Depreciation Accounting

Features of Depreciation

1. Depreciation is decline in the book value of fixed assets.
2. Depreciation includes loss of value of assets due to passage of time, usage or obsolescence.
3. Depreciation is a continuing process till the end of the useful life of assets.
4. Depreciation is an expired cost and hence must be deducted before calculating taxable profits.
5. Depreciation is a non-cash expense. It does not involve cash flow.
6. Depreciation is the process of writing-off the capital expenditure already incurred.
7. Loss should be gradual and constant.
8. Depreciation is the exhaustion of the effective life of business.
9. Depreciation is the normal feature.
10. Maintenance of assets is not depreciation.

Depreciation Accounting

Depreciation is an accounting process by which a company allocates an asset’s cost throughout its useful life. In other words, it records how the value of an asset declines over time. Each time a company prepares its financial statements, it records a depreciation expense to allocate a portion of the cost of the buildings, machines or equipment it has purchased to the current fiscal year. The purpose of recording depreciation as an expense is to spread the initial price of the asset over its useful life. For intangible assets such as brands and intellectual property this process of allocating costs over time is called amortization. For natural resources such as minerals, timber, and oil reserves it’s called depletion.

Assumptions

Critical assumptions about expensing depreciation are up to the company’s management. Management makes the call on the following things:

• Method and rate of depreciation
• The useful life of the asset
• Scrap value of the asset

Calculation Choices

Depending on their preferences, companies are free to choose from several methods to calculate the depreciation expense. To keep things simple, we’ll summarize just the two most common methods:

1. Straight-line Method

This takes an estimated scrap value of the asset at the end of its life and subtracts it from its original cost. This result is then divided by management’s estimate of the number of useful years of the asset. The company expenses the same amount of depreciation each year.

Here is the formula for the straight-line method:

Straight-line depreciation = (Original costs of asset – Scrap value)/estimated asset life

2. Accelerated Methods

These methods write-off depreciation costs more quickly than the straight-line method. Generally, the purpose behind this is to minimize taxable income. A popular method is the ‘double declining balance,’ which essentially doubles the rate of depreciation of the straight-line method:

Double Declining Depreciation = 2 x (Original costs of asset – Scrap value / estimated asset life)

Accounting Treatment

The accounting for depreciation requires an ongoing series of entries to charge a fixed asset to expense, and eventually to derecognize it. These entries are designed to reflect the ongoing usage of fixed assets over time.

Depreciation is the gradual charging to expense of an asset’s cost over its expected useful life. The reason for using depreciation to gradually reduce the recorded cost of a fixed asset is to recognize a portion of the asset’s expense at the same time that the company records the revenue that was generated by the fixed asset. Thus, if you charged the cost of an entire fixed asset to expense in a single accounting period, but it kept generating revenues for years into the future, this would be an improper accounting transaction under the matching principle, because revenues are not being matched with related expenses.

In reality, revenues cannot always be directly associated with a specific fixed asset. Instead, they can more easily be associated with an entire system of production or group of assets.

The journal entry for depreciation can be a simple entry designed to accommodate all types of fixed assets, or it may be subdivided into separate entries for each type of fixed asset.

The basic journal entry for depreciation is to debit the Depreciation Expense account (which appears in the income statement) and credit the Accumulated Depreciation account (which appears in the balance sheet as a contra account that reduces the amount of fixed assets). Over time, the accumulated depreciation balance will continue to increase as more depreciation is added to it, until such time as it equals the original cost of the asset. At that time, stop recording any depreciation expense, since the cost of the asset has now been reduced to zero.

For example, ABC Company calculates that it should have $25,000 of depreciation expense in the current month. The entry is:

In the following month, ABC’s controller decides to show a higher level of precision at the expense account level, and instead elects to apportion the $25,000 of depreciation among different expense accounts, so that each class of asset has a separate depreciation charge. The entry is:

Depreciation is considered an expense, but unlike most expenses, there is no related cash outflow. This is because a company has a net cash outflow in the entire amount of the asset when the asset was originally purchased, so there is no further cash-related activity. The one exception is a capital lease, where the company records it as an asset when acquired but pays for the asset over time, under the terms of the associated lease agreement.

Finally, depreciation is not intended to reduce the cost of a fixed asset to its market value. Market value may be substantially different, and may even increase over time. Instead, depreciation is merely intended to gradually charge the cost of a fixed asset to expense over its useful life.

Depreciation and a number of other accounting tasks make it inefficient for the accounting department to properly track and account for fixed assets. They reduce this labor by using a capitalization limit to restrict the number of expenditures that are classified as fixed assets. Any expenditure for which the cost is equal to or more than the capitalization limit, and which has a useful life spanning more than one accounting period (usually at least a year) is classified as a fixed asset, and is then depreciated.