it impacts profitability and tax liability, it does not directly affect the company’s cash flow.