Depreciation serves several important purposes in financial accounting. Its main functions include allocating asset costs over time, reflecting the carrying value of assets, and supporting a company's ability to finance future investments.
Depreciation ⇒ simple as that
Depreciation refers to the systematic allocation of the cost of a depreciable asset over its useful life. Instead of recognizing the entire cost of the asset as an expense when it is purchased, a company records depreciation expense over the accounting periods in which the asset is expected to generate economic benefits.
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Depreciation – Important facts
| What is depreciation? | Depreciation is the systematic allocation of a fixed asset's cost over its expected useful life. Instead of recognizing the entire cost at once, the business records depreciation expense over multiple accounting periods. |
| What are the main functions of depreciation? | Depreciation allocates the cost of an asset over its useful life, reflects the asset's decreasing book value, and supports financial planning for future asset replacement. |
| What causes an asset to depreciate? | Common causes include wear and tear, natural deterioration, technological changes, unexpected damage, and investments in assets that become obsolete or less useful over time. |
| How is depreciation recorded in accounting? | A portion of the asset's original cost is recognized as depreciation expense during each accounting period. The expense is reported on the income statement, while accumulated depreciation reduces the asset's carrying amount on the balance sheet. |
Depreciation reduces the carrying value of a fixed asset by recognizing part of its original cost as an expense over the asset's useful life. This depreciation expense is recorded in the company's financial statements rather than recognizing the entire asset cost in a single accounting period.
Functions of Depreciation
Cost Allocation Function
Depreciation spreads the original cost of a fixed asset over its expected useful life. A portion of the asset's cost is recognized as depreciation expense in each accounting period and reported on the income statement.
This approach matches the cost of an asset with the periods in which it contributes to the company's income-producing activities.
Valuation Function
Depreciation reduces the carrying amount of a depreciable asset on the company's balance sheet over its useful life. The accumulated depreciation recorded in the accumulated depreciation account reflects the portion of the asset's cost that has already been recognized as an expense.
- The asset's book value does not necessarily represent its actual market value. Depreciation is based on accounting principles and the asset's expected useful life rather than its current market price.
Financing Function
Depreciation is a non-cash expense, meaning that recording depreciation does not involve an immediate cash outflow. Although depreciation reduces reported net income, the cash originally spent to purchase the asset has already left the business.
As a result, depreciation expense is added back when calculating cash flow from operating activities. The resulting cash can remain available within the business and contribute to working capital or future capital expenditures and investments.
Causes of Depreciation
Several factors can cause a fixed asset to lose value or become less useful over time, making depreciation necessary. The most common cause is physical wear and tear, although technological changes and other factors can also affect an asset's useful life.
Wear and Tear from Use
Regular use is one of the primary reasons why a tangible asset loses value. Over time, frequent use can lead to physical deterioration, increased repair requirements, and reduced operating performance.
- The actual useful life of an asset depends not only on how often it is used but also on how well it is maintained and the intensity of its use. For example, equipment operated in multiple shifts may experience greater wear and tear than equipment used less frequently.
Other Causes of Asset Depreciation
In addition to regular wear and tear, several factors can reduce the usefulness or economic value of a fixed asset over time. These factors may affect an asset's useful life, salvage value, or expected future benefits.
Natural Deterioration
A tangible asset can lose value even when it is not actively being used. Exposure to weather, temperature changes, corrosion, and other environmental conditions can gradually reduce an asset's condition and useful life.
Technological Obsolescence
Technological advances can make existing equipment less efficient or competitive. New assets may offer better performance, lower operating costs, or improved technology, causing older equipment to become economically obsolete even if it remains physically functional.
Accidents and Unexpected Damage
Fires, accidents, explosions, or other unexpected events can cause significant damage to a fixed asset. If the resulting decline in value is significant, the company may need to recognize an impairment loss rather than treating the reduction as ordinary depreciation.
Economic Obsolescence
Changes in customer demand, market conditions, or business requirements can reduce the economic usefulness of an asset. In some cases, an asset may become obsolete before the end of its originally expected useful life, requiring the company to reassess its carrying value.
Depletion and amortization should generally be treated separately from depreciation. Depletion applies to natural resources whose physical substance is extracted, while amortization is generally used for intangible assets such as patents and trademarks.
Depreciation Methods
Businesses can choose from various approaches to determine how the cost of a depreciable asset is recognized as an expense throughout its useful life. The appropriate method depends on how the asset is expected to provide economic benefits or be used over time.
Straight-Line Depreciation
With straight-line depreciation, the depreciable amount is divided into equal portions for each year of the asset's useful life. This straightforward approach is widely used for assets whose value is expected to decline at a relatively consistent rate.
- Formula: Annual depreciation expense = (Asset cost − Salvage value) ÷ Useful life
For example, if a company purchases an asset for $10,000, expects a salvage value of $1,000, and estimates a useful life of five years, the annual depreciation expense is $1,800.
Double-Declining Balance Method
Double-declining balance depreciation accelerates the recognition of an asset's cost by assigning a larger depreciation expense to the first years of its useful life and progressively smaller amounts to subsequent periods.
The depreciation rate is twice the straight-line depreciation rate and is applied to the asset's beginning book value for each accounting period.
Units-of-Production Method
The units-of-production method bases depreciation on an asset's actual use or output rather than simply on the passage of time. It can be appropriate for machinery or equipment whose wear depends heavily on production volume.
- Formula: Depreciation expense = (Asset cost − Salvage value) × (Units produced during the period ÷ Total estimated units)
This method results in higher depreciation expense during periods when the asset is used more intensively.
How to Calculate Depreciation
Calculating depreciation requires several key figures, including the original cost of the asset, its estimated salvage value, and its useful life.
For the straight-line method, the calculation is:
- Depreciation expense = (Cost of the asset − Salvage value) ÷ Useful life
For example, a business purchases equipment for $20,000. The equipment has an estimated salvage value of $2,000 and an expected useful life of six years:
- ($20,000 − $2,000) ÷ 6 = $3,000
The company's annual depreciation expense would therefore be $3,000.
Different depreciation methods can produce different depreciation expenses in individual years, although the total depreciated amount over the asset's useful life generally reflects the same depreciable cost.
Depreciation Example
Consider a company that purchases machinery for $50,000. The company estimates a salvage value of $5,000 and an expected useful life of five years.
Using the straight-line method:
- ($50,000 − $5,000) ÷ 5 = $9,000
The company would therefore record $9,000 of depreciation expense per year.
After the first year, accumulated depreciation would be $9,000 and the asset's carrying amount would be $41,000. After five years, assuming the original estimates remain unchanged, the total depreciation would be $45,000 and the remaining carrying amount would equal the $5,000 salvage value.
How Depreciation Affects Financial Statements
Depreciation affects both the income statement and balance sheet, even though it does not represent a current cash payment.
- On the income statement, depreciation is recorded as a depreciation expense, which reduces operating income and net income.
On a company's balance sheet, accumulated depreciation is presented as a contra-asset that lowers the reported carrying value of the corresponding fixed asset.
Depreciation is also a non-cash expense. Under the indirect method of presenting cash flow from operating activities, depreciation is added back to net income because the expense does not involve a cash outflow in the current accounting period.
Book Depreciation vs. Tax Depreciation
Book depreciation and tax depreciation serve different purposes. Book depreciation is used for financial accounting and financial reporting, while tax depreciation is calculated according to the tax rules applicable to the business.
As a result, the depreciation expense recorded in a company's financial statements may differ from the amount used to calculate taxable income.
Tax Depreciation
For tax purposes, businesses may be required to use specific depreciation rules and recovery periods. In the United States, for example, the Modified Accelerated Cost Recovery System (MACRS) is used to calculate depreciation deductions for many types of property.
Tax depreciation can provide tax benefits by allowing businesses to deduct the cost of qualifying assets over prescribed recovery periods. Because tax rules can change and differ between jurisdictions, businesses should apply the rules relevant to their specific tax situation.
What Is Accumulated Depreciation?
Accumulated depreciation represents the total depreciation expense recorded for an asset since it was placed into service. It is maintained in an accumulated depreciation account and reduces the asset's carrying amount on the balance sheet.
For example, if an asset originally cost $30,000 and the company has recorded $12,000 in total depreciation, its carrying amount before considering other adjustments would be $18,000.
Accumulated depreciation is different from depreciation expense: depreciation expense refers to the amount recognized during a particular accounting period, while accumulated depreciation represents the total amount recognized over the asset's life.
Frequently Asked Questions
What is depreciation in simple terms?
Depreciation is the process of spreading the cost of a tangible asset over its expected useful life. Instead of recording the entire cost as an expense when the asset is purchased, a business recognizes depreciation expense over several accounting periods.
What is depreciation in accounting?
In accounting, depreciation is the systematic allocation of a depreciable asset's cost over its useful life. It is recorded as a non-cash expense on the income statement, while accumulated depreciation reduces the asset's carrying value on the balance sheet.
What best defines depreciation?
Depreciation is an accounting method used to allocate the depreciable cost of a tangible fixed asset over the period in which the asset is expected to provide economic benefits. Common depreciation methods include straight-line depreciation, declining balance methods, and the units of production method.
Is depreciation a good or bad thing?
Depreciation is neither inherently good nor bad. It is an accounting concept that reflects the consumption or loss of an asset's economic usefulness over time. Although depreciation expense reduces reported net income, it is a non-cash expense and can also reduce taxable income under applicable tax rules.