Every business uses assets to generate revenue. And depreciation expenses account for the wear and tear on assets. You can think of depreciation as a warning light that tells you the remaining value of each asset. But to understand depreciation, you’ll need to know what assets depreciate, common depreciation methods, and the impact depreciation has on your financial statements.
What is depreciation?
Depreciation is the decline in the value of a physical asset. As an asset depreciates, a portion of the asset’s value reclassifies into an expense account. Depreciation expenses don’t impact cash.
What are assets?
An asset is a resource you use to generate revenue for your business. Depreciation posts when you use an asset to produce revenue and profits. The cost of an asset reclassifies to an expense account over the asset’s useful life. For example, when a truck reaches the end of its useful life, its entire value becomes a depreciation expense.
What is accrual accounting?
Generally Accepted Accounting Principles (GAAP) require businesses to use the accrual method of accounting. The accrual method matches revenue earned with the expenses incurred to generate revenue.
Depreciation matches the revenue assets generate with the expense that uses the asset. A landscaper who drives a truck is using an asset to generate plumbing revenue. Each year, the landscaper reclassifies a portion of the truck’s value to depreciation expense.
Total depreciation expense is the same, regardless of the depreciation method you use. A truck that costs $20,000 will generate $20,000 in depreciation expense, assuming the owner can’t sell it. The only difference in depreciation methods is in the timing of the expenses.
What assets can I depreciate?
When a company purchases an asset, management must decide how to calculate depreciation. Tangible (physical) assets depreciate, while you expense intangible assets using amortization.
A patent, for example, is an intangible asset that a business can use to generate revenue. Most patents are only enforced for a number of years. As each year passes, a portion of the patent reclassifies to an amortization expense.
Land improvements, such as landscaping costs, depreciate. However, the land itself does not depreciate.
Common depreciation factors
Let’s assume that a landscaping company purchases a truck. The company can use several factors to determine the truck’s depreciation expense.
Useful life: The number of years that the company will use the asset for the business.
Salvage value: The dollar amount that the company can sell the asset for at the end of its useful life. In many cases, the salvage value is zero.
Depreciable base: The total cost that can depreciate over the asset’s useful life. Calculate the depreciable base by subtracting the cost of the asset by its salvage value. The formula follows:
Cost of the asset – salvage value = depreciable base
Depreciation schedule: The schedule lists the dollar amount of depreciation per year based on the factors listed and the depreciation method.
Common depreciation methods
The depreciation method you choose should relate to how you use the asset to generate revenue.
If you use the asset heavily in its early years, you should choose a depreciation method that posts more expenses in the early years. If you expect to use an asset at the same rate year over year, the annual depreciation expense amount is fixed.
There are five common depreciation methods:
- Double-declining balance
- Sum of the years’ digits
- Units of production
- Modified accelerated cost recovery system (MACRS)
How to calculate depreciation
Calculating depreciation is a two-step process. First, determine an asset’s useful life, salvage value, and original cost. Then select a depreciation method that aligns best with how you use that asset for the business.
The straight-line depreciation method
The most common type of depreciation is the straight-line method. The straight-line depreciation formula requires the same amount of depreciation expense each year.
Let’s say you need to determine the depreciation of a delivery truck. The truck costs $30,000. It has a salvage value of $3,000, a depreciable base of $27,000, and a five-year useful life.
To find the annual depreciation expense, divide the truck’s depreciable base by its useful life to get $5,400 per year. You find that you can sell the truck for $3,000 after five years because you subtracted the cost of the truck from its depreciable base.
The double-declining balance depreciation method
The double-declining balance method posts more depreciation expenses in the early years of an asset’s useful life. The double-declining balance method is an accelerated depreciation method because expenses post more in their early years and less in their later years. This method computes the depreciation as a percentage and then depreciates the asset at twice the percentage rate.
Let’s say you need to determine the depreciation of a van using the double-declining balance method. The van costs $25,000. It has a salvage value of $3,000, a depreciable base of $22,000, and five-year useful life. The straight-live depreciation method would show a 20% depreciation per year of useful life. The double-declining balance method would show a 40% depreciation rate per year.
The book value, accumulated depreciation method
This method uses an asset’s book value to compute depreciation. Book value is the asset’s cost minus its accumulated depreciation. Accumulated depreciation is the total amount of depreciation recognized to date.
Let’s say you want to find the van’s depreciation expense in the first, second, and third year you own it. Multiply the van’s cost ($25,000) by 40% to get a $10,000 depreciation expense in the first year.
The van’s book value at the beginning of the second year is $15,000, or the van’s cost subtracted from its first-year depreciation. Now, multiply the van’s book value ($15,000) by 40% to get a $6,000 depreciation expense in the second year.
The van’s book value at the beginning of the third year is $9,000, or the van’s cost minus its accumulated depreciation. Now, multiply the van’s book value ($9,000) by 40% to get a $3,600 depreciation expense in the third year.
Total depreciation expenses decline each year until the asset’s remaining book value equals its salvage value. At that point, depreciation expenses stop because the asset’s useful life is over. You can now sell the van for $3,000.
The double-declining balance method does not subtract the asset’s salvage value before it calculates the 40% deprecation amount each year. That’s because the asset’s salvage value is addressed at the end of the useful life.
The sum of the years’ digits depreciation method
To use this method, you’ll use a ratio. The numerator is the years left in the asset’s useful life, and the denominator is the sum of the years in the asset’s original useful life.
Let’s say you have a machine that costs $30,000. The machine has a salvage value of $3,000, a depreciable base of $27,000, and a five-year useful life. So the sum of all the years in the asset’s original useful life is 15.
In the first year, the ratio is five-fifteenths. Multiply the $27,000 depreciable base by the first-year ratio to get a $9,000 depreciation expense in the second year.
In the second year, the machine’s remaining useful life is four years or four-fifteenths. Multiply the $27,000 depreciable base by the second-year ratio to get a $7,200 depreciation expense in the second year.
When you compute depreciation expense for all five years, the total equals the $27,000 depreciable base.
The units of production depreciation method
Many manufacturing companies use the units of production method. This method calculates depreciation based on the number of units produced in a particular year. The method is useful for companies that have large variations in production each year.
If you own a piece of machinery, you should recognize more depreciation when you use the asset to make more units of product. If production declines, this method reduces the depreciation expense from one year to the next.
Let’s say you have a machine that costs $50,000. The machine has a salvage value of $10,000 and a depreciable base of $40,000. It can produce 100,000 units over a five-year useful life.
To find the depreciation amount per unit produced, divide the $40,000 depreciable base by 100,000 units to get 40¢ per unit. If the machine produced 40,000 units in the first year of its useful life, the depreciation expense was $16,000.
The modified accelerated cost recovery system (MACRS)
MACRS is a depreciation method that posts depreciation expenses for tax purposes. It’s common for businesses to use a different method of depreciation for accounting records and tax purposes. Accountants must create a reconciliation report that explains the differences between the accounting and tax depreciation for a business’s tax return. IRS publication 946 provides the tax depreciation method for each type of asset that your business owns.
How your depreciation method affects your income taxes
The type of depreciation you use impacts your company’s profits and tax liabilities. Accelerated depreciation methods, such as the double-declining balance method, generate more depreciation expenses in the early years of an asset’s life. As a result, the tax deduction for depreciation is higher, and the net income is lower.
Business owners may have a larger write-off for depreciation in the early years, but the situation reverses later. The double-declining balance method recognizes less depreciation in the later years of an asset’s useful life. The lower depreciation expense creates a higher tax liability. Depreciating an asset using the straight-line method generates the same amount of depreciation expense each year.
You’ll need to understand how depreciation impacts your financial statements. And to post accounting transactions correctly, you’ll need to understand how to record depreciation in journal entries.
Journal entries for depreciation
Let’s assume that a landscaping company is posting depreciation entries for a truck using the straight-line depreciation method. The truck costs $25,000. It has a salvage value of $3,000, a depreciable base of $22,000, and a five-year useful life.
To find the truck’s annual depreciation, divide the truck’s depreciable base by its useful life. The truck’s annual depreciation is $4,400. In the journal entry for the truck’s first year, the debit depreciation expense and the credit accumulated depreciation are $4,400.
The journal entry increases the depreciation expense and accumulated depreciation, also known as an asset account. Each asset account should have an accumulated depreciation account, so you can compare its cost and accumulated depreciation to calculate its book value.
While asset accounts increase with a debit entry, accumulated depreciation is a contra asset account that increases with a credit entry. This format is useful because the balance sheet will subtract each asset’s accumulated depreciation balance from its original cost.
The financial statement shows that the business has “used up” $4,400 of the truck’s value by the end of its first year. At the end of its fourth year, the truck’s accumulated depreciation balance is $17,600, or $4,400 multiplied by four years. Based on the numbers, you can see that the truck is nearing the end of its useful life.
Understanding depreciation can help you improve the planning process
Properly accounting for depreciation helps you plan for asset purchases. Posting depreciation helps you monitor the current status of your fixed assets. To determine when you must replace assets, review each fixed asset’s detailed listing.
You can use accounting software to track depreciation and use any depreciation method. The software will calculate the annual depreciation expense and post it to the necessary journal entries. An accounting solution can help you make more informed decisions to grow your business with confidence.
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