Depreciation Demystified: A Comprehensive Guide to Accounting for Depreciation

Depreciation is a crucial concept in accounting, as it helps businesses allocate the cost of tangible fixed assets over their useful lives. Whether you’re an aspiring accountant or just curious about how businesses manage their assets, understanding depreciation is essential. In this tutorial, we will walk you through the basics of calculating depreciation, provide you with clear examples, and guide you through the journal entries and financial statements.

What is Depreciation in Accounting?

Depreciation is the process of spreading the cost of a fixed asset over its useful life. Fixed assets, such as buildings, machinery, equipment, and vehicles, are purchased by businesses to help generate revenue. These assets lose value over time due to factors such as wear and tear, obsolescence, and age. Rather than recording the entire cost of the asset as an expense in the year it was purchased, depreciation allows businesses to allocate a portion of that cost each year.

In accounting, depreciation serves two main purposes:

1. Matching Principle: It matches the expense of the asset with the revenue it generates over its useful life.
2. Tax Deduction: Depreciation is an expense that reduces taxable income, which can lower tax liabilities.

There are various methods for calculating depreciation, and we’ll cover the most common ones in this tutorial.

Common Methods of Depreciation

Straight-Line Depreciation

This is the simplest and most commonly used method. Under straight-line depreciation, the same amount of depreciation is charged each year over the asset’s useful life. Formula for Straight-Line Depreciation:

• Cost of Asset is the initial purchase price.
• Salvage Value is the estimated value of the asset at the end of its useful life.
• Useful Life is the number of years the asset is expected to be used.

Declining Balance Depreciation

This method charges more depreciation in the early years of an asset’s life and less in the later years. It is based on a fixed percentage of the asset’s remaining book value. Formula for Declining Balance Depreciation:

• Depreciation Rate is a percentage (usually double the straight-line rate in the case of double declining balance).

Units of Production Depreciation

This method calculates depreciation based on the asset’s usage or output. It’s commonly used for assets whose value is more closely related to how much they are used rather than the passage of time. Formula for Units of Production Depreciation:

Example 1: Straight-Line Depreciation

Let’s say a company purchases a machine for $10,000. The machine has an estimated salvage value of $1,000, and its useful life is 5 years. To calculate the annual depreciation:

This means the company will record a depreciation expense of $1,800 each year for five years.

Journal Entries for Straight-Line Depreciation

The journal entry for recording the depreciation would look like this for the first year:

At the end of each subsequent year, the depreciation expense will remain the same, and the accumulated depreciation will increase by $1,800 each year.

Example 2: Declining Balance Depreciation

Now, let’s consider a company that purchases a machine for $10,000 with a 5-year useful life and no salvage value. The company will use the double-declining balance method (DDB), which charges depreciation at twice the straight-line rate.

Calculate the straight-line rate:

The depreciation rate for double declining balance method is:

Year 1 Depreciation

Journal Entry for Year 1

Year 2 Depreciation

After Year 1, the book value of the asset will be:

Now, calculate the depreciation for Year 2:

Journal Entry for Year 2

This process continues until the asset’s book value is fully depreciated.

Example 3: Units of Production Depreciation

Suppose a company buys a machine for $12,000 with a salvage value of $2,000. The machine is estimated to produce 100,000 units over its useful life. In a particular year, the machine produces 10,000 units.

The depreciation expense for that year is calculated as follows:

Journal Entry for Units of Production Depreciation

How Depreciation Affects Financial Statements

Depreciation affects both the income statement and the balance sheet.

1. Income Statement: Depreciation is recorded as an expense, reducing the company’s net income.
2. Balance Sheet: The accumulated depreciation reduces the book value of the asset on the balance sheet, which is shown as a contra-asset account.

Here’s how depreciation impacts a company’s financial statements.

Income Statement

Balance Sheet

Practice Questions and Answers

Question 1: Straight-Line Depreciation

A company buys a vehicle for $20,000 with a salvage value of $3,000 and a useful life of 4 years. What is the annual depreciation expense? Provide the journal entry for the first year.

Answer:

Depreciation Expense:

Journal Entry for Year 1:

Question 2: Double Declining Balance

A company purchases equipment for $8,000 with no salvage value and a useful life of 5 years. Calculate the depreciation for the first two years using the double declining balance method.

Answer:

Year 1 Depreciation:

Year 2 Depreciation:

Journal Entries:

Question 3: Units of Production

A company purchases a machine for $15,000 with a salvage value of $5,000. The machine is expected to produce 50,000 units. In the first year, the machine produces 8,000 units. Calculate the depreciation for the first year.

Answer:

Depreciation Expense:

Journal Entry for Year 1:

By understanding the different methods of calculating depreciation and the journal entries associated with them, you are now equipped to handle depreciation in various scenarios. Keep practicing, and soon you’ll be able to confidently calculate depreciation in your own accounting work!