What is depreciation?
– Depreciation is an accounting procedure that allocates the cost of a tangible long‑lived asset (for example, machinery or servers) across the period the asset is expected to provide economic benefit. Instead of recognizing the full cash outlay when the asset is bought, depreciation spreads that cost onto future income statements while reducing
the carrying value of the asset on the balance sheet over time (its “book value”). Depreciation is a noncash expense: it reduces reported profit but does not directly use cash after the purchase is made.
Common depreciation methods
– Straight-line (SL). Allocates an equal expense each period. Formula:
Depreciation expense = (Cost − Salvage value) / Useful life
Assumes consistent economic benefit each period.
– Double-declining balance (DDB). An accelerated, declining-balance method that front-loads expense. Steps:
1) Compute straight-line rate = 1 / Useful life.
2) Double that rate = 2 × (1 / Useful life).
3) Apply to beginning-of-period book value (cost less accumulated depreciation).
Note: Do not depreciate below estimated salvage value; switch to straight-line near the end if needed.
– Sum-of-the-years’-digits (SYD). Another accelerated method. Formula:
Denominator = n(n + 1) / 2, where n = useful life in periods.
Yearly expense = (Remaining life at start of year / Denominator) × (Cost − Salvage value).
– Units-of-production (UoP). Matches expense to actual usage. Formula:
Depreciation expense = (Cost − Salvage value) × (Units used in period / Total estimated units)
Useful when wear depends on activity (hours, miles, units produced).
– MACRS (Modified Accelerated Cost Recovery System). U.S. tax depreciation system with prescribed class lives and percentage tables; generally differs from GAAP book depreciation and ignores salvage value for most property.
Worked numeric examples (same asset, different methods)
Assumptions: cost = $50,000; salvage value = $5,000; useful life = 5 years; total expected units = 100,000 hours.
1) Straight-line:
Annual expense = (50,000 − 5,000) / 5 = 9,000 per year.
2) Double-declining balance:
Rate = 2 / 5 = 40%.
Year 1 expense = 50,000 × 40% = 20,000; book value end of year = 30,000.
Year 2 expense = 30,000 × 40% = 12,000; book value end of year = 18,000.
Continue but ensure book value does not fall below salvage (5,000).
3) Units-of-production (e.g., 12,000 hours used in year 1):
Expense = (50,000 − 5,000) × (12,000 / 100,000) = 5,400.
Accounting entries (basic)
– Record annual depreciation:
Debit Depreciation Expense (income statement)
Credit Accumulated Depreciation (contra-asset on balance sheet)
– When asset is disposed:
1) Remove cost and accumulated depreciation.
2) Record proceeds received.
3) Recognize gain or loss: Proceeds − Book value (Cost − Accum. Depreciation).
Example sale journal entry (simple):
Assume after 3 years book value = 50,000 − 27,000 = 23,000, and asset sold for 25,000.
– Debit Cash 25,000
– Debit Accumulated Depreciation 27,000
– Credit Asset (Cost) 50,000
– Credit Gain on Sale 2,000 (income statement)
Tax and financial reporting considerations
– Book depreciation (financial reporting) aims to match expense with economic benefit under accounting standards (GAAP or IFRS). Tax depreciation follows tax code rules (e.g., MACRS in the U.S.). Differences generate deferred tax assets or liabilities.
– Salvage value and useful life are management estimates. They affect reported earnings and book value but not cash flow (except for tax timing).
– Impairment: If an asset’s expected future cash flows or fair value falls materially, accounting standards require an impairment loss that reduces book value immediately.
Checklist for choosing a method
– Match expense pattern to how the asset produces benefits (steady → SL; front-loaded → DDB; usage-dependent → UoP).
– Consider tax implications and whether book and tax methods will differ.
– Keep documentation: cost, acquisition date, useful life rationale, and salvage value estimate.
– Reassess useful life and salvage periodically; change only if justified and disclose per accounting rules.
Limitations and common pitfalls
– Depreciation is an estimate-driven, noncash allocation — not a valuation of market value.
– Inconsistent application or arbitrary changes to useful life can mislead financial statement users.
– Confusion often arises when comparing financial (book) measures with taxable income.
Further reading and authoritative sources
– Investopedia — Depreciation: https://www.investopedia.com/terms/d/depreci
– Investopedia — Depreciation: https://www.investopedia.com/terms/d/depreciation.asp
– IRS — Publication 946, How To Depreciate Property: https://www.irs.gov/publications/p946
– IFRS Foundation — IAS 16 Property, Plant and Equipment (IFRS guidance): https://www.ifrs.org/issued-standards/list-of-standards/ias-16-property-plant-and-equipment/
– FASB — Financial Accounting Standards Board (Accounting Standards Codification and guidance): https://www.fasb.org/
Educational disclaimer: This content is for educational purposes only and does not constitute individualized tax, accounting, or investment advice. Consult a qualified professional for decisions specific to your circumstances.