Depreciation is the reduction in value of an asset over time. It is a method used to allocate the cost of an asset over its useful life. Accounting regulations require companies to record depreciation as an expense each year, which lowers their taxable income.
Most physical assets, such as properties and vehicles, lose value over time due to wear and tear, obsolescence, and other factors, and depreciation is used to account for this decrease in value.
What Is an Asset?
An asset is anything owned by a company that has value and can be used for future economic benefits.
Assets can include tangible items like machinery, buildings, and vehicles, as well as intangible items like patents, copyrights, and trademarks.
Example of Depreciation
Let’s say a construction company purchases a new bulldozer for $100,000.
They estimate that the bulldozer will have a useful life of 10 years. Using the straight-line depreciation method, the company would depreciate the bulldozer at a rate of $10,000 per year ($100,000 / 10 years).
This means that after one year, the bulldozer would be worth $90,000, and after 10 years, it would be worth $0.
Types of Depreciation
There are three main methods of calculating depreciation:
- Straight-line depreciation: The most common method of calculating depreciation, straight-line depreciation involves dividing the cost of the asset by its estimated useful life to determine the annual depreciation expense. For example, if a company purchases a vehicle for $50,000 with an estimated useful life of 5 years, the straight-line depreciation expense would be $10,000 per year.
- Double-declining balance depreciation: Double-declining balance depreciation is an accelerated method of depreciation that allocates a higher percentage of the asset’s cost to the earlier years of its useful life. This method results in a larger depreciation expense in the early years of the asset’s life and a smaller expense in later years.
- Units-of-production depreciation: Units-of-production depreciation is a method that calculates depreciation based on the number of units produced by the asset. This method is commonly used for assets that are used to produce goods or services, such as manufacturing equipment.
What Is the Journal Entry for Depreciation?
To account for depreciation, companies must make a journal entry each year to record the expense. Depreciation is recorded in the financial statements, specifically in the income statement and balance sheet.
The accumulated depreciation balance is a contra-asset account that offsets the balance in the asset account. As depreciation expenses are recorded over time in the income statement, the value of the asset on the balance sheet decreases by the same amount.
In the income statement, depreciation is recorded as an expense under the category of “Depreciation Expense” or “Depreciation Cost.” This expense reduces the company’s net income, reflecting the gradual consumption of the asset’s value over time.
In the balance sheet, depreciation is recorded as a contra-asset account called “Accumulated Depreciation.” This account is subtracted from the original cost of the asset to reflect its reduced value.
For example, if a company purchases a machine for $10,000 with a useful life of 5 years, the annual depreciation expense would be $2,000 per year. The journal entry for the first year of depreciation would be:
- Debit (income statement): Depreciation Expense ($2,000)
- Credit (balance sheet): Accumulated Depreciation ($2,000)
- What is the purpose of depreciation?
The purpose of depreciation is to spread out the cost of an asset over its useful life, rather than recording the full cost as an expense in the year it was purchased.
- How does depreciation affect taxes?
Depreciation reduces a company’s taxable income, which lowers their tax liability.
- What happens to an asset after it has been fully depreciated?
After an asset has been fully depreciated, it is considered to have no remaining value for accounting purposes. However, the asset may still have some useful life and can continue to be used by the company.