Understanding Depreciation: Impact on Income Statement and Balance Sheet

As business accounts are usually prepared on an annual basis, it is common to calculate depreciation only once at the end of each financial year. Also, depreciation expense is merely a book entry and represents a “non-cash” expense. Depreciation accounting is a system of accounting that aims to distribute the cost (or other basic values) of tangible capital assets less its scrap value over the effective life of the asset. Depreciation is the reduction in the value of a fixed asset due to usage, wear and tear, the passage of time, or obsolescence. Tim worked as a tax professional for BKD, LLP before returning to school and receiving his Ph.D. from Penn State.

Under U.S. tax law, a business can take a deduction for the cost of an asset, thereby reducing their taxable income. But, in most cases, the cost of the asset must be spread out over time; this is called asset depreciation. (In some instances, a business can take the entire deduction in the first year, under Section 179 of the tax code.) The IRS also has requirements for the types of assets that qualify.

The chart below represents the cost, accumulated depreciation, and depreciation expense of a $50,000 fixed asset depreciated $10,000 per year for five years. The first and last years deduct only $5,000 as it’s assumed the asset was placed in service mid-year. To introduce the concept of the units-of-activity method, let’s assume that a service business purchases unique equipment at a cost of $20,000. Over the equipment’s useful life, the business estimates that the equipment will produce 5,000 valuable items. Assuming there is no salvage value for the equipment, the business will report $4 ($20,000/5,000 items) of depreciation expense for each item produced. If 80 items were produced during the first month of the equipment’s use, the depreciation expense for the month will be $320 (80 items X $4).

Depreciation is a systematic procedure for allocating the acquisition cost of a capital asset over its useful life. When inventory items are acquired or produced at varying costs, the company will need to make an assumption on how to flow the changing costs. A balance on the right side (credit side) of an account in the general ledger. There are several steps involved in determining whether an impairment loss has occurred and how to measure and report it. You can learn more about impairment losses by reading the appropriate parts of an Intermediate Accounting textbook or visiting the Financial Accounting Standards Board’s website. Note that the depreciation amounts recorded in the years 2021 and before were not changed.

Example of a Change in the Estimated Useful Life of an Asset

Your tree removal business is such a success that your wood chipper will last for only five years before you need to replace it (useful life). Now that you know the difference between the depreciation models, let’s see the straight-line depreciation method being used in real-world situations. To do the straight-line method, you choose to depreciate your property at an what is depreciation expense equal amount for each year over its useful lifespan. However, before putting an asset into operation, the business must decide whether or not the item, after its useful life, will be likely sold and what the salvage value might be. In this Keynote Support tutorial, I define and explain depreciation in easy to understand terms, and provide useful examples including the journal entries involved. The depreciation expense comes out to $60k per year, which will remain constant until the salvage value reaches zero.

This method bases depreciation on the actual usage or production output of the asset, rather than time. Each method has its advantages and is suited to different types of assets or business situations. For example, if you purchase a new delivery truck for $50,000 and spend $2,000 on registration and customization, the total asset cost would be $52,000. It does not matter if the trailer could be sold for $80,000 or $65,000 at this point; on the balance sheet, it is worth $73,000. The second aspect is allocating the price you originally paid for an expensive asset over the period of time you use that asset.

The “declining-balance” refers to the asset’s book value or carrying value (the asset’s cost minus its accumulated depreciation). Recall that the asset’s book value declines each time that depreciation is credited to the related contra asset account Accumulated Depreciation. Note that the account credited in the above adjusting entries is not the asset account Equipment. Instead, the credit is entered in the contra asset account Accumulated Depreciation. Regardless of the depreciation method used, the total amount of depreciation expense over the useful life of an asset cannot exceed the asset’s depreciable cost (asset’s cost minus its estimated salvage value). To illustrate an Accumulated Depreciation account, assume that a retailer purchased a delivery truck for $70,000 and it was recorded with a debit of $70,000 in the asset account Truck.

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The “sum-of-the-years’-digits” refers to adding the digits in the years of an asset’s useful life. For example, if an asset has a useful life of 5 years, the sum of the digits 1 through 5 is equal to 15 (1 + 2 + 3 + 4 + 5). In DDB depreciation the asset’s estimated salvage value is initially ignored in the calculations. However, the depreciation will stop when the asset’s book value is equal to the estimated salvage value. If a company issues monthly financial statements, the amount of each monthly adjusting entry will be $166.67. This approach calculates depreciation as a percentage and then depreciates the asset at twice the percentage rate.

When the goods are sold, some of the depreciation will move from the asset inventory to the cost of goods sold that is reported on the manufacturer’s income statement. In the case of an asset with a 10-year useful life, the depreciation expense in the first full year of the asset’s life will be 10/55 times the asset’s depreciable cost. The depreciation for the 2nd year will be 9/55 times the asset’s depreciable cost. This pattern will continue and the depreciation for the 10th year will be 1/55 times the asset’s depreciable cost. A significant change in the estimated salvage value or estimated useful life will be reported in the current and remaining accounting years of the asset’s useful life.

Property

It splits an asset’s value equally over multiple years, meaning you pay the same amount for every year of the asset’s useful life. The number of years over which an asset is depreciated is determined by the asset’s estimated useful life, or how long the asset can be used. For example, the estimate useful life of a laptop computer is about five years. An accounting loss results from expensing a revenue-generating asset instead of capitalizing it and thus, not creating any future value for the company.

• If the equipment continues to be used, no further depreciation expense will be reported.
• This knowledge empowers you to make informed decisions about asset investments, replacements, and overall financial planning for your business.
• If you use a vehicle or piece of equipment exclusively for business, you can claim depreciation on that asset.
• To amplify this step, assume that a retailer had recorded depreciation on its fleet of delivery trucks up to December 31.
• By calculating the annual depreciation expense, one can determine the value of the asset on the balance sheet.
• This is done by debiting the Accumulated Depreciation account and crediting the applicable Asset account.

For example, buildings and equipment in areas with strong weather may see more rapid wear and tear from rust, water, and environmental damage. Number of units consumed is the amount that you used in a given year—in this case, perhaps your machine produced 30,000 products, so you would have used 30,000 units. Inverse year number is the first year of expected life, starting from the greatest digit, divided by the total years. Salvage value is the amount you expect to be able to obtain for the asset at the end of its usable life. Depreciation ends when the asset reaches the end of its usable life or when you sell it.

In some cases, an asset may decline in value at a steady rate, while others may decline more rapidly in years where they see heavier use. Certain assets have specific depreciation rules that, if misunderstood, can lead to errors. Given the details of depreciation and how it affects taxes, it can be helpful to collaborate with tax experts. Salvage value, also called residual value, is the estimated amount you expect to receive when disposing of the asset at the end of its useful life. At Finance Strategists, we partner with financial experts to ensure the accuracy of our financial content.

Expenses are written off at the time of purchase; but since assets are expensive and have a useful life of many years, their costs are capitalized over their lifespan using a process called depreciation. The units of production method recognizes depreciation based on the perceived usage (“wear and tear”) of the fixed asset (PP&E). The Modified Accelerated Cost Recovery System, or MACRS, is another method for calculating accelerated depreciation. This works well for vehicles, equipment, and other physical assets, but it cannot be used for intangible assets. The General Depreciation System (GDS) is the most common method for calculating MACRS.