Personal Finance guide

In accounting terms depreciation is the distribution of an assets cost over its useful life. In other words when a firm purchases an asset it has to make the decision if the asset will economically benefit the organization for more than a year. If the answer is yes than the firm would add this asset as a non current asset on its balance sheet, and would commence depreciating this asset over its useful life. In depreciating the asset the firm is subtracting the value (or the original cost) of the asset that was originally booked when the asset was purchased (under the non current asset section of the firm’s balance sheet) and is then expensing (the calculated accounting period depreciation amount) from the firms revenues earned in the same accounting period. The firm is in essence matching the cost (or value in terms of assets) against the revenues earned by the asset use. Many methods exist to calculate depreciation but I am going to focus on two of the more popular methods: Straight Line and Double Declining Balance.

Straight Line:

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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.

Continue reading ‘Appreciation for Depreciation’ »