Businesses can depreciate long-term assets for both tax
and accounting purposes. For example, companies can take a tax
deduction for the cost of the asset, meaning it reduces taxable income.
However, the Internal Revenue Service
(IRS) states that when depreciating assets, companies must spread the
cost out over time. The IRS also has rules for when companies can take a
Depreciation is an accounting convention that allows a company to write
off an asset's value over a period of time, commonly the asset's useful
life. Assets such as machinery and equipment are expensive. Instead of
realizing the entire cost of the asset in year one, depreciating the
asset allows companies to spread out that cost and generate revenue from
Depreciation is used to account for declines in the carrying value over time. Carrying value represents the difference between the original cost and the accumulated depreciation of the years.
Each company might set its own threshold amounts for when to begin depreciating a fixed asset–or
property, plant, and equipment. For example, a small company may set a
$500 threshold, over which it depreciates an asset. On the other hand, a
larger company may set a $10,000 threshold, under which all purchases
are expensed immediately.
For tax purposes, the IRS publishes depreciation schedules detailing
the number of years an asset can be depreciated, based on various asset
The entire cash outlay might be paid initially when an asset is
purchased, but the expense is recorded incrementally for financial
reporting purposes because assets provide a benefit to the company over a
lengthy period of time. Therefore, depreciation is considered a
non-cash charge since it doesn't represent an actual cash outflow. However, the depreciation charges still reduce a company's earnings, which is helpful for tax purposes.
The matching principle under generally accepted accounting principles
(GAAP) is an accrual accounting concept that dictates that expenses must
be matched to the same period in which the related revenue is
generated. Depreciation helps to tie the cost of an asset with the
benefit of its use over time. In other words, each year, the asset is
put to use and generates revenue, the incremental expense associated
with using up the asset is also recorded. The total amount that's depreciated each year, represented as a
percentage, is called the depreciation rate. For example, if a company
had $100,000 in total depreciation over the asset's expected life, and
the annual depreciation was $15,000; the rate would 15% per year.
When an asset is purchased, it is recorded as a debit to increase an
asset account, which then appears on the balance sheet, and a credit to
reduce cash or increase accounts payable, which also appears on the
balance sheet. Neither side of this journal entry affects the income statement,
where revenues and expenses are reported. In order to move the cost of
the asset from the balance sheet to the income statement, depreciation
is taken on a regular basis.
At the end of an accounting period, an accountant will book depreciation
for all capitalized assets that are not fully depreciated. The journal
entry for this depreciation consists of a debit to depreciation expense,
which flows through to the income statement, and a credit to
accumulated depreciation, which is reported on the balance sheet.
Accumulated depreciation is a contra asset account, meaning its natural
balance is a credit which reduces the net asset value. Accumulated
depreciation on any given asset is its cumulative depreciation up to a
single point in its life.
As stated earlier, carrying value is the net of the asset account and
accumulated depreciation. The salvage value is the carrying value that
remains on the balance sheet after all depreciation has been taken until
the asset is sold or otherwise disposed. It is based on what a company
expects to receive in exchange for the asset at the end of its useful
life. As such, an asset’s estimated salvage value is an important
component in the calculation of depreciation.
If a company buys a piece of equipment for $50,000, it could expense the
entire cost of the asset in year one or write the value of the asset
off over the asset's 10-year useful life. This is why business owners
like depreciation. Most business owners prefer to expense only a portion
of the cost, which boosts net income.
In addition, the company can scrap the equipment for $10,000 at the end
of its useful life, which means it has a salvage value of $10,000. Using
these variables, the accountant calculates depreciation expense as the
difference between the cost of the asset and its salvage value, divided
by the useful life of the asset. The calculation in this example is
($50,000 - $10,000) / 10, which is $4,000 of depreciation expense per
This means the company's accountant does not have to expense the entire
$50,000 in year one, even though the company paid out that amount in
cash. Instead, the company only has to expense $4,000 against net
income. The company expenses another $4,000 next year and another $4,000
the year after that, and so on until the asset reaches its $10,000
salvage value in ten years.
Depreciating assets using the straight-line method is typically the most
basic way to record depreciation. It reports equal depreciation expense
each year throughout the entire useful life until the entire asset is
depreciated to its salvage value. The example above used straight-line
Assume, for another example, that a company buys a machine at a cost of
$5,000. The company decides on a salvage value of $1,000 and a useful
life of five years. Based on these assumptions, the depreciable amount
is $4,000 ($5,000 cost - $1,000 salvage value) and the annual
depreciation using the straight-line method is: $4,000 depreciable
amount / 5 years, or $800 per year. As a result, the depreciation rate
is 20% ($800/$4,000). The depreciation rate is used in both the
declining balance and double-declining balance calculations.
The declining balance method is an accelerated depreciation
method. This method depreciates the machine at its straight-line
depreciation percentage times its remaining depreciable amount each
year. Because an asset's carrying value is higher in earlier years, the
same percentage causes a larger depreciation expense amount in earlier
years, declining each year.
Using the straight-line example above, the machine costs $5,000, has a
salvage value of $1,000, a 5-year life, and is depreciated at 20% each
year, so the expense is $800 in the first year ($4,000 depreciable
amount * 20%), $640 in the second year (($4,000 - $800) * 20%), and so
The double-declining balance (DDB) method
is another accelerated depreciation method. After taking the reciprocal
of the useful life of the asset and doubling it, this rate is applied
to the depreciable base, book value, for the remainder of the asset’s
expected life. For example, an asset with a useful life of five years
would have a reciprocal value of 1/5 or 20%. Double the rate, or 40%, is
applied to the asset's current book value for depreciation. Although
the rate remains constant, the dollar value will decrease over time
because the rate is multiplied by a smaller depreciable base each
The sum-of-the-year’s-digits (SYD) method
also allows for accelerated depreciation. To start, combine all the
digits of the expected life of the asset. For example, an asset with a
five-year life would have a base of the sum of the digits one through
five, or 1+ 2 + 3 + 4 + 5 = 15. In the first depreciation year, 5/15 of
the depreciable base would be depreciated. In the second year, only 4/15
of the depreciable base would be depreciated. This continues until year
five depreciates the remaining 1/15 of the base.
This method requires an estimate for the total units an asset will
produce over its useful life. Depreciation expense is then calculated
per year based on the number of units produced. This method also
calculates depreciation expenses based on the depreciable amount.