What Is Depreciation?
Depreciation is an accounting practice used to spread the cost of a tangible or physical asset over its useful life. Depreciation represents how much of the asset’s value has been used up in any given time period. Companies depreciate assets for both tax and accounting purposes and have several different methods to choose from.
- Depreciation allows businesses to spread the cost of physical assets (such as a piece of machinery or a fleet of cars) over a period of years for accounting and tax purposes.
- There are several different depreciation methods, including straight-line and various forms of accelerated depreciation.
- Some methods of accounting for depreciation require that the business estimate the “salvage value” of the asset at the end of its useful life.
Assets like 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 cost and match depreciation expenses to related revenues in the same reporting period. This allows the company to write off an asset’s value over a period of time, notably its useful life.
Companies take depreciation regularly so they can 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.
At the end of an accounting period, an accountant books depreciation for all capitalized assets that are not yet 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
Depreciation and Taxes
As noted above, businesses use depreciation for both tax and accounting purposes. Under U.S. tax law, they can take a deduction for the cost of the asset, reducing their taxable income. But the Internal Revenue Servicc (IRS) states that when depreciating assets, companies must generally spread the cost out over time. (In some instances they can take it all in the first year, under Section 179 of the tax code.) The IRS also has requirements for the types of assets that qualify.
Buildings and structures can be depreciated, but land is not eligible for depreciation.
Depreciation in Accounting
In accounting terms, 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 provide a benefit to the company over an extended period of time. But the depreciation charges still reduce a company’s earnings, which is helpful for tax purposes.
The matching principle under generally accepted accounting principles (GAAP) 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 the cost of an asset with the benefit of its use over time. In other words, the incremental expense associated with using up the asset is also recorded for the asset that is put to use 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, the rate would be 15% per year.
Different companies may set their own threshold amounts to determine when to depreciate a fixed asset or property, plant, and equipment (PP&E) and when to simply expense it in its first year of service. For example, a small company might set a $500 threshold, over which it will depreciate an asset. On the other hand, a larger company might set a $10,000 threshold, under which all purchases are expensed immediately.
Accumulated Depreciation, Carrying Value, and Salvage Value
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.
Carrying value is the net of the asset account and the accumulated depreciation, while 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. Salvage value is based on what a company expects to receive in exchange for the asset at the end of its useful life.
The IRS publishes depreciation schedules indicating the number of years over which assets can be depreciated for tax purposes, depending on the type of asset.
Types of Depreciation With Calculation Examples
There are a number of methods that accountants can use to depreciate capital assets. They include straight-line, declining balance, double-declining balance, sum-of-the-years’ digits, and unit of production. We’ve highlighted some of the basic principles of each method below, along with examples to show how they’re calculated.
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 asset is depreciated down to its salvage value.
Let’s assume that a company buys a machine at a cost of $5,000. The company decides that the machine has a useful life of five years and a salvage value of $1,000. Based on these assumptions, the depreciable amount is $4,000 ($5,000 cost – $1,000 salvage value).
The annual depreciation using the straight-line method is calculated by dividing the depreciable amount by the total number of years. In this case, it comes to $800 per year ($4,000 / 5 years). This results in an annual depreciation rate of 20% ($800 / $4,000).
The declining balance method is an accelerated depreciation method that begins with the asset’s book, rather than salvage, value. Because an asset’s carrying value is higher in earlier years (before it has begun to be depreciated), the same percentage causes a larger depreciation expense amount in earlier years, then declines each year thereafter. This is the formula:
Declining Balance Depreciation = Book Value x (1/Useful Life)
Using the straight-line example above, the machine costs $5,000 and has a useful life of five years. In year one, depreciation would be $1,000 ($5,000 x 1/5 =$1,000).
In year two it would be ($5,000-$1,000) x 1/5, or $800. In year three, ($5,000-$1,000-$800) x 1/5, or $640, and so forth.
Double-Declining Balance (DDB)
The double-declining balance (DDB) method is an even more accelerated depreciation method. It doubles the (1/Useful Life) multiplier, making it essentially twice as fast as the declining balance method.
DDB = Book Value x (2/Useful Life )
Continuing to use our example of a $5,000 machine, depreciation in year one would be $5,000 x 2/5, or $2,000. In year two it would be ($5,000-$2,000) x 2/5, or $1,200, and so on.
Note that while salvage value is not used in declining balance calculations, once an asset has been depreciated down to its salvage value, it cannot be further depreciated.
Sum-of-the-Years’ Digits (SYD)
The sum-of-the-years’ digits (SYD) method also allows for accelerated depreciation. You 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 year, 5/15 of the depreciable base would be depreciated. In the second year, 4/15 of the depreciable base would be depreciated. This continues until year five when the remaining 1/15 of the base is depreciated. The depreciable base in all of these cases is the purchase price minus the salvage value, or $4,000 in the example we’ve been using.
For example, year one depreciation would be $1,333 ($4,000 x 5/15 = $1,333). In year two, it would be $1,067 ($4,000 x 4/15 = $1,067).
Units of Production
This method, which is often used in manufacturing, requires an estimate of the total units an asset will produce over its useful life. Depreciation expense is then calculated per year based on the number of units produced that year. This method also calculates depreciation expenses using the depreciable base (purchase price minus salvage value).
Why Are Assets Depreciated Over Time?
New assets are typically more valuable than older ones for a number of reasons. Depreciation measures the value an asset loses over time—directly from ongoing use through wear and tear and indirectly from the introduction of new product models and factors like inflation. Writing off only a portion of the cost each year, rather than all at once, also allows businesses to report higher net income in the year of purchase than they would otherwise.
How Do Businesses Determine Salvage Value?
Salvage value can be based on past history of similar assets, a professional appraisal, or a percentage estimate of the value of the asset at the end of its useful life.
What Is Depreciation Recapture?
Depreciation recapture is a provision of the tax law that requires businesses or individuals that make a profit in selling an asset that they have previously depreciated to report it as income. In effect, the amount of money they claimed in depreciation is subtracted from the cost basis they use to determine their gain in the transaction. Recapture can be common in real estate transactions where a property that has been depreciated for tax purposes, such as an apartment building, has gained in value over time.
How Does Depreciation Differ From Amortization?
Depreciation refers only to physical assets or property. Amortization essentially depreciates intangible assets, such as intellectual property like trademarks or patents, over time.
The Bottom Line
Depreciation allows businesses to spread the cost of physical assets over a period of time, which can have advantages from both an accounting and tax perspective. Businesses also have a variety of depreciation methods to choose from, allowing them to pick the one that works best for their purposes.