Essentially, your company is an interconnected network of assets. The people and things that make up your business are all assets. Some are current and short-term, while other assets are fixed and with you for the long haul. The assets you keep for numerous years tend to lose their value as time and wear change their condition. This decline in value is known as depreciation.
In accounting terms, depreciation has a more specific definition. Here, depreciation refers to the value of an asset over its useful life. Accounting for depreciation helps improve a company’s understanding of its asset turnover and quantify how much the value of the asset justifies its cost.
Depreciation occurs in all physical or tangible assets, from vehicles and computer hardware to machinery and plants. It can also apply to intangible assets like intellectual property and patents. However, here it is referred to as amortization.
Failing to account for asset depreciation profoundly impacts your company’s profits.
Example of depreciation
Businesses often invest in capital expenditures like machinery and equipment to enhance their operations. Unlike general operating expenditures, these expenditures cannot be claimed against profits in the same year. Instead, the IRS states that businesses can depreciate the asset by deducting a portion of the cost on their tax return over several years.
Let’s say you buy a new machine for $9,000. You expect to get around ten years of useful life out of it before selling it at a value of $900. Due to wear and the declining market value of the machine as other, more capable replacements come to market, the company effectively “loses” $8,100 in value over ten years. As such, it is able to write off $810 per year or $67.50 per month in depreciation.
Depreciation allows the company to move the asset’s cost from its balance sheet to its income statement, gradually writing off the asset’s value over time and thereby boosting its net income.
Different types of depreciation
This is where an equal depreciation expense is reported for each year of the asset’s useful lifetime.
Here, as assets depreciate, the depreciation expense declines each year. The asset depreciates at its straight-line depreciation percentage multiplied by its remaining depreciable amount with every passing year of its useful life.
Units of production
Depreciation expense is calculated each year based on estimated units produced.
Sum-of-the year’s-digits (SYD)
Here, the depreciation rate is calculated by combining each digit of the asset’s expected useful life. This is another form of accelerated depreciation that can make it easier to reconcile asset expenses with other overhead costs over time.
Frequently asked questions about depreciation
What is accumulated depreciation?
Accumulated depreciation is recorded on an asset up to a specified date (such as the end of its useful life). Accumulated depreciation is registered as a credit on the company’s balance sheet.
What is an asset’s carrying value?
The carrying value of an asset represents its historical cost minus the accumulated depreciation over time. An asset will have a higher carrying value in earlier years, and this will decline as the asset nears the end of its useful life. After all depreciation is deducted, the asset’s carrying value is its resale or salvage value.
What is the difference between depreciation and amortization?
Amortization and depreciation account for the loss of an asset’s value over time. However, amortization refers to intangible assets like intellectual property, patents, copyrights, and the costs associated with issuing bonds.
Because these assets tend not to have scrap value at the end of their useful lives, they are expensed on a straight-line basis with the same amount expensed in each period throughout the asset’s useful life.