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What is depreciation?

Depreciation is a reduction in value of a long-term, tangible, definite asset. Long-term assets are usually supposed or planned to serve for more than a year or one operating cycle, whichever is longer that’s why they are capitalized. Depreciation is usually associated with property plant and equipment “P,P&E” account. All tangible capitalized assets except for land will wear out and the cost should be allocated over the useful life of these properties. On the other hand, such pieces of land as parking lots, paved driveways or irrigation systems do wear out over time and must be depreciated.

The calculation of reduction in cost is important for any company because it will adjust the amount of the carrying (book) value of the assets over time. For example, when a new asset is acquired, the purchase price plus any additional cost to get it ready for the intended use will be the asset basis. Then after one year of its use the basis will be reduced by the amount of depreciation for the period. Initial cost might include such expense as for title fees, legal fees, survey costs, zoning fees, and so forth.

What accounting methods used to calculated depreciation?

Companies may choose depreciation methods once the cost, useful life, and salvage value of an asset are determined. There are different ways to calculate depreciation, such as straight line or accelerated methods. Accelerated depreciation include such methods as 200% or 150% depreciation and sum of years digits (SYD) where an entity may allocate more cost of an assets in the early years of the useful life of the property.

Which depreciation method to choose?

Which depreciation method to choose usually depends on the property type and its useful life. Firms select some depreciation method according to their needs and goals they what to reach at certain point in time, whether lower or higher depreciation amount desired to be shown. Companies may choose different depreciation methods for different assets even within the same organization and can change them from time to time if the need arise. However, they need to do all the necessary adjustments and reflect explanations in the notes to the financial statements for the period.

Comparison of changes in depreciation rate and bases among different depreciation methods

Depreciation rate from period to period
Depreciation bases from period to period
Straight line depreciation method
Sum years’ digits depreciation method
Declining balance depreciation method
Same (until the end…)

Which depreciation method is better?

There is no only one right answer for the question because different properties have different specifications. Some assets wear out faster than the other or require more maintenance cost with years of service. For example, if for furniture the straight line depreciation method might be appropriate, but for computers or some equipment it might be more reasonable to use one of accelerated depreciation methods.

What is salvage value?

Salvage value is the estimated amount of a property value at the end of an asset’s service life. This value is important in calculating depreciation expense for the period in order not to expense more than necessary or allowed. Scrap value will be in case an entity is going to use the asset up entirely and nothing will be left at the end. In other words, the asset will be worth $0 at the end of its useful life.

Where depreciation is reported?

Each period while depreciated assets in use some portion of its cost should be expensed and reported as Depreciation Expense on the income statement. Balance sheet and the income statement have ties through depreciation. Accumulated depreciation account of the balance sheet transfers a portion of a property's cost to the income statement Depreciation Expense account during each year of the asset's useful life.

What accounting entries to record depreciation?

Dr. Depreciation expense

Cr. Accumulated depreciation

Formulas for computing depreciation expenses by using different depreciation methods:

Straight line depreciation method

Depreciation expense = (Initial cost – Salvage value)
Estimated useful life of an asset

Sum of the years’ digits depreciation method

Depreciation expense = (Initial cost – Salvage value) x Remaining useful life of an asset

Sum of the years’ digits

Declining balance depreciation methods

200% 150%
Depreciation expense = 2 x 1/N x (Initial cost - Accumulated Depreciation) 1.5 x 1/N x (Initial cost - Accumulated Depreciation)

Units of production depreciation method

Depreciation expense = Rate per unit (or hour)* x # of units produced (or hours worked)  
* Rate per unit (or hour) = (Initial cost – Salvage value)  
Estimated units or hours