What is Asset Depreciation?
Depreciation is an accounting procedure that helps businesses allocate or calculate the cost of a tangible asset over its estimated useful life.
For example, if a business purchases a machine for $10,000 and expects it to last for 10 years, the machine’s value will gradually decrease each year. The business will “depreciate” a portion of the machine’s value each year to reflect this decline.
Asset depreciation specifically refers to the depreciation of a particular asset, like machinery, buildings, or equipment, over time. The primary purpose of asset depreciation is to match the cost of an asset with the revenue it generates over time. It is crucial for businesses because it impacts tax calculations and provides a more accurate reflection of asset values on financial statements.
What is an asset?
An asset is anything of value that is expected to provide economic benefits in the future. It can be either tangible (physical items like a delivery truck) or intangible (non-physical items like a patent).
How does Asset Depreciation work?
When an asset is used, its value decreases over time due to wear and tear or becoming outdated. This decrease in value is usually reflected in financial statements and is used by businesses to allocate costs over the asset’s useful life.
To calculate depreciation accurately, here are the key elements to consider:
Depreciation Start Date
The calculation begins when the asset is first used in business operations.
Estimated Useful Life
An estimate of how long the asset will remain productive for the business.
Initial Cost
The amount paid to acquire the asset, including taxes, installation costs, and any other fees necessary to bring the asset into working condition.
Residual or Salvage Value
The estimated value of the asset at the end of its useful life when it is either sold, repurposed, or reconditioned.
Types of Depreciation
In the US, it is mandatory for accountants to calculate depreciation as per the rules set by GAAP (Generally Accepted Accounting Principles).
Straight-Line Depreciation
The most common method, the straight-line depreciation, spreads the cost of the fixed asset evenly over its useful life.
| Straight-line depreciation Expense = | Cost of Asset – Salvage Value |
| Useful Life of an Asset |
Double-Declining Balance Depreciation
The double-declining balance method depreciates the asset more quickly in the earlier years of its useful life.
| Double Declining Balance = | 2 x | Cost of Asset – Accumulated Depreciation |
| Useful Life of an Asset |
Units of Production Depreciation
This method bases depreciation on the asset’s usage, activity, or units produced per year. It is mainly used in the manufacturing sector.
| Depreciation Expense = | (Original Value – Salvage Value) | X Units Produced |
| Estimated Production Capacity |
Sum-of-the-Year’s Digits Depreciation
The sum-of-the-year’s digit depreciation method calculates the percentage based on the sum of the number of years in an asset’s useful life.
| Depreciation Expense = | Remaining Useful Life | X Depreciable Cost |
| Sum of the years’ digits |