Depreciation accounting can seem a bit overwhelming, but once you learn a little bit about why depreciation is necessary and how depreciation formulas work, you’ll see it’s fairly straightforward and easy to understand.
Of course, there are some intricacies, and it can be a bit more complex depending on the type of business you are in, but here is a basic overview so you can become familiar with the process.
The basic definition for the calculation of depreciation expense is allocating the cost of a particular asset over the course of the anticipated life of that asset.
This includes anything that will not last forever, like a building, equipment, trucks, computers, fixtures, etc.
Even though a company will often pay for that item outright, as far as accounting purposes are concerned, the expense of that item will be spread out through the “lifespan” of that item.
Assets will not all be treated the same way, and there are several depreciation methods that accountants will employ.
Some of these different methods of depreciation that lead to the depreciation calculation are the unit of production method, double declining balance method, accelerated depreciation method, double declining-balance depreciation, digits depreciation method, the modified accelerated cost recovery system or MACRS, the sum of the years’ digits depreciation method and straight-line depreciation rate. The MACRS is the method generally required on a tax return by the IRS. For intangible assets, amortization is the method used for depreciation.
Also see: What is a tangible good?
The two basic methods are straight line depreciation and accelerated depreciation.
Straight-line depreciation is more commonly used and means that each year the same amount or percentage of the value of the asset is depreciated, not including the salvage value of the asset.
Depreciation Expense Methods
There are 2 methods for calculating the depreciation formula; the straight-line depreciation formula and the declining balance depreciation formula.
Straight-Line Depreciation Method
The straight-line depreciation method is the most simple formula and is also the most commonly used by businesses. With a straight line, the cost of a fixed asset is depreciated evenly over the useful life of the asset.
Straight Line Depreciation Example & Formula:
The straight-line depreciation expense formula is Straight Line Annual Depreciation Expense = Depreciable Amount /Estimate Useful Life. The depreciable amount is calculated as the Cost of the Asset – Salvage Value.
In this example, a piece of heavy machinery was purchased for $60,000 and has an estimated useful life of five years, upon which time it will have an estimated salvage value of $5,000. Using the formula above, the depreciable amount is $55,000 ($60,000 – $5,000) and the straight line annual depreciation expense is $11,000 ($55,000 / 5)
Straight Line Journal Entry:
Using the straight-line method of depreciation, the expense would be journalized like:
This journal entry would be posted at the end of the year, showing the increase of accumulated depreciation.
Declining Balance Depreciation Method
The Declining Balance method of depreciation lets a business accelerate the amount of depreciation for an asset. More depreciation is taken at the beginning of the asset’s life than at the end. This is allowed as some assets are more productive when new and then when they are used.
Declining Balance Depreciation Formula & Example
The formula to calculate the declining balance formula is Depreciation Rate × Book Value of Asset. The depreciation rate is found by Accelerator (multiplication factor) × Straight-Line Rate. The accelerator is a multiplication factor that shows increased depreciation at the end of the first year of purchase and then declines for the remaining years.
Let’s say your company bought a computer system and it cost $15,000. It is expected to last 10 years. Here is how the asset depreciation would look:
|Cost of Asset: Cost of Asset – Salvage Value
Less: Salvage Value
Years of estimated useful life:
Depreciation expense per year:
So your depreciation rate would be $1,000 per year for 10 years in this example.
Accelerated depreciation is, as the name suggests…the asset’s cost is allocated in a much faster manner, with more of the cost being allocated at the beginning and less at the end. The total amount of depreciation or total depreciation expense remains the same, but the rate at which it takes place is different.
In the depreciation accounting example above, the year one amount will be the highest, and every year after that, the amount recorded will be less throughout the 10-year period. There are several depreciation methods for this, including SYD, 150% declining, and double-declining.
So now you can answer the question of what depreciation accounting is and how does it work. It’s simply a way to spread the cost of any asset you have over the life of that asset, removing its residual value from the equation.
What Is The Difference Between Depreciation Expense And Accumulated Depreciation?
Basically, the difference between depreciation expense and accumulated depreciation is that one appears on the income statement as a business expense, and accumulated depreciation is on the balance sheet as a contra asset. Accumulated depreciation is a running total of depreciation on the balance sheet and shows the purchase price minus the accumulated depreciation over the useful life of the asset.
What Is Salvage Value?
Salvage value is the expected market value of an asset after the end of its useful life. Take, for instance, a truck that was purchased and would fall into a five-year depreciation schedule. While the truck would be fully depreciated on the company’s books, the truck would still have a market value.
When Does Depreciation Increase A Business’s Taxable Income?
Depreciation is the reduction of the value of an asset over time as that asset’s life expectancy decreases. Depreciation expense shows on the income statement and reduces the amount of taxes paid by lowering a business’s net income.
Why Is Depreciation Important To A Business?
Depreciation provides several benefits to a business, but two of the most important are:
- Allowing a business to recover the cost of an asset when it was purchased.
- Proving tax benefits that lower a business’s taxable income and increases tax savings.
If you have any questions about how depreciation works, talk to your accountant. He or she will be familiar with all of the particulars that apply to your business. Together you will be able to figure out the best way to record depreciation for your company.