Personal Finance guide

Depreciation in accounting is used to spread an asset’s cost over the number of years it will be useful to the entity. It is used to reflect the decreasing value of the asset over time due to wear-and-tear, usage, technological outdating, etc… The original purchase affects the entity’s cash account one time. For the remaining useful life of the item, the assets are affected on the balance sheet as accumulated depreciation and the expenses are affected on the income statement as depreciation expenses. Depreciation is a way to spread the expense of an asset over the span of its useful life, as long as that span is longer than one accounting period. Many different types of assets are depreciable including tangible assets (buildings, equipment, machinery) and intangible assets (software, patents, copyrights). There are several types of depreciation methods used in bookkeeping today. A few are outlined below.

Straight-line depreciation method is graphically exactly what the name implies. It is a straight, horizontal line on a graph of annual depreciation expense versus years of life. It is one pre-determined standard amount that is divided over the estimated useful life span of the asset. This expense is then recorded once per year for the appropriate length of time. This can be calculated by taking the difference of the original cost minus the salvage value (or the amount that the item can be sold for at the end of its useful life to the entity) divided by the useful life. This calculation will give you the amount to be recorded as depreciation each year. For example, if an asset is purchased for $125,000, it’s salvage value is $5,000 ($125,000 – $5,000 = $120,000), and it is estimated to last the entity 6 years ($120,000/ 6 years = $20,000/year) an accumulated depreciation of $20,000 should be recorded each year for the next 6 years.

Related to straight-line depreciation is units-of-production depreciation. Instead of spreading the total asset depreciation over a span of time, it is spread over the amount of units it is expected to produce in its useful life. The depreciation is constant for each unit produced, but if some years are more fruitful in production than others, the amount recorded as depreciation will vary. This is most relevant with an asset that has a useful life closely related to its output. For example, if the same asset listed above was estimated to be able to produce 60,000 units of product in its lifetime ($120,000/60,000) each unit produced should be recorded as an accumulated depreciation of $2. If in 2007 the entity was able to produce 12,000 units, $24,000 should be recorded as accumulated depreciation. Likewise if in 2008 the entity was able to produce 16,000 units, an accumulated depreciation of $32,000 should be recorded for that year.

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Let us start with a simple question. When is it best to use the straight-line method or the Accelerated method when reporting depreciation? But, to answer this question the quadrant would need to understand the differences between the two. Recognize the benefits and faults of each method when put into practice. Is the straight-line depreciation method better suited for tax purposes or should it be used for financial reporting? The quadrant could look to industry; seeing that the straight-line method is used for reporting to stockholders by most firms. To see why we would need to study how the straight-line method works and why it is better used for financial accounting.

The key to understanding anything is to always start with the basics. The simple mechanics of how the straight-line depreciation method works and even what depreciation is. Simply defined depreciation is a term used to spread the cost of an asset over a span of several years. In other words, it is the reduction in the value while that asset is being used by the company or organization. The straight-line depreciation method is one way of recording this reduction in value. This method calculates the annual depreciation expense by taking the cost of the fixed asset minus the scrap value of that asset then dividing by the life span (the number of years the fixed asset will be in use). For example, a fixed asset that depreciates over six years is purchased by a firm. The cost of that asset is $35,000 and it has a scrap value of $5000. The calculated annual depreciation expense will be $5000. This method is used in financial accounting because it allows for the firm or organization to report a higher net income in the earlier years to the stockholders. Financially it makes the company or organization look better to current investors and future investors. But for tax purposes it might not be the company or organization’s first choice for recording depreciation. Often the company or organization will use a method such as the double declining depreciation method because of its benefit to maximize the early tax deduction.

How can the double declining depreciation method help with maximizing the early tax deductions for a company or organization’s fixed asset? When the method is broken down to mechanics it becomes easy to see. The double declining depreciation method, like the straight-line method, is another way to record the reduction in value of an asset while it is in use. In this method the annual depreciation expense is calculated by doubling the straight-line depreciation rate then multiplying it by the asset’s net book value at the beginning of the year. So, hypothetically, if a company or organization’s fixed asset has a twenty percent straight-line depreciation rate the double declining balance depreciation rate would be forty. But, unlike the straight-line depreciation method, when using the double declining depreciation the depreciation expense is recalculated each year using the previous year’s net book value at end of year. The early calculations are noticeably higher forcing higher taxes early on. But, the benefit to using the double declining balance depreciation method is that as the fixed asset is used throughout its life span the depreciation expense decreases significantly. So, companies and organizations choose this method so they can pay a larger sum of the taxes upfront instead of having to pay them further down the road.

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Depreciation can be easily defined as the decrease in value of any asset, through use, wear and tear, and age.

The first thing to be determining when depreciating an asset is its initial cost, which is the cost to purchase the asset plus any costs incurred to get the asset ready to use. Examples of these extra costs are: sales taxes, freight and installation costs.

After determining the initial cost and by the time the asset is placed in service, the expected useful life should be determined. According to the Internal Revenue Service guidelines, most machinery and equipment have a useful life of seven years, while automobiles and light duty trucks have a useful life of five years. Even though these are mandatory for federal income tax purposes, companies may decide using different expected useful life for financial reporting purposes.

The last information to be determined before depreciating an asset is its residual value at the end of the useful life. The residual value is the estimated value of the asset at the end of its useful life. The depreciable cost of the asset will be the difference between its initial cost and its residual value. As a consequence, if an asset is expected to have no residual value, the entire initial cost must be depreciated.

Among the several methods of depreciation, the most common are: straight line method, the 200 percent declining-balance method, the Service Hours method, the Sum of the Years Digits method and the Modified Accelerated Cost Recovery System (MACRS).

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Congratulations, you just bought a new truck for your landscaping business. You will now be more efficient because you no longer have to travel back and forth to get your tools to the job site. This new asset will take your business to the next level and you can now compete for those large jobs the competition gets every day. The question is, “how do you account for this large expense in your financial statements to your investors and your tax returns?” Depreciation is the accounting tool that allows you to account for the cost of this new asset.

Depreciation is an application of the matching principle. The purchase or buildings and equipment are recorded at their original cost. In our example, the new landscaping truck costs $30K, but the financial benefit from this new vehicle will not be realized until future jobs are earned. Therefore it is necessary to come up with some correlation between this expensive asset and the future economic benefit it brings to the company. Depreciation is that correlation. At face value, some think depreciation is just a recalculation of the new market value of an asset. This is not the case; depreciation applies a portion of that initial expense to the revenue earned for a given period of time. We will explore this relationship and how they are applied through straight-line depreciation and accelerated depreciation.

Straight-line depreciation takes the total cost of an asset, in our case $30K for the new truck, and divides it by the years of life for that asset. The straight-line depreciation method is most often used for reporting to stockholders because in early years it accounts for lower depreciation expense and therefore maximizes the revenue for that period. In our example, the trucks useful life is 10 years so we would take $30K and divide by 10 years to come up with yearly depreciation of $3K. During every fiscal year $3K would be applied to the income statement as an expense and reduce net income by $3K.

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For many people, the job titles of accountant and bookkeeper are interchangeable. After all, doesn’t a bookkeeper maintain the accounts of a business by tracking accounts receivable, accounts payable, rent expense, payroll, etc.? The answer is yes, a bookkeeper does perform all of these accounting functions. So why does an accountant get paid so much more than a bookkeeper? Aren’t they one in the same?

To answer this question, we can first think back to geometry. To say that a bookkeeper is equivalent to an accountant is like saying a square is equivalent to a quadrilateral. Both are shapes with four sides. But a square is a specific type of quadrilateral with all four sides equal in length and four right angles. A quadrilateral, on the other hand, is more encompassing. A rectangle, a square and a trapezoid all are quadrilaterals. All have four sides, but it is the length of those sides and the angles between them that differentiate these shapes. The same holds true for accounting. Bookkeeping is a very specific part of accounting which looks at the tracking of money being spent and earned. We all do bookkeeping by (hopefully) balancing our checkbooks. But accounting, like a quadrilateral, is much more encompassing. Accountants use a technique called matching, which goes way beyond standard bookkeeping. Beyond basic bookkeeping, accountants must make decisions regarding the “how, when and why” of documenting a businesses finances. Matching is a principle used to allocate debits and credits to certain accounting periods and reconcile across types of financial statements. Although there are strict laws governing accounting, there is a certain amount of flexibility that allows accountants to have some control over the outcomes of their financial statements.

As a more specific example, let’s compare straight-line and double-declining balance depreciation. To oversimplify, in straight-line depreciation the cost of the equipment is divided by the number of years of its “useful life” (less the salvage cost, or final “worth,” of the equipment once it has reached the end of its useful life). This gives a depreciation amount that is the same year one as it is year ten. It is a very neat and reliable method to use, as there is no variation in the fixed amount.

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