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Depreciation refers to the allocation of the cost of the asset to its useful life. Depreciation reduces the fair value of tangible assets due to deterioration, wear and tear, or obsolescence.
Usually by the end of the useful life of the asset, its book value should be zero, therefore depreciation spreads the value of an asset to its useful life. The initial price of purchase which is mentioned in the balance sheet is known as the historical cost of the asset. The cost basis of depreciation is one of the ways to reduce the book value of the asset in relation to the wear and tear.
An asset deteriorates due to its regular usage and may also lose its relevance for being obsolete over a period of time, depreciation takes into account these factors and adjusts the book value of the asset periodically.
A small business has to specify the method of depreciation chosen in their accounting policies and duly record depreciation in their accounts. Before applying depreciation, the business owner must differentiate between which property can be depreciated and which property cannot be depreciated.
The depreciable cost reduces the cost of the asset and as a non-cash expense it also reduces the taxable income of the business.
In US GAAP, depreciation is addressed under the “Accounting Standard Codification (ASC) 360,” which guides the presentation and disclosure of long-lived assets.
Under US GAAP, there are four methods for calculating depreciation:
In IFRS, depreciation is addressed under the International Accounting Standard (IAS) 16, which provides guidelines on the measurement, recognition, and depreciation of the property, plant, and equipment.
Depreciation is considered as an operating expense in the company’s financial statements. It is marked as an expense on the income statement.
When a company buys an asset, it records the transaction on its balance sheet as a debit, which increases the asset account, and a credit, which reduces cash (or increases accounts payable) on its balance sheet. Neither of these entries impacts the income statement, where revenues and expenses are reported.
At the end of an accounting period, the company that uses depreciation will record the depreciation for all its capitalized assets that still need to be fully depreciated.
This accounting entry will include the following:
| Particulars | Dr($) | Cr ($) |
| Depreciation Expense A/c …. Dr | XXX | |
| To Accumulated Depreciation A/c | XXX |
| Particulars | Dr($) | Cr ($) |
| Accumulated Depreciation A/c …. Dr | XXX | |
| To Asset A/c | XXX |
Depreciation is an accounting concept that applies to businesses or commercial entities. All business assets are subjected to depreciation unless stated otherwise in the accounting principles.
For taxation purposes, IRS and accounting standards have given guidelines that only business assets are depreciated.
Personal property or assets of the owner are not subjected to depreciation, only business assets with the useful life of more than 1 year. Apart from these there are detailed guidelines given by the IRS.
Under the income forecast method, you can depreciate a few intangible properties, such as copyrights, patents, and sound recordings.
Straight-line depreciation is a method of distributing the cost of an asset evenly over its useful life. It is usually used by small businesses that don’t have an accountant or tax advisor to handle their financial records.
Formula of Straight-line Depreciation = (asset cost – salvage value)/ useful life, where;
The double-declining balance depreciation method is a form of accelerated depreciation that multiplies an asset’s value by a depreciation rate. It is usually used by businesses that want to retrieve more of an asset’s value.
Formula of Double-declining Balance Depreciation = (2 x straight-line depreciation rate) x (book value at the beginning of the year)
Sum-of-the-year depreciation is an accelerated depreciation method used to determine an asset’s expected depreciation over time. It is commonly utilized by businesses that aim to recover more value from an asset but with a slightly more equal distribution compared to what the double-declining balance method allows.
Formula of Sum-of-the-year Depreciation = (remaining lifespan / SYD) x (asset cost – salvage value)
Units of production depreciation is a method of estimating the depreciation of an asset’s value based on the number of units it produces rather than the number of years it has been in use. It is commonly used by businesses that want to take more depreciation in years when they use the asset more and less depreciation when they use the asset less.
Formula of Units of Production Depreciation = (asset cost – salvage value) / units produced in useful life
Rock-start Private Limited purchases equipment. The salvage value of the equipment is $10,000, and its useful life is 10 years. Its purchase price is $50,000.
Annual Depreciation = (50000-10000)/10 = $4000
where:
Asset value = 50000
Salvage value= 10000
Useful life = 10 years
Depreciation ( 1st year ) = 2* (50000-10000)/10 = $8000
Net Book Value ( end of 1st year) = $42000 ($50000-$8000)
Depreciation ( 2nd year ) = 2*(42000-10000)/10 = $6400
Sum of useful life = 55 (10+9+…..+2+1)
Depreciation factor in:
1st Year: 10/55
2nd Year: 9/55
3rd Year: 8/55 and so on.
so,
Depreciation ( 1st year ) =(10/55)*$40000 = $7272.72
In case the company uses the purchased equipment for 6 months,
so,
Depreciation = (4000/12)*6 = $2000
Depreciation expense represents the distribution of a tangible fixed asset’s cost over its useful life. It is documented on the income statement every accounting period, which shows how the asset is used and how much wear and tear it sustains.
The goal is to ensure that the costs and revenue of the asset are balanced throughout its useful life.
Methods of Calculating Depreciation Expense:
The total amount of depreciation expense reported for an asset since it was placed into use is known as accumulated depreciation. The income statement records the depreciation expense for each period, and the balance sheet adds the corresponding amount to the total depreciation. Until the asset is completely depreciated or sold, accumulated depreciation keeps rising.
The goal is to monitor the overall amount of depreciation recorded during the asset’s life.
Formula of Accumulated Depreciation = Summing up the depreciation expense amounts for each year
| Depreciation Expense | Accumulated Depreciation | |
| Defines as: | It is a periodic charge to expense for allocating asset cost. | It is a cumulative total of depreciation charged over time. |
| Recorded | It is recorded on the income sheet of the company’s record. | It is recorded on the balance sheet of the company’s record. |
| Impact on records | It affects the net income of the business. | It reduces the net book value of the asset. |
| Reporting frequency | It is reported in each accounting period. | It updates cumulatively over the asset’s life. |
A depreciation schedule is a comprehensive table that shows how much a business will spend on depreciating its fixed assets over its useful lives.
This schedule plays a crucial role in managing and documenting depreciation charges by providing an organized approach to tracking the cost allocation of an asset as it ages.
It typically includes the following information:
MACRS, which stands for modified accelerated cost recovery system, is a method of depreciation used for tax purposes.
To depreciate property under MACRS, you can either use:
MACRS replaced ACRS (Accelerated Cost Recovery System) in 1986. For property placed in service before 1987, you must use the Accelerated Cost Recovery System (ACRS) or the same method you used previously to depreciate it. For property placed in service after 1986, you should generally use the Modified Accelerated Cost Recovery System (MACRS).
You cannot use MACRS to depreciate the following types of property:
Every business should ensure that its accountant claims the IRS Form 4562, as it helps the business deduct taxes.
The IRS Form 4562 is used to claim:
Always keep a complete record of all depreciable assets, including tax filings, depreciation schedules, and purchase paperwork, and adhere to the applicable tax laws and accounting standards (GAAP, IFRS) when calculating and reporting depreciation.
Depreciation is an essential accounting term that reflects wear and tear, obsolescence, and degradation by spreading out the cost of physical assets over their useful lives. In addition to giving financial statements a more realistic picture of an asset’s value, this methodical decline in asset value lowers taxable income, which has tax benefits.
Various techniques for computing depreciation, including straight-line, declining balance method, sum-of-the-year, and units of production, enable companies to select the best strategy to record depreciation in their accounts.
