April 16, 2020 Bookkeeping en_US Read about depreciation, and the most common depreciation methods. Learn how each method impacts the financial statements, and asset replacement. https://quickbooks.intuit.com/cas/dam/IMAGE/A1YpxyjRM/Accounting-depreciation-calculated-1.jpg https://quickbooks.intuit.com/r/bookkeeping/depreciation/ What is depreciation and how is it calculated?
Bookkeeping

What is depreciation and how is it calculated?

By Ken Boyd April 16, 2020

Every business uses assets to generate revenue, and depreciation expenses are posted to account for the wear and tear on assets. You can think of depreciation as a “warning light” that tells you how much value each asset has left, and when an asset must be replaced.

This discussion defines depreciation, and the types of assets that are depreciated. You’ll learn about the most-used depreciation methods, and the impact on your financial statements.

What is depreciation?

The definition of depreciation is the decline in value of a physical asset, meaning that a portion of the asset’s value is reclassified into an expense account. It’s important to note that depreciation expense does not impact cash.

Asset and expense accounts

An asset is a resource used to generate revenue for a business, and depreciation is posted when an asset is used to produce revenue and profits. The cost of an asset is reclassified to an expense account over the asset’s useful life. If, for example, a truck reaches the end of its useful life, the entire value of the truck should be posted to depreciation expense.

Generally Accepted Accounting Principles (GAAP) require that businesses use the accrual method of accounting.

Accrual accounting

The accrual method matches revenue earned with the expenses incurred to generate revenue.

Depreciation matches the revenue generated by an asset with the expense of using up the asset. A plumber that drives a truck to perform residential plumbing work is using an asset to generate plumbing revenue. Each year, a portion of the truck’s value is reclassified to depreciation expense.

Total depreciation expense is the same, regardless of the depreciation method used. A truck costing $20,000 will generate $20,000 in depreciation expense, assuming that the asset cannot be sold at the end of its useful life. The only difference in depreciation methods is in the timing of the expenses.

What assets can I depreciate?

Tangible (physical) assets are depreciated, while intangible assets are expensed 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 specific number of years. As each year passes, a portion of the patent is reclassified to amortization expense.

Land improvements, such as landscaping costs, are depreciated. Land, however, has an infinite life and is not depreciated.

When a company purchases an asset, management must make some decisions in order to calculate depreciation.

Depreciation terms: defined

Let’s assume that a landscaping company purchases a truck. Here are some factors used to determine depreciation expense on the truck:

Useful life

This is the number of years that the company will use the asset in the business.

Salvage value

The dollar amount that the asset can be sold for at the end of the useful life. In many cases, the salvage value is zero.

Depreciation base

The total cost that can be depreciated over the asset’s useful life. The formula is (cost of the asset – salvage value). Here’s the same information, stated another way:

Salvage value + depreciable base = cost of asset

Depreciation schedule

The schedule lists the dollar amount of depreciation per year, based on the factors listed above, and the depreciation method chosen. There are a number of depreciation methods you can use.

Depreciation methods

The depreciation method you choose should relate to how the asset is used to generate revenue.

If the asset is used heavily in the early years, a company should choose a depreciation method that posts more expense in the early years. On the other hand, if a firm expects to drive a truck the same number of miles each year, the annual amount of depreciation expense should be fixed.

Here are the most frequently used depreciation methods:

  • Straight line
  • Double-declining balance
  • Sum of the years digits
  • Units of production
  • Modified accelerated cost recovery system (MACRS)

Each method is explained below.

How to calculate depreciation

Calculating depreciation is a two-step process. First, you determine the useful life, salvage value, and the original cost of the asset. You then select a depreciation method, based on how the asset is used in the business.

The most common type of depreciation is the straight line method.

Straight line depreciation

Straight line depreciation formula requires the same amount of depreciation expense each year.

Here is information to depreciate a van using the straight line depreciation method:

  • Asset cost: $30,000 delivery van
  • Salvage value: $3,000
  • Depreciable base: $30,000 asset – $3,000 salvage value = $27,000
  • Useful life: 5 years

The annual depreciation expense is ($27,000 depreciable base) / (5 years) = $5,400 a year. At the end of five years, the van is sold for $3,000 ($30,000 cost – $27,000 depreciable base).

The double-declining balance method posts more depreciation expenses in the early years of an asset’s useful life.

Double-declining balance method

The double-declining balance (DDB) method is an accelerated depreciation method, because more expense is posted in the early years, and less in later years. This method computes the straight-line depreciation method as a percentage, and then depreciates the asset based on twice the percentage rate.

Here is information to depreciate a truck using the DDB method:

  • Asset cost: $25,000 truck
  • Salvage value: $3,000
  • Depreciable base: $25,000 asset – $3,000 salvage value = $22,000
  • Useful life: 5 years

The useful life of the asset is five years, which means that the straight-line method posts depreciation of 20% a year for five years. The DDB method uses a depreciation rate of 40% per year.

Book value, accumulated depreciation

This method uses book value to compute depreciation. Book value is (original cost less accumulated depreciation), and accumulated depreciation is the total amount of depreciation recognized to date.

Here is depreciation expense for the truck in years one, two, and three:

Depreciation expense- first year

($25,000 cost X 40%) = $10,000

Depreciation expense- year two

Book value at the beginning of year two is ($25,000 cost less $10,000 year one depreciation), or $15,000. Year two depreciation is:

($15,000 book value X 40%) = $6,000

Depreciation expense- year three

Book value at the beginning of year three is ($25,000 cost less $16,000 in accumulated depreciation), or $9,000. Year three depreciation is:

($9,000 book value X 40%) = $3,600

Stopping at salvage value

Total depreciation expense declines each year, until the remaining book value of the asset equals salvage value ($3,000). At that point, depreciation expense stops, because the asset’s useful life is over, and the truck is sold for $3,000.

The DDB method does not subtract salvage value before calculating the 40% deprecation amount each year, because salvage value is addressed at the end of the useful life.

Sum of the years digits is another accelerated depreciation method.

Sum of the years digits depreciation method

To use this method, you use a ratio. The numerator of the ratio is the number of years left in the asset’s useful life. The denominator is the sum of all the years in the asset’s original useful life.

Let’s use this information for the calculation:

  • Asset cost: $30,000 machine
  • Salvage value: $3,000
  • Depreciable base: $30,000 asset – $3,000 salvage value = $27,000
  • Useful life: 5 years

The sum of all the years in the asset’s original useful life is (5+4+3+2+1), or 15. In year one, the ratio is (5/15).

Depreciation expense- year one

($27,000 depreciable base X (5/15)) = $9,000 depreciation expense

Depreciation expense- year two

In year two, four years remain in the useful life, and the ratio is (4/15).

($27,000 depreciable base X (4/15)) = $7,200 depreciation expense

When you compute depreciation for all five years, the total amount equals the $27,000 depreciable base.

Many manufacturing companies use the units of production method.

Units of production depreciation

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 allows you to reduce the depreciation expense from one year to the next.

Here’s the information for this calculation:

  • Asset cost: $50,000 machine
  • Salvage value: $10,000
  • Depreciable base: $50,000 asset cost – $10,000 salvage value = $40,000
  • Units to be produced over 5 year useful life: 100,000 units

The depreciation amount per unit produced is ($40,000 depreciable base / 100,000 units), of $.40 per unit. If the company produced 40,000 units in year one, the depreciation expense is ($0.40 per unit X 40,000 units), or $16,000.

MACRS is a depreciation method used to post depreciation expenses for tax purposes.

Modified accelerated cost recovery system (MACRS)

It’s common for businesses to use a different method of depreciation for “book” (accounting record) purposes and for tax purposes. Accountants must create a reconciliation report that explains the differences between the book and tax depreciation, and post the information to the tax return.

IRS Publication 946, How to Depreciate Property, provides the tax depreciation method for each type of asset that your business owns. The calculations are complex, and you should consult with a tax accountant.

The type of depreciation you use impacts company profit, and the firm’s tax liability.

Income tax impact

Accelerated methods of depreciation, 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 net income is lower.

Business owners will have a larger write off for depreciation in the early years, but the situation reverses in later years. The double-declining balance method recognizes less depreciation in the later years of the 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. Small business owners need to understand how depreciation impacts the financial statements.

To post accounting transactions correctly, you need to understand the typical journal entries to record depreciation.

Accounting for depreciation: Journal entry example

Let’s assume that a landscaping company is posting depreciation entries for a truck, using the straight-line method of depreciation. Here is the details:

  • Asset cost: $25,000 truck
  • Salvage value: $3,000
  • Depreciable base: $25,000 asset – $3,000 salvage value = $22,000
  • Useful life: 5 years

Annual depreciation is ($22,000 depreciable base) / (5 year useful life), or $4,400.

Depreciation expense- year one

The accounting entry to post depreciation in year one is:

Debit #6000 depreciation expense- truck $4,400

Credit #4100 accumulated depreciation- truck $4,400

(To record depreciation expense for the truck in year one)

This journal entry increases both depreciation expense and accumulated depreciation, which is an asset account. Each asset account should have a specific accumulated depreciation account, so that the asset’s cost can be compared with accumulated depreciation to calculate book value for each asset.

Contra asset accounts

Asset accounts are increased with a debit entry, but accumulated depreciation is a contra-asset account that is increased with a credit entry. This format is useful, because the balance sheet will list each asset’s accumulated depreciation balance as a subtraction from the original cost of each asset. For example:

Balance sheet- end of year one

Truck $25,000

Accumulated depreciation-truck ($4,400)

Book value- truck $20,600

The financial statement reader can see that the business has “used up” $4,400 of the truck’s value by the end of year one. At the end of year four, the accumulated depreciation-truck balance is $17,600. ($4,400 X 4 years), and the truck is nearing the end of its useful life.

Properly accounting for depreciation helps you plan for asset purchases in future years.

Improve the planning process

You need assets to generate revenue in your business, and purchasing assets is expensive. Posting depreciation helps you monitor the current status of your fixed assets.

To determine when assets must be replaced, review the detailed listing of each fixed asset. Each asset’s book value (cost less accumulated depreciation) tells you how much value remains in the asset, so you can plan for replacement.

Use accounting software to track depreciation. You can use any depreciation method, and the software will calculate the annual depreciation expense and post the necessary journal entries. Software can help you make more informed decisions, so you can grow your business with confidence.

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Ken Boyd is the Co-Founder of Accountinged.com, and owns St. Louis Test Preparation (accountingaccidentally.com). He provides blogs, videos and speaking services on accounting and finance. Ken is the author of four Dummies books, including Cost Accounting for Dummies. Read more