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. Tangible (physical) assets are depreciated, while intangible assets are expensed using amortization. Depreciation expense does not impact cash.
Depreciation method: factors
When a company purchases an asset, you must make some decisions in order to calculate depreciation. Assume, for example, that a landscaping company purchases a truck for $25,000. Here are some factors used to determine depreciation expense:
- Useful life: This is the number of years that the company will use the asset in the business. Assume a useful life of five years.
- 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, but assume a value of $3,000 in this example.
- Depreciation method: There are a variety of depreciation methods.The method chosen should relate to how the asset is used in the business. If, for example, the asset is used heavily in the early years, a company should choose a depreciation method that posts more expense in the early years. Assume a straight-line method for the truck, because the firm expects to drive the same amount of miles each year over the useful life.
Each of these variables impacts the dollar amount of depreciation expense posted each year.
Calculating depreciation expense
The landscaping company must calculate the depreciable base for the truck, which is the asset value used in the calculation. The straight-line method subtracts any salvage value from the purchase price of the asset.
The depreciable base is ($25,000 – $3,000 = $22,000).
Annual depreciation is ($22,000 depreciable base) / (5 year useful life), or $4,400.
The accounting entry to post depreciation in year one is:
Debit depreciation expense- truck $4,400
Credit 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.
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 cost of each asset. For example:
Balance sheet: End of year one
Accumulated depreciation-truck ($4,400)
The financial statement reader can see that the business has “used up” $4,400 of the truck’s value. By 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.
Book value is defined as (cost less accumulated depreciation), and the truck’s book value at the end of year one is ($25,000 – $4,400 = $20,600). Book value is the true value of an asset, because this amount reflects how much use remains in the asset.
Gain or loss on sale
When a business sells a fixed asset, the company may post a gain or a loss, and the journal entry for a sale includes these components:
- Debit cash for the sales proceeds received
- Debit to remove accumulated depreciation
- Credit the asset to remove the original cost of the asset
Assume that the landscaping company sells the truck at the end of year four and receives $10,000 in cash. Here is the journal entry to record the sale:
|Debit accumulated depreciation-truck||$17,600|
|Credit gain on sale- truck||$2,600|
The debits total $27,600. In order to balance total debits with total credits in the journal entry, the company posts a credit to gain on sale: truck for $2,600. If the journal entry required a debit entry to balance, the firm would post a loss on sale.
Accelerated depreciation methods
Accelerated depreciation methods recognize more depreciation expense in the early years, and less expense in the later years. One frequently used accelerated method is the double-declining balance (DDB) method. This method computes the straight-line depreciation method as a percentage, and then depreciates the asset based on twice the percentage rate.
As an example, the truck has a useful life of five years, which means that the straight-line method posts depreciation of 20% a year for five years. The DDB method recognizes depreciation at a rate of 40% per year.
Here is depreciation expense for the truck in years one and two:
Depreciation expense, year one: ($25,000 cost X 40%) = $10,000
Depreciation expense, year two: ($15,000 book value X 40%) = $6,000
Note that, in year two, the 40% depreciation rate is multiplied by the book value ($25,000 cost less $10,000 year one depreciation). This generates a smaller dollar amount of depreciation in year two. The book value for year three is ($25,000 cost less $16,000 in accumulated depreciation), or $9,000.
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.
Total depreciation expense
Keep in mind that total depreciation amount expensed is the same, regardless of the method used. The landscaping company truck, has a depreciable base of ($25,000 – $3,000 = $22,000). Total depreciation will be $22,000, regardless of the method selected. The difference in depreciation methods is only in the timing of the expense.
The double-declining balance (DDB) method for truck generates $10,000 in year-one depreciation expense, while the straight-line method posts $4,400. If the landscaping company uses the DDB method, depreciation expense will be higher in the early years, and net income will be lower. In later years, depreciation expense slows down, and net income is higher.