A depreciation expense arises due to the reduction in value of a long term asset caused by its limited useful life.
Most long term assets (except for land) have a limited useful life as a result of wear and tear and obsolescence and therefore depreciate over time.
Wear and tear or physical deterioration results from use. The asset can be kept in good working order by regular repairs and maintenance but ultimately it will have to be discarded and replaced.
Obsolescence is a consequence of changing technology. An asset such as a computer may not have worn out but may have gone out of date and need replacing due to technological changes.
In accounting, the depreciation expense is the allocation of the cost of the asset to the accounting periods over which it is to be used. The allocation is necessary to comply with the matching principle, ensuring that the expense of owning the asset is matched to the revenues generated by the asset.
The depreciation cost estimate is an expense of the business included in the income statement for each accounting period.
How to Calculate the Depreciation Expense
If for example, a business has purchased furniture with a value of 4,000 and expects it to have a useful life of 4 years and no salvage value, then we can calculate the straight line depreciation expense as follows:
Depreciation expense = (Cost of fixed asset - Salvage value) / Useful life Depreciation expense = (4,000 - 0) / 4 = 1,000
In this example the depreciable value is 4,000 and the depreciation expense is 1,000 per year for the next 4 years.
Partial Year Depreciation Expense
The example above assumes that the business purchased the asset at the beginning of the accounting period and a full years depreciation expense (1,000) is calculated. If the business acquires the asset part way through the year it has two options:
- Decide on a specific depreciation accounting policy, such as a full years depreciation expense will be charged in the year of acquisition or,
- Pro rata the depreciation expense for the first year depending on the number of months the equipment was in use. Using the example above, suppose the equipment was acquired at the start of month 3, then it would have been in use for 9 months of the year, and the depreciation expense for the first year is calculated as 1,000 x 9/12 = 750.
In both cases the depreciation expense method should be applied consistently each accounting period.
Methods of Depreciation
There are various methods used to calculate depreciation, but they generally fall into two categories.
Straight Line Method
The straight line method depreciates the asset at a constant rate over its useful life. The depreciation charge will be the same for each accounting period. Further details on using the method can be found in our straight line depreciation tutorial.
Accelerated Depreciation Methods
The accelerated depreciation method as the name implies, will accelerate the charge for depreciation by making the charge in the early years higher than the charge in the later years. There are various ways in which accelerated depreciation can be calculated including, declining balance, double declining balance, and sum of digits methods.
The choice of depreciation method is governed by the distribution of the economic benefit of using the asset. If most of the benefit arises in the early years then an accelerated depreciation method is best. If the benefit falls evenly over the life of the asset then the straight line depreciation method is best.
Depreciation Expense Journal Entry
The depreciation expense is calculated at the end of an accounting period and is entered as a journal
The first entry is the expense being recorded in the income statement, the second entry is to the accumulated depreciation account which is a contra asset account in the balance sheet.
The accumulated depreciation account is used as it reflects only an estimate of how much the asset has been used during the accounting period, and the asset account itself continues to show the original cost of the asset.
It is normal to group long term (fixed) assets into categories which have the same useful life (e.g. computer equipment might have a 3 year useful life) so that depreciation can be more easily calculated and recorded in the accounting records.
It is important to understand that although the charging of depreciation affects the net income (and therefore the amount equity attributable to shareholders) of a business, it does not involve the movement of cash.