Definition
The financial accounting term depreciation is sometimes defined as a decline in tangible plant's service potential. Depreciation is a method of allocating the cost of a tangible asset in a systematic manner to those time periods that benefit from the use of the asset.
Calculation
Straight line depreciation, the most common method used today, is calculated as follows:
Annual Depreciation = (Cost - Salvage Value) / Estimated Service Life
Explanation
Depreciation is sometimes confused with the concept of valuation, or fair market value. Depreciation is an accounting method of cost allocation. It is used to allocate the cost of an asset over its useful life.
Depreciation is sometimes called a non-cash expense. This is because the cash used to purchase the asset was paid in year 0. Depreciation expense flows to the income statement over the depreciable life of the asset. This accounting practice allows a company to expense the cost of the asset over time, thereby avoiding a large impact to earnings in the year the asset is purchased.
Accelerated depreciation uses rules established by the Internal Revenue Service for income tax purposes. The most common of which is the Modified Accelerated Cost Recovery System, or MACRS.
Example
Company A purchases a backup generator for $400,000. The estimated service life is expected to be 20 years. The generator has no residual value.
Company A would create an asset on its balance sheet for $400,000 in year 0. Each year, the company would depreciate the asset using the straight line method as follows:
= ($400,000 - 0) / 20, or $20,000 per year for 20 years.
Company A would show a depreciation expense of $20,000 on its income statement. After 12 months, the asset's net book value would be:
$400,000 - $20,000 or $380,000
To make things easier, we created a depreciation calculator for all sorts of assets.
Related Terms
The accounting term used to describe an economic resource, which is owned by the corporation and expected to provide future benefits to its operation, is asset. Appearing on the balance sheet, assets are typically broken down into two categories:
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The finance term Modified Accelerated Cost Recovery System, or MACRS, refers to the tax depreciation structure created as a result of the Tax Reform Act of 1986. MACRS is an accelerated approach to the depreciation of an asset, and is based on both the declining balance and straight line methods.Moneyzine EditorFebruary 8th, 2024.png)
The financial accounting term depreciable base is used to describe the value that is divided by the service life of the asset to determine the annual depreciation expense under the straight line method. The depreciable base is the value of the asset to be written off over time.Moneyzine EditorJanuary 15th, 2024
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