Depreciation: Definition and Types, With Calculation Examples

Depreciation is a way for businesses to allocate the cost of fixed assets, including buildings, equipment, machinery, and furniture, to the years the business will use the assets. Carrying value is the net of the asset account and the accumulated depreciation. Salvage value is the carrying value that remains on the balance sheet after which all depreciation is accounted for until the asset is disposed of or sold. Salvage value is what a company expects to receive in exchange for the asset at the end of its useful life. Accumulated depreciation is a contra-asset account on a balance sheet; its natural balance is a credit that reduces the overall value of a company’s assets.

It’s most useful where an asset’s value lies in the number of units it produces or in how much it’s used, rather than in its lifespan. The formula determines the expense for the accounting period multiplied by the number of units produced. For tax purposes, businesses are generally required to use the MACRS depreciation method. It’s an accelerated method for calculating depreciation because it allows larger depreciation write-offs in the early years of the asset’s useful life. The difference between the end-of-year PP&E and the end-of-year accumulated depreciation zero based budgeting forces managers to is $2.4 million, which is the total book value of those assets.

How to calculate straight-line depreciation

1. Salvage value is what a company expects to receive in exchange for the asset at the end of its useful life.
2. This entry indicates that the account Depreciation Expense is being debited for $10,000 and the account Accumulated Depreciation is being credited for $10,000.
3. The carrying value, or book value, of an asset on a balance sheet is the difference between its purchase price and the accumulated depreciation.
4. The cumulative depreciation of an asset up to a single point in its life is called accumulated depreciation.
5. This happens because of the matching principle from GAAP, which says expenses are recorded in the same accounting period as the revenue that is earned as a result of those expenses.

Put another way, accumulated depreciation is the total amount of an asset’s cost that has been allocated as depreciation expense since the asset was put into use. Assuming the company pays for the PP&E in all cash, that $100k in cash is now out the door, no matter what, but the income statement will state otherwise to abide by accrual accounting standards. The depreciation expense is scheduled over the number of years corresponding to the useful life of the respective fixed asset (PP&E). Unlike the account Depreciation Expense, the Accumulated Depreciation account is not closed at the end of each year. Instead, the balance in Accumulated Depreciation is carried forward to the next accounting period. After the truck has been used for two years, the account Accumulated Depreciation – Truck will have a credit balance of $20,000.

However, it is logical to report $10,000 of expense in each of the 7 years that the truck is expected to be used. Using this new, longer time frame, depreciation will now be $5,250 per year, instead of the original $9,000. That boosts the income statement by $3,750 per year, all else being the same. It also keeps the asset portion of the balance sheet from declining as rapidly, because the book value remains higher.

Calculating Depreciation Using the Straight-Line Method

Some companies may use the double-declining balance equation for more aggressive depreciation and early expense management. X wants to charge depreciation using the diminishing balance method and wants to know the amount of depreciation it should charge in its profit and loss account. Help Mr. X calculate the depreciation and closing value of the machine at the end of each year. Depreciation recapture is a provision of the tax law that requires businesses or individuals that make a profit in selling an asset—that was previously depreciated—to report it as income. In effect, the amount of money they claimed in depreciation is subtracted from the cost basis they use to determine their gain in the transaction. Recapture can be common in real estate transactions where a property that has been depreciated for tax purposes, such as an apartment building, has gained value over time.

To calculate depreciation using the straight-line method, subtract the asset’s salvage value (what you expect it to be worth at the end of its useful life) from its cost. To start, a company must know an asset’s cost, useful life, and salvage value. Then, it can calculate depreciation using a method suited to its accounting needs, asset type, asset lifespan, or the number of units produced. Depreciation is an accounting method that companies use to apportion the cost of capital investments with long lives, such as real estate and machinery.

Both of these can make the company appear “better” with larger earnings and a stronger balance sheet. The expected useful life is another area where a change would impact depreciation, the bottom line, and the balance sheet. Suppose that the company is using the straight-line schedule originally described. After three years, the company changes the expected useful life to a total of 15 years but keeps the salvage value the same.

Most companies use selling general and administrative expenses sganda a single depreciation methodology for all of their assets. Thus, the methods used in calculating depreciation are typically industry-specific. Let us take another example to understand the unit of production method formula.

By using this formula, you can calculate when you will need to replace an asset and prepare for that expense. Determining monthly depreciation for an asset depends on the asset’s useful life, as well as which depreciation method you use. New assets are typically more valuable than older ones for a number of reasons.

Why is the straight-line depreciation method important?

To see how the calculations work, let’s use the earlier example of the company that buys equipment for $50,000, sets the salvage value at $2,000 and useful life at 15 years. Companies seldom report depreciation as a separate expense on their income statement. Thus, the cash flow statement (CFS) or footnotes section are recommended financial filings to obtain the precise value of a company’s depreciation expense. On the balance sheet, depreciation expense reduces the book value of a company’s property, plant and equipment (PP&E) over its estimated useful life. Depreciation is a non-cash expense that allocates the purchase of fixed assets, or capital expenditures (Capex), over its estimated useful life.

Note that for purposes of simplicity, we are only projecting the incremental new capex. For the past 52 years, Harold Averkamp (CPA, MBA) hasworked as an accounting supervisor, manager, consultant, university instructor, and innovator in teaching accounting online. This entry indicates that the account Depreciation Expense is being debited for $10,000 and the account Accumulated Depreciation is being credited for $10,000.

To illustrate the cost of an asset, assume that a company paid $10,000 to purchase used equipment located 200 miles away. The company will record the equipment in its general ledger account Equipment at the cost of $17,000. This approach calculates depreciation as a percentage and then depreciates the asset at twice the percentage rate.

Accumulated depreciation is used to calculate an asset’s net book value, which is the value of an asset carried on the balance sheet. The formula for net book value is cost an asset minus accumulated depreciation. The assumption behind accelerated depreciation is that the fixed asset drops more of its value in the earlier stages of its lifecycle, allowing for more deductions earlier on. The units of production method recognizes depreciation based on the perceived usage (“wear and tear”) of the fixed asset (PP&E). The double declining method (DDB) is a form of accelerated depreciation, where a greater proportion of the total depreciation expense is recognized in the initial stages. The straight-line depreciation method gradually reduces the carrying balance of the fixed asset over its useful life.

For the past 52 years, Harold Averkamp (CPA, MBA) has worked as an accounting supervisor, manager, consultant, university instructor, and innovator in teaching accounting online.

Management that routinely keeps book value consistently lower than market value might also be doing other types of manipulation over time to massage the company’s results. However, one can see that the amount of expense to charge is a function of the assumptions made about both the asset’s lifetime and what it might be worth at the end of that lifetime. Those assumptions affect both the net income and the book value of the asset. Further, they have an impact on earnings if the asset is ever sold, either for a gain or a loss when compared to its book value.