Depreciation is the process of allocating the cost of long‐lived plant assets other than land to expense over the asset's estimated useful life. For financial reporting purposes, companies often select a depreciation method that apportions an asset's depreciable cost to expense in accordance with the matching principle. For income tax purposes, companies usually select a depreciation method that reduces or postpones taxable income and, therefore, tax payments. In the United States, straight‐line depreciation is the method companies most frequently use for financial reporting purposes, and a special type of accelerated depreciation designed for income tax returns is the method they most frequently use for income tax purposes. Show
For purposes of financial reporting and tax liability, businesses need to demonstrate how their assets decrease in value, an accounting process known as depreciation. What Is Depreciation?The concept of depreciation recognizes that assets decline in value over time and it spreads their cost over their useful life. Depreciation is a methodical way to write off the cost of a fixed asset a little at a time, over the course of its useful life. By smoothing out the financial impact of asset purchases, depreciation affects a business’s income statement and balance sheet, two of the company’s most important financial statements, as well as its annual tax liabilities. It can eliminate swings in profitability that would otherwise be caused by expensing major asset purchases upfront. Key Takeaways
What Is an Asset and Which Types of Assets Depreciate?Accountants have a very specific definition of an asset that differs from the everyday use of the word. Capital assets are items with a future economic benefit that are purchased or otherwise controlled by a business. Capital assets can be tangible (such as equipment and buildings), or intangible (such as patents or trademarks). Companies also have current assets, which are short-term and include cash/cash equivalents, inventory, accounts receivable, etc. Depreciation is applied to certain tangible assets, known as fixed assets. A different cost allocation process, called amortization, is applied to intangible assets. Fixed assets are a subset of tangible assets that are expected to last more than one year and decrease in value over time. For example, a computer is a fixed asset because it will likely be in service for several years and will decrease in value every year. Fixed assets are different from current assets like inventory, which are expected to be converted into cash within a year and are therefore not subject to depreciation. Fixed assets are sometimes referred to as capital assets, property plant and equipment, long-term assets or noncurrent assets. Fixed assets tend to be higher-value items, but for bookkeeping purposes every company sets its own dollar threshold for determining whether an item should be treated as an asset that depreciates over time, instead of recognizing its full cost in the period that it was purchased. Recording an item as a fixed asset is also known as capitalization. However, for tax purposes, the IRS issues a threshold for what assets should be capitalized (see the difference between book depreciation and tax depreciation later in this article). Land is a significant exception to this rule, because it is a fixed asset that is not subject to depreciation. It is considered a non-depleting asset because it does not become obsolete, wear out or have a finite useful life. Depreciation ExplainedWhen thinking about the nature of fixed assets, especially the length of their service lives, cost should be reflected over the accounting periods during which they will be useful, rather than just in the period in which they were paid for. This approach reflects their use by the business and provides a clearer picture of business performance. Depreciation is an example of the matching principle, one of the basic tenets of Generally Accepted Accounting Principles (GAAP), where expenses are recognized in the same period as the revenue they help generate, rather than when they are paid. However, depreciation is not designed to estimate the fair market value of an asset at any point in time, which could be subjective or difficult to measure. Calculating depreciation combines some hard facts (such as the initial cost of an asset) with some estimates (such as its useful life or salvage value). Examples of Depreciation in BusinessA business can depreciate any fixed asset except land. Assets can be large, like airplanes, skyscrapers or windmills. Or they can be small, like laptops, furniture or cell phones. Depreciation is a large expense for many businesses and is represented on the P&L statements of publicly traded companies. For example, Coca-Cola recorded more than $1 billion in depreciation expenses during 2019. An airline might record even higher annual depreciation expenses because it is depreciating a large number of very expensive aircraft, while a software company might only record a fraction of that amount because it doesn’t have many high-value fixed assets. Book Depreciation vs. Tax DepreciationA company may calculate the depreciation of its fixed assets differently for its P&L than for tax reporting. Book depreciation is the amount recorded in a company’s general ledger and shown as an expense on a company’s P&L statement for each reporting period. It’s considered a non-cash expense that doesn’t directly affect cash flow. Tax depreciation refers to the way a company reports depreciation on its income tax returns. Tax depreciation must be calculated based on specific rules set by the IRS. The differences between book depreciation and tax depreciation mostly relate to the length of time over which an asset can be depreciated. However, the total depreciation expense over the entire life of an asset should be similar with both methods. The IRS also sets guidelines for the threshold value above which assets should be capitalized for tax purposes (currently $2,500 or $5,000, depending on whether the company has an applicable financial statement). Items costing less than that amount are considered “de minimis” and can be fully expensed when they are purchased. Those guidelines change from time to time and businesses should monitor those changes. Recording DepreciationDepreciation impacts both a company’s P&L statement and its balance sheet. The depreciation expense during a specific period reduces the income recorded on the P&L. The accumulated depreciation reduces the value of the asset on the balance sheet. Example of DepreciationHere is an example of the journal entries required to record depreciation of a laptop with an anticipated service life of five years. To record the cash purchase of a laptop: DebitCreditAsset - Laptop$5,000Asset - Cash$5,000 To record one month of depreciation expense based on the laptop’s five-year life (using the straight-line method, described later in this article, and assuming no salvage value): DebitCreditDepreciation Expense – Laptop$83Accumulated Depreciation$83 The net result of these entries shows cash being spent and the depreciation expense hitting the P&L. The value of the asset also decreases on the company’s balance sheet: Laptop$5,000Accumulated Depreciation$83Net Asset - Laptop$4,917 What Is a Depreciation Schedule?Each asset has its own depreciation schedule, or chart, that shows a timetable of monthly depreciation expense and a rolling net asset value. The deprecation schedule is usually established when the asset is purchased, and it is used to compute recurring depreciation expense amounts. At the end of the schedule, the asset should be depreciated down to its salvage value. Common elements of a depreciation schedule include:
How to Calculate DepreciationThere are three key items to consider when establishing a depreciation schedule for a particular asset:
Methods of DepreciationThe most commonly used methods of depreciation fall into three categories, although there are other specialty methods that can be applied for specific situations. Time-based MethodsThese methods assume that an asset’s economic usefulness is the same each year of its useful life. Accurately estimating the useful life of an asset is particularly important when applying time-based methods.
Activity MethodsActivity depreciation methods use productivity to measure the usefulness of an asset. Productivity can be determined based on the output that an asset produces, the number of hours it works, or other measures. Determining the most appropriate unit of productivity and then estimating production over the asset’s life are challenging but critical estimates for activity-based methods.
Decreasing Charge Methods (Accelerated Depreciation Methods)This approach assumes that an asset loses more of its value in its early years. These methods generate higher depreciation expense early in the asset’s life and lower depreciation later, when repairs and maintenance expenses tend to be higher.
Tax DepreciationFor tax purposes, businesses must use a depreciation method prescribed by the IRS. For most fixed assets, the IRS says businesses must use the modified accelerated cost recovery system (MACRS) method. MACRS generates higher depreciation expenses in the early years of an asset’s life, which in turn creates a higher tax deduction and lower taxable income on a company’s tax return. MACRS uses the straight-line and double declining balance methods to calculate depreciation expense, but it requires that businesses base their depreciation schedules on useful lives that are determined and published by the IRS for various asset classes. A few examples of MACRS useful lives are:
Additionally, MACRS fully depreciates the asset to zero, regardless of potential salvage value. MACRS is not approved by GAAP because salvage values are ignored and because the IRS-determined useful lives tend to be shorter than those estimated using GAAP principles. Comparing the Types of DepreciationTo illustrate the impact of different depreciation methods on a company’s P&L, consider the following example. Depending on the depreciation method selected, the depreciation expense recorded in the first year can more than triple. A company purchases a new tractor for $50,000 in January, putting it into service immediately. Based on past experience, it estimates the tractor will last about five years, or about 10,400 running hours. At the end of five years, the company estimates the salvage value will be $5,000. Depreciation MethodAsset CostSalvage ValueUseful LifeDepreciation ExpenseYearsRunning HoursYear 1Year 2Year 3Year 4Year 5Straight-line$ 50,000$ 5,0005n/a$ 9,000$ 9,000$ 9,000$ 9,000$ 9,000Units of production50,0005,000n/a10,4008,65419,4718,6544,3273,894Actual running hours2,0004,5002,0001,000900Sum of the years’ digits50,0005,0005n/a15,00012,0009,0006,0003,000Declining balance50,000n/a5n/a10,0008,0006,4005,1204,096Double declining balance50,000n/a5n/a20,00012,0007,2004,3201,480MACRS50,000–3n/a33,50011,0555,445–– #1 Cloud How Accounting Software Can Streamline Your Depreciating Asset CalculationsEven smaller businesses can have hundreds of fixed assets, each with its own depreciation schedule. Accounting software can help businesses track depreciation with less effort and a lower probability of errors because it eliminates the hassle and potential mistakes that come with juggling multiple spreadsheets. Accuracy is critical since depreciation reduces the value of assets on the balance sheet and affects numbers on the income statement as well as tax liability. By automating depreciation calculations for fixed assets, businesses can redirect employees, and the accounting team in particular, to focus on higher-value tasks such as strategic capital planning. Leading accounting software can not only calculate depreciation using various methods, but is integrated with a larger ERP suite that measures the performance of the entire business. What happens to depreciation when you sell an asset?When a company sells or retires an asset, its total accumulated depreciation is reduced by the amount related to the sale of the asset. The total amount of accumulated depreciation associated with the sold or retired asset or group of assets will be reversed.
When an asset is sold depreciation expense should be recorded up to the date of?Defining the Entries When Selling a Fixed Asset
The fixed asset's depreciation expense must be recorded up to the date of the sale. The fixed asset's cost and the updated accumulated depreciation must be removed. The cash received must be recorded. The difference between the amounts removed in 2.
Is depreciation charged on sale of asset?the profit or loss on sale or disposal of the asset is transferred to the Profit & Loss A/c. When the asset is sold during its useful life, the depreciation should be charged for the period the asset is used in the year of sale.
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