Depreciation is a way accountants use to spread out the cost of something real, like a machine or a building, over time it’s useful. It shows how much of the thing’s value has been used up over time. Businesses do this for taxes and accounting reasons, and they can pick from various methods to do it.
Machinery and equipment can cost a lot of money. Instead of paying for the whole thing in one go, companies use depreciation to spread out the cost. This helps match the expense of depreciation with the money the asset makes in the same time frame. Depreciation lets a company deduct the value of an asset gradually over its useful life.
Companies use depreciation to move the cost of their assets from their balance sheets to their income statements. When a company buys an asset, it records the purchase by increasing an asset account and decreasing cash (or increasing accounts payable), both on the balance sheet. These transactions don’t affect the income statement, where revenues and expenses are reported.
At the end of each accounting period, accountants calculate depreciation for all the assets that haven’t fully depreciated yet. They do this by:
- Increasing depreciation expense, which shows up on the income statement.
- Decreasing accumulated depreciation, which is listed on the balance sheet.
Depreciation and Taxes
Businesses use depreciation for tax and accounting reasons. In the United States, they can deduct the cost of assets, lowering their taxable income. However, the Internal Revenue Service (IRS) requires companies to spread the cost of depreciating assets over time, except in cases where they can deduct all of it in the first year under Section 179 of the tax code. The IRS also specifies which types of assets qualify for depreciation.
Depreciation in Accounting
In accounting, depreciation means the value of an asset goes down over time. It’s not an actual spending of cash. When a company buys something valuable, like equipment, they may pay for it all at once. However, for accounting reasons, the cost is spread out over time to show how much the asset is used up each year. This is because assets, like machinery or buildings, benefit the company for many years. Even though depreciation doesn’t involve real cash going out, it still lowers the company’s profits, which can be good for taxes.
According to the matching principle in accounting rules, expenses should match the period when revenue is earned. Depreciation helps connect the cost of an asset with the benefit it provides over time. It means that the cost of using up the asset is recorded each year as the asset generates revenue.
The annual amount of depreciation, shown as a percentage, is called the depreciation rate. For instance, if a company had $100,000 in total depreciation for an asset’s life expectancy and the yearly depreciation was $15,000, the rate would be 15% per year.
Each company decides when to start depreciating a fixed asset, like property, plants, and equipment (PP&E), or when to just count it as an expense in the first year. They do this by setting their limit for the value of the asset. For instance, a small company might choose $500 as its limit. This means any asset costing more than $500 will be depreciated over time. However, a bigger company might set a higher limit, say $10,000. This means they’ll only depreciate assets worth more than $10,000, while anything below that gets expensed right away.
Accumulated Depreciation, Carrying Value, and Salvage Value
Accumulated depreciation is like a special account that reduces the value of assets. It’s called a contra-asset account because it naturally decreases the total value of assets and it’s recorded as a credit. The accumulated depreciation for any asset is the total depreciation it has accumulated until a specific point in time.
The carrying value is what’s left of the asset’s value after we subtract the accumulated depreciation from its original value. Salvage value, on the other hand, is the remaining value of the asset that stays on the balance sheet after we’ve accounted for all the depreciation until the asset is sold or disposed of. It’s an estimation of what the company thinks it will get for the asset at the end of its useful life.
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