Lesson 21 - Beginner accounting course

21. Depreciation: How Businesses Account for Asset Value Reduction

Depreciation is a fundamental accounting concept that reflects the gradual reduction in the value of long-term assets over time. Businesses use depreciation to allocate the cost of assets across their useful lives, ensuring that financial statements accurately represent the wear and tear of assets used in operations. Without depreciation, a company’s financial reports might overstate its profitability by not accounting for the declining value of its assets.

This concept is particularly important for businesses that own significant physical assets such as machinery, buildings, vehicles, and equipment. Understanding depreciation helps businesses manage their finances, make informed investment decisions, and comply with accounting and tax regulations.

What is Depreciation?

Depreciation is the process of allocating the cost of a tangible asset over its useful life. Instead of recognizing the entire cost of an asset as an expense in the year it was purchased, businesses spread the expense over several years, aligning the cost with the revenue generated by the asset.

For example, if a company purchases a delivery truck for $50,000 and expects it to last 10 years, it does not record a one-time expense of $50,000. Instead, it records a depreciation expense of $5,000 per year ($50,000 ÷ 10 years), ensuring that the financial statements reflect the asset's gradual loss of value.

Why Do Businesses Use Depreciation?

There are several reasons why businesses apply depreciation to their financial statements:

• Accurate Financial Reporting: Depreciation ensures that the cost of long-term assets is matched with the revenue they help generate, providing a more accurate picture of profitability.

• Tax Benefits: Many tax systems allow businesses to deduct depreciation as an expense, reducing taxable income and lowering tax liabilities.

• Asset Management: Tracking depreciation helps businesses plan for asset replacements and investments in new equipment.

• Investor and Lender Confidence: Proper depreciation practices give investors and creditors confidence in a company's financial stability by preventing inflated asset values on financial statements.

Types of Depreciation Methods

Different businesses use various depreciation methods depending on financial strategy, industry standards, and tax regulations. The most commonly used methods include:

1. Straight-Line Depreciation

The straight-line method is the simplest and most commonly used depreciation method. It spreads the asset's cost evenly over its useful life.

Formula:

• Cost of Asset: The original purchase price.

• Salvage Value: The estimated value of the asset at the end of its useful life.

• Useful Life: The expected number of years the asset will be used.

Example:
A company buys a machine for $10,000. The machine’s salvage value is $1,000, and its useful life is 5 years.

The company will record $1,800 in depreciation expense each year for five years.

2. Declining Balance (Accelerated Depreciation)

The declining balance method applies a higher depreciation rate in the early years of an asset’s life, recognizing that some assets lose value more quickly at the beginning. The most common version of this method is double-declining balance (DDB), which applies twice the straight-line depreciation rate.

Formula:

Example:

If a company buys a truck for $20,000 with a 5-year useful life, the first year’s depreciation would be: 

This method results in higher expenses in the early years and lower expenses in later years.

3. Units of Production Method

This method bases depreciation on the actual usage of the asset, rather than time. It is useful for assets whose wear and tear depend on production levels, such as factory machinery.

Formula:

Example:

A printing press costs $50,000, has a salvage value of $5,000, and is expected to print 1,000,000 pages over its lifetime. If it prints 200,000 pages in the first year: 

This method ensures that depreciation expenses match actual asset usage.

4. Sum-of-the-Years’-Digits (SYD) Method

This is another accelerated depreciation method that assigns more depreciation expense in the earlier years of an asset's life. The sum of the years' digits is calculated as follows:

Formula:

This method is less common but still useful for assets that lose efficiency quickly.

Recording Depreciation in Financial Statements

Depreciation appears on a company's income statement as an expense, reducing taxable income. On the balance sheet, the asset's value is recorded under property, plant, and equipment (PPE) and is reduced each year by accumulated depreciation.

Example of a Journal Entry for Depreciation:

Each year, the company records depreciation as follows:

Debit: Depreciation Expense (Income Statement)
Credit: Accumulated Depreciation (Balance Sheet)

This entry ensures that both the income statement and balance sheet reflect the reduced value of the asset.

Impact of Depreciation on Business Decisions

Understanding depreciation is crucial for making informed financial decisions:

• Investment Planning: Businesses need to plan for replacing assets before they become obsolete.

• Tax Strategy: Choosing the right depreciation method can impact tax savings.

• Loan Approvals: Lenders examine a company’s depreciation expenses to assess its financial health.

Conclusion

Depreciation is a vital accounting concept that helps businesses allocate the cost of long-term assets over time. By using various depreciation methods, companies can match expenses with revenue, gain tax benefits, and plan for asset replacements. Understanding how depreciation works is essential for financial decision-making and maintaining accurate financial statements.