Accounting / Bookkeeping Basics: Depreciation

Depreciation

With long-term assets you will have many assets that will depreciate over time.  Land is the one thing that is the exception to depreciation.  Mainly because land does not depreciate.  Depreciation is for those assets that are good for only a given number of years and will eventually need to be replaced.  Therefore, we need to figure out how much it will depreciate over time.
Depreciation will assign a cost of a long-term asset to an expense account in the periods when the asset generates revenue.  So when you think about it, depreciation basically offsets the revenue of an accounting period with the costs of the product or service consumed to generate the revenue.
The depreciation expense does not come to decrease value.  Instead it is a result from allocating cost of a period of time.  Once you start using the asset that is to be depreciated it is generally done quarterly or annually.  The depreciation ends when the company or businesses disposes of the asset or determines that its lifespan is over.
There are several ways to record depreciation.  The GAAP rule only requires the method used is rational and systematic through the asset’s lifespan.  Let’s look at some of the ways to figure and record depreciation.
Straight-line method—this is the most common for financial reporting.  It will maximize net income more than any other method.  It is also the easiest to understand and follow the calculations.  This method attributes an equal amount of expense to each period of lifespan for the assets.  Before we can understand the calculations we first need to find out what salvage value is.  When a business uses the lifespan of the asset and is ready to sale it you need to ask yourself how much you expect to earn from selling the asset.  This is the salvage value.  

So let’s look at the equation for the straight-line method:
Depreciation = (Cost – Salvage Value) / Lifespan

To explain this better let’s look at each aspect of the equation.  First you will take the cost of the asset and subtract the salvage value.  The cost will be the original cost when you purchased the asset.  Then you will take this total and divide it by the lifespan.  The lifespan is the number of years that the business sees the asset as useful.  This gives you the depreciation cost.

For example, you have a flow jet for your business.  The estimated lifespan is five years.  You originally purchased it for $20,000 and  the estimated salvage value would be $5,000.  Let’s put this in the equation.  $20,000 - $5,000 = $15,000 / 5 = $3,000.  Therefore, the depreciation will be $3,000.  Many times, you can think of the lifespan as a percentage.  The rate is 1.  So the lifespan for the flow jet will be 1/5 or 20%.
With a depreciation schedule we see the book value.  It is important to know the book value of an asset.  

To find this you will take the original asset cost and minus the accumulated depreciation.
Book Value = Cost – Accumulated Depreciation

Market value and book value are not the same.  Book value represents the value of the asset according to the business books.  Each year the book value has to be updated.  This is because the accumulated depreciation will change each year and the company or business needs to know when the lifespan will be up.  However, the book value should never go below the salvage value of the asset.  This is a conservation principle.  Keep in mind that when the depreciation is finished you will see the salvage value and the book value will be equal.

Declining-balance method—with this method the depreciation assigned for each year of usage is different.  Suppose that you feel that your asset is more productive and creates more revenue early in its life.  This method is an accelerated method.  You will see more depreciation expense allocated early in the asset’s life than it would be in the later years.  

For the declining-balance method we can calculate the depreciation expense with the following formula:
Depreciation Expense = Rate * Current Book Value

Since the book value decreases each period so does the depreciation expense.  This is why it is called declining-balance method.
With all the methods you need to keep in mind that the book value will never go below its salvage value and it will be equal when it is at the end of its lifespan.

Sum of the Years’ Digits (SOYD) method—is another accelerated method for depreciation.  With this method the amount of depreciation is assigned to each year of life based on an inverted scale of the sum of the years of its lifespan.
Units of Production method—is different than the other methods.  It is based on depreciation from a measurement of the asset’s output instead of its lifespan.  With this method it allows for more depreciation when the asset is used more.  The method is more used  for assets such as vehicles and machinery.  

For calculating this method you would use the following formula.  

It is similar to the formula for the straight-line method.
Depreciation Rate per Unit = (Cost – Salvage Value) / Estimated Units of Output

Keep in mind that natural resources are depreciated differently than other assets.  This is because once their lifespan is up or they are used up then they can only be replaced through natural processes.  

To figure this you will need to first find the cost per unit.
Cost Per Unit = Depletable Cost / Estimated Total Number of Units

Once you have the cost per unit then you can calculate the depletion expense.
Depletion Expense = Cost Per Unit * Yearly Number of Units Extracted

Modified Accelerated Cost of Recovery System (MACRS) method—must be used for a business’s income tax returns.  Businesses are allowed to use one method for their income tax returns and another method for their financial statements.  With this method the Internal Revenue Service (IRS) will specify depreciation rates and time periods for particular categories of fixed assets, for example, furniture and computer equipment.  Using this method will lower net income which will lower the taxes owed to the IRS.