Accounting for Depreciation
Definition of accounting for depreciation:
For accounting purposes, depreciation indicates how much of an asset’s value has been used up. For tax
purposes, businesses can deduct the cost of the tangible assets they purchase as business expenses; however,
businesses must depreciate these assets in accordance with IRS rules about how and when the deduction may be
taken based on what the asset is and how long it will last.
Depreciation is used in accounting to try to match the expense of an asset to the income that the asset helps the
company earn. For example, if a company buys a piece of equipment for $1 million and expects it to have a
useful life of 10 years, it will be depreciated over 10 years. Every accounting year, the company will expense
$100,000 (assuming straight-line depreciation), which will be matched with the money that the equipment helps
to make each year.
Buildings, machinery, equipment, furniture, fixtures, computers, outdoor lighting, parking lots, cars, and trucks
are examples of assets that will last for more than one year, but will not last indefinitely. During each
accounting period (year, quarter, month, etc.) a portion of the cost of these assets is being used up. The portion
being used up is reported as Depreciation Expense on the income statement. In effect depreciation is the
transfer of a portion of the asset's cost from the balance sheet to the income statement during each year of the
asset's life.
Depreciation is the process of allocating the depreciable cost of a long-lived asset, except for land which is
never depreciated, to expense over the asset's estimated service life. Depreciable cost includes all costs
necessary to acquire an asset and make it ready for use minus the asset's expected salvage value, which is the
asset's worth at the end of its service life, usually the amount of time the asset is expected to be used in the
business.
Significance of depreciation
Depreciation reduces the value of assets on the balance sheet
It is a negative items on the profit and loss account
It reduces the income available for distribution
It can be seen as conserving and retaining a part of shareholders’ investment
Depreciation policy can be changed to “window dress” the accounts
Methods of calculating depreciation
There are several methods for calculating depreciation, generally based on either the passage of time or the level
of activity (or use) of the asset.
Straight-line depreciation
Straight-line depreciation is the simplest and most-often-used technique, in which the company estimates the
salvage value of the asset at the end of the period during which it will be used to generate revenues (useful life)
and will expense a portion of original cost in equal increments over that period. The salvage value is an
estimate of the value of the asset at the time it will be sold or disposed of; it may be zero or even negative.
Salvage value is also known as scrap value or residual value.
Straight-line method:
Annual Depreciation Expense: (Cost of Fixed Asset – Residual Value) ÷ Useful Life of Asset (years)
, For example, a vehicle that depreciates over 5 years, is purchased at a cost of US$17,000, and will have a
salvage value of US$2000, will depreciate at US$3,000 per year: ($17,000 − $2,000)/ 5 years = $3,000 annual
straight-line depreciation expense. In other words, it is the depreciable cost of the asset divided by the number
of years of its useful life.
This table illustrates the straight-line method of depreciation. Book value at the beginning of the first year of
depreciation is the original cost of the asset. At any time book value equals original cost minus accumulated
depreciation.
Book value at the end of year
book value = original cost − accumulated depreciation
becomes book value at the beginning of next year. The asset is depreciated
until the book value equals scrap value.
Book value at Depreciation Accumulated Book value at
beginning of year expense depreciation end of year
$17,000 (original cost) $3,000 $3,000 $14,000
$14,000 $3,000 $6,000 $11,000
$11,000 $3,000 $9,000 $8,000
$8,000 $3,000 $12,000 $5,000
$5,000 $3,000 $15,000 $2,000 (scrap value)
If the vehicle were to be sold and the sales price exceeded the depreciated value (net book value) then the
excess would be considered a gain and subject to depreciation recapture. In addition, this gain above the
depreciated value would be recognized as ordinary income by the tax office. If the sales price is ever less than
the book value, the resulting capital loss is tax deductible. If the sale price were ever more than the original
book value, then the gain above the original book value is recognized as a capital gain.
If a company chooses to depreciate an asset at a different rate from that used by the tax office then this
generates a timing difference in the income statement due to the difference (at a point in time) between the
taxation department's and company's view of the profit.
Declining-balance method (or Reducing balance method)
Depreciation methods that provide for a higher depreciation charge in the first year of an asset's life and
gradually decreasing charges in subsequent years are called accelerated depreciation methods. This may be a
more realistic reflection of an asset's actual expected benefit from the use of the asset: many assets are most
useful when they are new. One popular accelerated method is the declining-balance method. Under this
method the book value is multiplied by a fixed rate.
Annual Depreciation = Depreciation Rate * Book Value at Beginning of Year
The most common rate used is double the straight-line rate. For this reason, this technique is referred to as the
double-declining-balance method. To illustrate, suppose a business has an asset with $1,000 original cost,
$100 salvage value, and 5 years useful life. First, calculate straight-line depreciation rate. Since the asset has 5
years useful life, the straight-line depreciation rate equals (100% / 5) = 20% per year. With double-declining-
balance method, as the name suggests, double that rate, or 40% depreciation rate is used. The table below
illustrates the double-declining-balance method of depreciation.
Book value at Depreciation Depreciation Accumulated Book value at
beginning of year rate expense depreciation end of year
Definition of accounting for depreciation:
For accounting purposes, depreciation indicates how much of an asset’s value has been used up. For tax
purposes, businesses can deduct the cost of the tangible assets they purchase as business expenses; however,
businesses must depreciate these assets in accordance with IRS rules about how and when the deduction may be
taken based on what the asset is and how long it will last.
Depreciation is used in accounting to try to match the expense of an asset to the income that the asset helps the
company earn. For example, if a company buys a piece of equipment for $1 million and expects it to have a
useful life of 10 years, it will be depreciated over 10 years. Every accounting year, the company will expense
$100,000 (assuming straight-line depreciation), which will be matched with the money that the equipment helps
to make each year.
Buildings, machinery, equipment, furniture, fixtures, computers, outdoor lighting, parking lots, cars, and trucks
are examples of assets that will last for more than one year, but will not last indefinitely. During each
accounting period (year, quarter, month, etc.) a portion of the cost of these assets is being used up. The portion
being used up is reported as Depreciation Expense on the income statement. In effect depreciation is the
transfer of a portion of the asset's cost from the balance sheet to the income statement during each year of the
asset's life.
Depreciation is the process of allocating the depreciable cost of a long-lived asset, except for land which is
never depreciated, to expense over the asset's estimated service life. Depreciable cost includes all costs
necessary to acquire an asset and make it ready for use minus the asset's expected salvage value, which is the
asset's worth at the end of its service life, usually the amount of time the asset is expected to be used in the
business.
Significance of depreciation
Depreciation reduces the value of assets on the balance sheet
It is a negative items on the profit and loss account
It reduces the income available for distribution
It can be seen as conserving and retaining a part of shareholders’ investment
Depreciation policy can be changed to “window dress” the accounts
Methods of calculating depreciation
There are several methods for calculating depreciation, generally based on either the passage of time or the level
of activity (or use) of the asset.
Straight-line depreciation
Straight-line depreciation is the simplest and most-often-used technique, in which the company estimates the
salvage value of the asset at the end of the period during which it will be used to generate revenues (useful life)
and will expense a portion of original cost in equal increments over that period. The salvage value is an
estimate of the value of the asset at the time it will be sold or disposed of; it may be zero or even negative.
Salvage value is also known as scrap value or residual value.
Straight-line method:
Annual Depreciation Expense: (Cost of Fixed Asset – Residual Value) ÷ Useful Life of Asset (years)
, For example, a vehicle that depreciates over 5 years, is purchased at a cost of US$17,000, and will have a
salvage value of US$2000, will depreciate at US$3,000 per year: ($17,000 − $2,000)/ 5 years = $3,000 annual
straight-line depreciation expense. In other words, it is the depreciable cost of the asset divided by the number
of years of its useful life.
This table illustrates the straight-line method of depreciation. Book value at the beginning of the first year of
depreciation is the original cost of the asset. At any time book value equals original cost minus accumulated
depreciation.
Book value at the end of year
book value = original cost − accumulated depreciation
becomes book value at the beginning of next year. The asset is depreciated
until the book value equals scrap value.
Book value at Depreciation Accumulated Book value at
beginning of year expense depreciation end of year
$17,000 (original cost) $3,000 $3,000 $14,000
$14,000 $3,000 $6,000 $11,000
$11,000 $3,000 $9,000 $8,000
$8,000 $3,000 $12,000 $5,000
$5,000 $3,000 $15,000 $2,000 (scrap value)
If the vehicle were to be sold and the sales price exceeded the depreciated value (net book value) then the
excess would be considered a gain and subject to depreciation recapture. In addition, this gain above the
depreciated value would be recognized as ordinary income by the tax office. If the sales price is ever less than
the book value, the resulting capital loss is tax deductible. If the sale price were ever more than the original
book value, then the gain above the original book value is recognized as a capital gain.
If a company chooses to depreciate an asset at a different rate from that used by the tax office then this
generates a timing difference in the income statement due to the difference (at a point in time) between the
taxation department's and company's view of the profit.
Declining-balance method (or Reducing balance method)
Depreciation methods that provide for a higher depreciation charge in the first year of an asset's life and
gradually decreasing charges in subsequent years are called accelerated depreciation methods. This may be a
more realistic reflection of an asset's actual expected benefit from the use of the asset: many assets are most
useful when they are new. One popular accelerated method is the declining-balance method. Under this
method the book value is multiplied by a fixed rate.
Annual Depreciation = Depreciation Rate * Book Value at Beginning of Year
The most common rate used is double the straight-line rate. For this reason, this technique is referred to as the
double-declining-balance method. To illustrate, suppose a business has an asset with $1,000 original cost,
$100 salvage value, and 5 years useful life. First, calculate straight-line depreciation rate. Since the asset has 5
years useful life, the straight-line depreciation rate equals (100% / 5) = 20% per year. With double-declining-
balance method, as the name suggests, double that rate, or 40% depreciation rate is used. The table below
illustrates the double-declining-balance method of depreciation.
Book value at Depreciation Depreciation Accumulated Book value at
beginning of year rate expense depreciation end of year
