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CandleFocus Glossary Editor
Depreciation is the accounting treatment used to distribute the cost of a tangible asset, such as a car or a machine, over its useful life. Accounts receivable and inventory, being current assets, are not eligible for depreciation, as they are used or consumed within a year. To calculate the depreciation of an asset, one must first determine the cost of the asset and its estimated useful life in years.
Straight-line depreciation is the easiest and simplest way to calculate the depreciation of an asset. Under this method, the same amount of depreciation is charged each year over the asset's useful life. To determine the yearly depreciation, one must subtract the asset's salvage value at the end of its useful life from its initial cost. Then, divide the difference by the number of years of its estimated useful life. For example, an asset purchased at a cost of $1000 with an estimated useful life of 5 years and a salvage value of $100 would have a straight-line depreciation expense of $180 every year ($1000 - $100 / 5).
Another common way to depreciate an asset is using accelerated depreciation methods. These methods recognize the fact that an asset typically produces the most benefit in its early years and decline in benefit as its useful life passes. Under accelerated depreciation, a higher depreciation expense is recorded in the first few years of an asset's life, with a tailing off of the depreciation expense over its remaining life. The two most popular methods of accelerated depreciation are double-declining-balance and sum-of-the-years digits.
The double-declining-balance method computes depreciation at a rate double the straight-line rate applied to the carrying value of the asset at the beginning of the year. For the asset example above, the amount of depreciation in the first year would be $360 (2 X $180), and the depreciation expense would decline linearly each year.
The sum-of-the-years digit method also accelerates depreciation by allowing for higher depreciation expenses in the early years of an asset's useful life. To determine the depreciation expense, one must first sum the years in the asset’s useful life (3 + 2 + 1 = 6). Then, multiply the asset’s cost by a fraction that has each year in its useful life as the numerator and the total of the years as the denominator. Finally, subtract the salvage value to get the annual depreciation expense. In our example, the depreciation in the first year would be $400 ($1000 x 3/6 - $100).
Accumulated depreciation is the total amount of depreciation recorded on an asset to a particular date. This amount is usually recorded in a separate account on the balance sheet and serves as an offset to the cost of the asset. It can also be used to calculate a company's book value by subtracting it from the asset’s cost. As a result, accumulated depreciation is a key figure in determining a company's worth.
In conclusion, depreciation is an important accounting tool that allows businesses to spread the cost of purchased assets over their useful life. By properly managing and accounting for depreciation, businesses can optimize the use of their assets and maximize the benefit gained from them.
Straight-line depreciation is the easiest and simplest way to calculate the depreciation of an asset. Under this method, the same amount of depreciation is charged each year over the asset's useful life. To determine the yearly depreciation, one must subtract the asset's salvage value at the end of its useful life from its initial cost. Then, divide the difference by the number of years of its estimated useful life. For example, an asset purchased at a cost of $1000 with an estimated useful life of 5 years and a salvage value of $100 would have a straight-line depreciation expense of $180 every year ($1000 - $100 / 5).
Another common way to depreciate an asset is using accelerated depreciation methods. These methods recognize the fact that an asset typically produces the most benefit in its early years and decline in benefit as its useful life passes. Under accelerated depreciation, a higher depreciation expense is recorded in the first few years of an asset's life, with a tailing off of the depreciation expense over its remaining life. The two most popular methods of accelerated depreciation are double-declining-balance and sum-of-the-years digits.
The double-declining-balance method computes depreciation at a rate double the straight-line rate applied to the carrying value of the asset at the beginning of the year. For the asset example above, the amount of depreciation in the first year would be $360 (2 X $180), and the depreciation expense would decline linearly each year.
The sum-of-the-years digit method also accelerates depreciation by allowing for higher depreciation expenses in the early years of an asset's useful life. To determine the depreciation expense, one must first sum the years in the asset’s useful life (3 + 2 + 1 = 6). Then, multiply the asset’s cost by a fraction that has each year in its useful life as the numerator and the total of the years as the denominator. Finally, subtract the salvage value to get the annual depreciation expense. In our example, the depreciation in the first year would be $400 ($1000 x 3/6 - $100).
Accumulated depreciation is the total amount of depreciation recorded on an asset to a particular date. This amount is usually recorded in a separate account on the balance sheet and serves as an offset to the cost of the asset. It can also be used to calculate a company's book value by subtracting it from the asset’s cost. As a result, accumulated depreciation is a key figure in determining a company's worth.
In conclusion, depreciation is an important accounting tool that allows businesses to spread the cost of purchased assets over their useful life. By properly managing and accounting for depreciation, businesses can optimize the use of their assets and maximize the benefit gained from them.