Depreciation for Financial Accounting

Depreciation in accounting is used to spread an asset’s cost over the number of years it will be useful to the entity. It is used to reflect the decreasing value of the asset over time due to wear-and-tear, usage, technological outdating, etc… The original purchase affects the entity’s cash account one time. For the remaining useful life of the item, the assets are affected on the balance sheet as accumulated depreciation and the expenses are affected on the income statement as depreciation expenses. Depreciation is a way to spread the expense of an asset over the span of its useful life, as long as that span is longer than one accounting period. Many different types of assets are depreciable including tangible assets (buildings, equipment, machinery) and intangible assets (software, patents, copyrights). There are several types of depreciation methods used in bookkeeping today. A few are outlined below.

Straight-line depreciation method is graphically exactly what the name implies. It is a straight, horizontal line on a graph of annual depreciation expense versus years of life. It is one pre-determined standard amount that is divided over the estimated useful life span of the asset. This expense is then recorded once per year for the appropriate length of time. This can be calculated by taking the difference of the original cost minus the salvage value (or the amount that the item can be sold for at the end of its useful life to the entity) divided by the useful life. This calculation will give you the amount to be recorded as depreciation each year. For example, if an asset is purchased for $125,000, it’s salvage value is $5,000 ($125,000 - $5,000 = $120,000), and it is estimated to last the entity 6 years ($120,000/ 6 years = $20,000/year) an accumulated depreciation of $20,000 should be recorded each year for the next 6 years.

Related to straight-line depreciation is units-of-production depreciation. Instead of spreading the total asset depreciation over a span of time, it is spread over the amount of units it is expected to produce in its useful life. The depreciation is constant for each unit produced, but if some years are more fruitful in production than others, the amount recorded as depreciation will vary. This is most relevant with an asset that has a useful life closely related to its output. For example, if the same asset listed above was estimated to be able to produce 60,000 units of product in its lifetime ($120,000/60,000) each unit produced should be recorded as an accumulated depreciation of $2. If in 2007 the entity was able to produce 12,000 units, $24,000 should be recorded as accumulated depreciation. Likewise if in 2008 the entity was able to produce 16,000 units, an accumulated depreciation of $32,000 should be recorded for that year.

200% or double-declining balance depreciation involves using the straight-line depreciation rate but doubling it. If an asset has an estimated useful life span of 10 years, a 10% depreciation is recorded each year. In double-declining balance depreciation, a 20% depreciation of the asset’s net book value at the beginning of the year is recorded. As time goes on, that 20% depreciation is a lower and lower value because the net book value decreases with time. In this method of depreciation recording, the biggest expense is recorded in the first year. Many entities choose not to use this method, because a large depreciation expense in one year can drastically affect their net income for the year. Many prefer to spread the expense out evenly as demonstrated in straight-line depreciation above.

The MACRS depreciation technique does not use salvage value or an estimated useful live on the accountant’s part. It utilizes a standard estimate of useful life based on the class life of the asset, which are determined by the IRS. In this method, the asset is depreciated all the way down to $0 instead of to its salvage value. The percentage that an asset is to be depreciated in each year of its life can be found on the IRS website on depreciation tables. There are tables available for each class of property depending on its pre-determined useful life. This method can also be useful for small businesses because it allows an entity to depreciate up to a total dollar amount in one year. This can help avoid many small depreciation expenses on income statements and balance sheets for years to come, if they can be depreciated in total in one year.

Although there are many methods of recording depreciation in financial statements, they all are essentially used to accomplish the same thing. Once the total original value of the asset is recorded as accumulated depreciation, there is no need to mention on accounting statements again (even if the asset is still useful to the entity). Accountants may prefer one method over another in order to achieve lower taxable income in a given year, or spin the documents in a favorable light, but the end result is always essentially the same.