A depreciation expense arises due to the reduction in value of a long term asset as a result of its limited useful life.
Most long term assets have limited useful life resulting from wear and tear and obsolescence and therefore depreciate over time. The main exception to this is land.
Wear and tear or physical deterioration results from use. The asset can be kept in good working order by regular repairs and maintenance. However, 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 An asset such as a computer may not have worn out but may have gone out of date and need replacing due to technological changes.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.
How to Calculate the Depreciation Expense
The depreciation cost estimate is an expense of the business included in the income statement for each accounting period. Furthermore, the expense is calculated using the straight line depreciation formula shown below.
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 4 years.
Partial Year Depreciation Expense
The example above assumes that the business purchases the asset at the beginning of the accounting period and calculates a full years depreciation expense (1,000). In contrast if the business acquires the asset part way through the year it has two options:
- Decide on a specific depreciation accounting policy, such as charge a full years depreciation expense 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 business acquires the equipment at the start of month 3, then it would have been in use for 9 months of the year. Consequently the amount of depreciation expense for the first year is 1,000 x 9/12 = 750.
In both cases the depreciation 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. Consequently 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 expense in the early years higher than the expense 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. Additionally 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 depreciation expense affects net income (and therefore the amount of equity attributable to shareholders), it does not involve the movement of cash.
Accumulated Depreciation is simply the total of all the depreciation charges for an asset since it was purchased or first brought into use. Furthermore the accumulated depreciation account is a balance sheet account and has a credit balance.
For example, if an asset has a cost 10,000 and is depreciated over 5 years, then the annual depreciation expense is 10,000/5 = 2,000 per year. This amount is charged to the profit and loss account each year.
After 3 years the total depreciation charge = accumulated depreciation = 3 x 2,000 = 6,000. This link between depreciation and accumulative depreciation is represented in the diagram below.
The cumulative depreciation can also used to determine the net book value of the asset.
Using the example above, the net book value is the cost less the accumulated depreciation = 10,000 – 6,000 = 4,000.
About the Author
Chartered accountant Michael Brown is the founder and CEO of Double Entry Bookkeeping. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a degree from Loughborough University.