Depreciation is the accounting practice of spreading out the cost of a fixed asset over time and deducting it from taxable income. The practice works according to rules set by the IRS (or other competent taxation authorities).
These rules state that accountants need to spread out costs over time. They also spell out when companies are allowed to take deductions. The IRS sets the type of depreciation (linear or otherwise) that companies can use on their fixed assets.
Below, we cover the essentials concerning this accounting method, such as:
- What you need to know about depreciation.
- How accounting handles depreciation.
- Various types of depreciation.
How Depreciation Works
What is the purpose of depreciation? Through it, companies can account for the costs they incur when acquiring the assets they need to perform their activities. Accountants cannot slap newly acquired assets onto the income statement.
They can only do that according to a rigid set of rules, formulated and enforced by the tax authority.
Loading the costs of new machinery onto the income statement directly would ruin the profitability of a company.
By requiring companies to gradually expense these costs over the years, tax authorities make sure they can derive profits from them.
The companies have a say in the matter of depreciation as well. They set the thresholds over which they depreciate assets. Under this threshold, they expense all equipment acquisitions immediately.
For small companies, these thresholds are smaller. For larger operations, they are much more generous. Machinery, in general, is expensive. Such purchases therefore almost always fall above the depreciation threshold.
When it comes to details concerning depreciation, the IRS holds all the cards, however.
It publishes depreciation schedules that include an asset-class breakdown. Such schedules specify the length of time a given asset can be depreciated.
How Accounting Handles Depreciation
When a company buys an asset, accounting records its cost as a credit and a debit on the balance sheet. From there, accountants painstakingly transfer this cost to the income statement, over as many years as specified by the IRS.
This way, the company gets to have the costs deducted from its earnings. The IRS gets to maintain the profitability of the company, so it can collect taxes from it.
When an accounting period wraps up, accountants enter a debit to depreciation expense on the balance sheet. This is the part that shows up on the income statement as well. They also add a credit to accumulated depreciation.
Accumulated depreciation is the total depreciated value of an asset at a given time.
If we subtract accumulated depreciation from the original cost of an asset, we get its carrying value.
After a while, accounting fully depreciates all assets. Assets do, however, retain some value even after full depreciation. This value is called the salvage value.
Various Types of Depreciation
As mentioned, there are several ways to depreciate an asset to its salvage value over the years.
- – Straight-line depreciation is the simplest method. It depreciates an equal amount of an asset’s value each year of its useful lifetime. An asset that costs $7,000, with a salvage value of $1,500 and a depreciation time of five years, will be depreciated by (7,000-1,500)/5 = $1,100 per year.
- – Declining Balance Depreciation is a form of accelerated depreciation. This method attributes a larger depreciation rate in the first year of an asset’s depreciation. This rate gradually declines each year. The logic behind this approach is that an asset retains more of its carrying value during its early years.
- – The Double Declining Balance method is also accelerated depreciation. This method’s formula uses the reciprocal of the asset’s useful life, doubled. It applies this variable to the base of depreciation.
- – The Units of Production method bases its depreciation rate on the number of units produced by the machinery.
- – The Sum-of-the-Year’s-Digits method adds up the digits of the years of the asset’s depreciation period. For five years, that would be 1+2+3+4+5=15. For six years, it would be 1+2+3+4+5+6 = 21. In the first year, 6/21 of the asset’s value would be depreciated. In the second year, the rate would be 5/21 and so on.