Depreciation is the concept that most assets will not last indefinitely, but decrease in value over time and be replaced at a certain point. As an asset depreciates, portions of the cost are allocated as depreciation expenses on an income statement for each accounting period in which the asset is used. Examples of assets which depreciate include machinery and equipment, office furniture, computers, vehicles, and buildings. Intangible property such as copyrights, computer software, and patents can also depreciate over time. Land, on the other hand, is considered to last indefinitely and cannot depreciate in value.
Depreciation is calculated by utilizing the cost principle and the matching principle of accounting. The cost principle states that item values listed in financial statements must be the actual cost of an item, as opposed to its market value. In most cases, the value of an item cannot be greater than its cost. When a depreciation cost is reported on an income statement and the corresponding asset amount is reported on a balance sheet, the cost should represent the asset’s original cost, not the market value.
Next, the matching principle of accrual accounting states that related revenues and expenses should be reported together in the same accounting period. While an asset is in use, its costs must be recorded as a depreciation expense as the asset depreciates.
When a depreciation expense is reported over time, there are several means of calculating the depreciation costs. The simplest, most common method is straight line depreciation, where an item’s value and useful life are determined. If any salvage value remains at the end of the useful, this amount is calculated in as well. Once the lifespan is determined, depreciation costs are evenly divided among accounting periods.
Another means of calculating depreciation is the declining balance method, which expenses a percentage of depreciation costs over an item’s useful life instead of an even division. For example, by using a constant percentage, an asset’s cost decreases after each accounting period. It is possible to switch between using the declining balance method and the straight line depreciation method, though this must be approved by the IRS first.
Accelerated depreciation is another method of determining depreciation. Under this method, assets depreciate more in the first half of that asset’s life than in the last half. So, depreciation expenses are higher in the earlier parts of an asset’s life and are lower in the later parts of an asset’s life. Because expenses are higher in the first part, a company will report smaller profits. Still, higher depreciation at the beginning of an asset’s life will result in more immediate income tax savings than if the depreciation was more spread out.
Depreciation contained within financial statements must be listed within a general journal as a contra asset account of accumulated depreciation. With this, the equipment asset account will detail an item’s cost. To arrive at the book value of an item, the credit balance in accumulated depreciation is subtracted from the debit balance of the equipment account.
When calculating depreciation for financial reporting, there are two important estimates at work: an item’s salvage value and useful life. Salvage value refers to the amount a company is expected to receive when, at the end of an asset’s lifespan, that asset is disposed of. In many cases, items do not have a salvage value and are discarded.
Useful life refers to the length of time a depreciable asset will be used by a company. This does not necessarily refer to the lifespan of an asset. For example, vehicles used by a business may only be used for a few useful years before a newer model is purchased. The vehicles may be in a good state of repair and still functioning at the end of the asset’s useful life for the company.
Note that an asset’s salvage value may change over time. For example, if a product unexpectedly becomes outdated before its projected time and must be sold off earlier, depreciation expenses during the next accounting periods must compensate for higher amounts. Depreciation in the past cannot be updated.