Understanding Methods and Assumptions of Depreciation

The balance in the Equipment account will be reported on the company’s balance sheet under the asset heading property, plant and equipment. To illustrate the cost of an asset, assume that a company paid $10,000 to purchase used equipment located 200 miles away. The company then paid $2,000 to transport the equipment to its location. Finally, the company paid $5,000 to get the equipment in working condition. The company will record the equipment in its general ledger account Equipment at the cost of $17,000.

• The company will continue to record the depreciation expense in the income statement for the next 10 years.
• An amortization schedule is often used to calculate a series of loan payments consisting of both principal and interest in each payment, as in the case of a mortgage.
• Thus, companies use different depreciation methods in order to calculate depreciation.
• $3,200 will be the annual depreciation expense for the life of the asset.
• On the other hand, a larger company might set a $10,000 threshold, under which all purchases are expensed immediately.

Even if you defer all things depreciation to your accountant, brush up on the basics and make sure you’re leveraging depreciation to the max. Harold Averkamp (CPA, MBA) has worked as a university accounting instructor, accountant, and consultant for more than 25 years. Upgrading to a paid membership gives you access to our extensive collection of plug-and-play Templates designed to power your performance—as well as CFI’s full course catalog and accredited Certification Programs. Our partners cannot pay us to guarantee favorable reviews of their products or services.

Use of Contra Account

The straight-line depreciation method is the most widely used and is also the easiest to calculate. The method takes an equal depreciation expense each year over the useful life of the asset. Using this new, longer time frame, depreciation will now be $5,250 per year, instead of the original $9,000. That boosts the income statement by $3,750 per year, all else being the same.

After three years, the company changes the expected useful life to a total of 15 years but keeps the salvage value the same. With a book value of $73,000 at this point (one does not go back and “correct” the depreciation applied so far when changing assumptions), there is $63,000 left to depreciate. This will be done over the next 12 years (15-year lifetime minus three years already). The second scenario that could occur is that the company really wants the new trailer, and is willing to sell the old one for only $65,000. The first two are the same as above to remove the trailer from the books.

How Does Depreciation Differ From Amortization?

There are several methods for calculating depreciation, generally based on either the passage of time or the level of activity (or use) of the asset. The asset’s cost minus its estimated salvage value is known as the activity-based management asset’s depreciable cost. It is the depreciable cost that is systematically allocated to expense during the asset’s useful life. This formula is best for small businesses seeking a simple method of depreciation.

This method also calculates depreciation expenses using the depreciable base (purchase price minus salvage value). Instead of realizing the entire cost of an asset in year one, companies can use depreciation to spread out the cost and match depreciation expenses to related revenues in the same reporting period. This allows the company to write off an asset’s value over a period of time, notably its useful life. To get around this linkage problem, we assume a steady rate of depreciation over the useful life of each asset, so that we approximate a linkage between the recognition of revenues and expenses over time. Also, the matching principle does not work in those cases where depreciation expense is recognized but there are no sales, as occurs in seasonal sales situations. Another accelerated depreciation method is the Sum of Years’ Digits Method.

A deduction for the full cost of depreciable tangible personal property is allowed up to $500,000 through 2013. When an asset is sold, debit cash for the amount received and credit the asset account for its original cost. Under the composite method, no gain or loss is recognized on the sale of an asset.

The units-of-production method depreciates equipment based on its usage versus the equipment’s expected capacity. The more units produced by the equipment, the greater amount the equipment is depreciated, and the lower the depreciated cost is. The depreciated cost can be used as an asset valuation tool to determine the useful value of an asset at a specific point in time.

Understanding Methods and Assumptions of Depreciation

GAAP is a set of rules that includes the details, complexities, and legalities of business and corporate accounting. GAAP guidelines highlight several separate, allowable methods of depreciation that accounting professionals may use. This method, which is often used in manufacturing, requires an estimate of the total units an asset will produce over its useful life. Depreciation expense is then calculated per year based on the number of units produced that year.

The Capitalization Limit

The depreciated cost can also be calculated by deducting the sum of depreciation expenses from the acquisition cost. In some cases, it makes more sense to calculate depreciation by measuring the work the asset does, rather than the time it serves. So, in this depreciation method, equal expense rates are assigned to each unit of production, meaning that depreciation is based on output capacity rather than number of years. There are two steps you’ll need to go through to calculate units of production depreciation. The four depreciation methods include straight-line, declining balance, sum-of-the-years’ digits, and units of production.

Recording Accounting Depreciation in Books

The two main assumptions built into the depreciation amount are the expected useful life and the salvage value. 10 × actual production will give the depreciation cost of the current year. Suppose an asset has original cost $70,000, salvage value $10,000, and is expected to produce 6,000 units. To make the topic of Depreciation even easier to understand, we created a collection of premium materials called AccountingCoach PRO. Our PRO users get lifetime access to our depreciation cheat sheet, flashcards, quick tests, quick test with coaching, business forms, and more. SmartAsset Advisors, LLC (“SmartAsset”), a wholly owned subsidiary of Financial Insight Technology, is registered with the U.S.

Regardless of the depreciation method used, the total amount of depreciation expense over the useful life of an asset cannot exceed the asset’s depreciable cost (asset’s cost minus its estimated salvage value). Depreciation is necessary for measuring a company’s net income in each accounting period. To demonstrate this, let’s assume that a retailer purchases a $70,000 truck on the first day of the current year, but the truck is expected to be used for seven years. It is not logical for the retailer to report the $70,000 as an expense in the current year and then report $0 expense during the remaining 6 years. However, it is logical to report $10,000 of expense in each of the 7 years that the truck is expected to be used. The depreciated cost of an asset is the value that remained after the asset’s been depreciated over a period of time.

Here are four common methods of calculating annual depreciation expenses, along with when it’s best to use them. Accumulated depreciation is reported on the balance sheet as a negative number in the asset section, reducing the overall value of the fixed assets owned by the company. The purpose of depreciation is to match the expense recognition for an asset to the revenue generated by that asset. You need to determine a suitable way to allocate cost of the asset over the periods during which the asset is used. Generally, the method of depreciation to be used depends upon the patterns of expected benefits obtainable from a given asset. This means different methods would apply to different types of assets in a company.