Depreciation Meaning Simply Explained

Depreciation is an accounting method for gradually decreasing the value of a tangible item over the course of its useful life. An asset's remaining value is also visible, thanks to depreciation.

The Benefits of Depreciation

With depreciation, the initial cost of ownership is greatly lowered since businesses do not have to fully account for the entire purchase in the year the assets are bought.

Consequently, a company's profitability can be significantly impacted by not accounting for depreciation. Note that long-term assets can also be depreciated for tax and accounting reasons.

Depreciation is comparable to amortization, which is the method used to account for the increase and decrease in the value of intangible assets over time.

Main Takeaways

• The expense of utilizing a tangible asset and the benefit received over the course of its useful life are linked through depreciation.
• Depreciation can take many different forms, including accelerated and straight-line depreciation.
• The amount of depreciation recorded on an asset until a certain date is referred to as accumulated depreciation.
• A balance sheet asset's carrying value is its price less all accumulated depreciation
• Salvage value is the carrying value of an item after all deductions for depreciation have been made.

Insights About Depreciation

Equipment and machinery are expensive assets. Companies can utilize depreciation to hedge the cost of an asset rather than recognizing the whole amount in the first year. Corresponding revenues and costs can also be reported in the same period. This enables a business to write off an asset's worth over time, particularly throughout its useful life.

Businesses constantly depreciate their assets in order to transfer the expenses from their balance sheets to their income statements. Asset purchases are recorded as credit transactions to decrease cash and as debit entries to increase the asset accounts on the balance sheet. Neither journal item has an impact on the income statement, which lists revenues and costs.

An accountant records depreciation for all capitalized assets that have not yet been fully depreciated when an accounting period ends. A debit to the income statement's depreciation expenditure is included in the journal entry, while a credit to the balance sheet's reported accumulated depreciation is made.

Depreciation may be used by organizations for both tax and accounting reasons, as mentioned. As a result, firms’ taxable income will be lower since they may deduct the asset's cost from their payable.

Two Important Points To Note

Because it doesn't really involve a cash outflow, depreciation is seen as a non-monetary charge. When an asset is acquired, the whole cash expenditure may be paid at once, but the expense is reported in stages for financial reporting purposes. This is so because assets assist the business over a long period of time. However, depreciation costs still lower a company's earnings, which is advantageous for taxation.

According to the generally accepted accounting principles (GAAP), costs must be recorded in the same period in which the relevant revenue is earned. This is a notion of accrual accounting. Depreciation lets companies connect an asset's cost to its long-term value. In other words, the asset that is used annually and creates income also has an extra expenditure connected to the activities.

Read more in detail about Accrual accounting.

The depreciation rate is the annual total depreciation expressed as a percentage. When the yearly depreciation was SAR 13,000 and the total depreciation throughout the asset's anticipated lifespan was SAR 130,000, the annual rate would be 10%. Also, note that land is not eligible for depreciation, but buildings and other constructions are.

Depreciation Threshold

Various businesses may choose their own price points for when to start depreciating a fixed asset or piece of property, plant, and equipment (PP&E). For instance, a small business may establish a SAR 1,000 limit over which it depreciates an asset.

On the other hand, a bigger business can establish a SAR 30,000 cap below which all purchases are instantly expensed.

A Special Kind: Accumulated Depreciation

In a contra-asset account, accumulated depreciation has a natural balance of credit that lowers the value of the corresponding asset. Any asset's accumulated depreciation is the total amount of depreciation it has experienced up to that point.

Carrying value, as previously mentioned, is the sum of the asset account and accrued depreciation. The value that remains on the balance sheet after all depreciation is accounted for is known as the salvage value. This is mostly used until the asset is sold. The above also shows what a business anticipates getting in return for the asset when its useful life is over. The anticipated salvage value of an item plays a significant role in determining depreciation.

According to different asset classifications, the IRS releases depreciation schedules that specify how many years an item can be written down for tax reasons.

Different Kinds of Depreciation

Accountants typically depreciate capital assets and other revenue-generating assets using a variety of techniques. These are the following: unit of production, sum-of-the-years' digits, straight line, decreasing balance, and double-declining balance. Below, we've highlighted some of the fundamental ideas behind each.

Number 1: Straight-Line

The most straightforward approach for keeping track of depreciation is the straight-line method. Throughout the asset's full useful life, up until the point at which the entire asset has been depreciated to its salvage value, it records an identical depreciation expenditure each year.

Number 2: Declining Balance

An accelerated depreciation approach is the decreasing balance method. Using this approach, the machine is depreciated annually at its straight-line depreciation percentage times the amount still depreciable. The same percentage results in a larger depreciation expenditure amount in the early years, with lower values later on.

Number 3: Double Declining Balance (DDB)

Another technique for accelerating depreciation is the double-declining balance (DDB) method. This is applied to the depreciable base, which is the asset's book value, over the remainder of the estimated life of the asset after multiplying the asset's useful life by its reciprocal and by two. As a result, depreciation moves along almost twice as quickly as it would with the basic declining balance technique.

Number 4: Sum of the Years' Digits

Another possible method for accelerated depreciation is using the sum-of-the-years' digits (SYD) approach. Start by adding up all the asset's projected lifespan digits. The basis of an asset with a five-year life, for instance, would be 1 + 2 + 3 + 4 + 5 = 15, or the sum of the numbers 1 through 5. 5/15 of the base would be written off in the first year of depreciation. Only 4/15 of the base would be depreciated in the second year. This continues until the remaining 1/15 is depreciated in the fifth year.

Number 5: Units of Production

An estimate of the overall units an asset will create throughout the course of its useful life is needed for this procedure. The cost of depreciation is then computed annually depending on the volume of units produced. Based on the depreciable value, this approach also computes depreciation costs.

What Is The Goal Of Asset Depreciation?

Generally speaking, newer assets are worth more than older ones. Depreciation calculates how much an asset loses in value over time, both directly from usage-related wear and tear and indirectly from variables like inflation and the introduction of new product models.

Amortization vs. Depreciation Explained

Depreciation only applies to tangible assets or real estate. In accounting, the phrase "amortization" refers to the gradual depreciation of intangible assets like intellectual property or loan interest.

Does Depreciation Qualify As An Expense?

Depreciation is seen as an expense for accounting reasons since it increases a company's operating costs. Machines and other assets undergo wear and tear over the course of their useful life and lose value as a result. The expense of depreciation is recorded on the income statement.