Depreciation is an accounting method used to reduce a tangible asset’s value over its useful life. Accountants depreciate an asset, such as a factory or piece of machinery, to show that a portion of its original value has been used up.
For small expenditures, the full value is expensed in a given accounting period. For example, spending $500 on office supplies will show up as an expense on the income statement. However, purchasing a $500,000 piece of factory equipment would dramatically impact the income statement and not adequately capture how long the equipment will be used for.
As such, these expenditures are capitalized, a process of adding an expenditure to the balance sheet as an asset. Businesses depreciate assets for both tax and business purposes.
There are several depreciation methods, with the most common four being the straight line method, the double declining method, the units of production method, and the sum of years digits method.
In this post, we will define depreciation, show you how to calculate depreciation in different situations, and talk through depreciation and accumulated depreciation.
In this section, we will walk through how to calculate depreciation and define the most important terms and concepts. Depreciation is related to an asset, such as a building, vehicle, or piece of machinery.
Next, let’s look at examples of the journal entries (debits and credits) for depreciation. In this example, the company purchased a building for $2,500,000 for cash. The building has a useful life of 20 years.
Journal Entries for Asset Purchase
Journal Entries for 1st Year Depreciation
As a reminder, a debit will increase an asset account on the balance sheet and a credit will decrease an asset account on the balance sheet.
Great! Now we’re going to dive into the different methodologies and more in-depth examples.
Now we are going to explore three examples of depreciation. In our first example, Company A purchases a fixed asset for $70,000.
The useful life of the asset is 5 years and a salvage value of $20,000. It’s expected to produce 500,000 units over its useful life and the asset produced 87,000 units in its first year.
We will walk through how to depreciation the assets using the straight line method, which is the simplest formula.
The straight-line depreciation method relies on decreasing an asset’s value equally over its useful life.
The name refers to the fact that the book value of the asset follows a straight down, starting at the purchase price and ending at the salvage value.
The straight line depreciation formula is:
Straight Line = (Asset Cost - Salvage Value) / Useful Life
Here is the depreciation calculation using straight line depreciation and the information given about.
Straight Line = ($70,000 - $20,000) / 5 years
Straight Line = $50,000 / 5 years
Straight Line = $10,000 / year
Under this treatment, we would deduct $10,000 of asset value every year and hold that value in accumulated depreciation. Here is the math:
The straight line method provides the same depreciation expense (dollar amount) and depreciation rate (percentage) in the first year as the second year, third year, etc.
Remember: Book value + accumulated depreciation always the asset's purchase price.
The double-declining balance method, also called the double declining method, is an accelerated treatment done by doubling the straight line depreciation rate.
For each year, we have to calculate the math all over as the book value does not follow a straight line under this treatment.
The double declining balance (DDB) formula is:
Double Declining Balance = 2 x Straight Line Depreciation Rate x Book Value
Straight line depreciation rate is the percent depreciation under the straight line method above. This is calculated by 1 divided by the useful life. In our case, it’s 1 / 5 or 20%. So double this value would be 40%.
We will be using 40% multiplied by the book value for each year. Here is the math for the first year:
DDB = 40% x $70,000
DDB = $28,000
Since we depreciated $28,000 in the first year, the book value for year two is now $42,000. Let’s do the math for the second year now:
DDB = 40% x $42,000
DDB = $16,800
The $42,000 book value less $16,800 in depreciation is $25,200, which means that depreciation expense in year 3 would be $5,200. Why? Because we cannot depreciate past our salvage value.
Here are all of the depreciation expenses side by side to show how it’s declining in nature:
This is an accelerated depreciation method compared to straight line depreciation. The company will show higher depreciation expense and higher depreciation rates, but for a shorter number of years. The net impact over the asset’s useful life is unchanged.
The units of production depreciation method relies on production output, instead of time, to calculate depreciation.
The amount of depreciation is based on two factors: the total number of units the asset can produce over its lifetime and the number of units actually produced in a given period.
The units of production formula is:
Units of Production = (Total Depreciation / Estimated Lifetime Units) * Actual Units Produced
Let’s dig into the numbers using the example for Company A.
Units = ($50,000 / 500,000) * 87,000
Units = $0.10 * 87,000
Units = $8,700
As you can see, the company expected to produce 100,000 units per year (500,000 lifetime units over a 5 year useful life). That number (100,000 * $0.10 per unit) would have given us the same $10,000 as the straight line method.
Since we produced fewer than 100,000 units this year, the depreciation expense was lower than straight line. If the number of units produced next year is higher than 100,000, the depreciation expense would be higher than straight line.
The sum of the years digits depreciation method (SYD) is an accelerated depreciation method that relies on summing the digits in the useful time to calculate the depreciation rate.
This method, also called the sum of years depreciation method, provides higher depreciation in earlier years and lower depreciation in later years. For an asset with a 5 year useful life, here are the digits: 5, 4, 3, 2, and 1.
You would sum those digits (5 + 4 + 3 + 2 + 1 = 15) and use that as the denominator. For each year, you would take a digit (starting with the largest digit for the first year and working your way down) to get the depreciation rate.
Example with 5 year useful life:
All of these percentages need to sum up to 100%.
The digits method provides a quick way to get an accelerated depreciation schedule. For our example company with $50,000 of total depreciation, their yearly depreciation would be:
Year 1: $50,000 * 33% = $16,500
Year 2: $50,000 * 27% = $13,500
Year 3: $50,000 * 20% = $10,000
Year 4: $50,000 * 13% = $6,500
Year 5: $50,000 * 7% = $3,500
As a quick check, let’s make sure these values sum to $50,000.
Total Depreciation = $16,500 + $13,500 + $10,000 + $6,500 + $3,500
Total Depreciation = $50,000
Now we can be sure that we calculated the math correctly using the sums method correctly.
Executives, managers, investors, accountants, and others want to understand the full cost of purchasing and using an asset. These stakeholders will pay careful attention to an asset’s useful life, upfront cost, maintenance cost, and productivity.
Here are some key takeaways about depreciation:
The Internal Revenue System (IRS) has rules governing how assets are depreciated over time because depreciation expenses is a tax deduction. There are several methods available to businesses and accountants, each with their pros and cons.
Depreciation expense can have a large impact on the profits reported, and thus the taxes due, for a business each year.
Business owners and accounting professionals should make decisions about purchasing fixed assets by considering the cost of the asset, repairs, maintenance, and the tax implications resulting from depreciating the asset.
Ultimately, depreciation accounting provides a clearer understanding of the true cost of purchasing an asset.
Keep in mind that rules for depreciation vary significantly based on geography, type of taxpayer, and type of asset. Please consult a tax professional for specific information relating to your tax calculations and tax return.
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