Depreciation: An In-Depth Explanation

Introduction

• Depreciation is a systematic process of allocating the cost of a long-lasting asset over its useful life.
• Necessary for accurate net income measurement, matching asset cost with revenue generated.

Reasons for Depreciation

• Provides a logical spread of asset cost over its useful life (e.g., $70,000 truck used over 7 years at $10,000 per year).
• Matches asset cost to periods of usage.

Depreciable Assets Examples

• Buildings, machinery, vehicles, computers, furniture, land improvements.
• Recorded initially at cost necessary to make assets operational.

Calculating Depreciation

• Key factors: asset cost, estimated salvage value, estimated useful life.
• Common formula: (Asset Cost - Salvage Value) / Useful Life.

Recording Depreciation

• Adjusting entry at period's end.
• Involves accounts: Depreciation Expense (temporary) and Accumulated Depreciation (contra asset, balance sheet).

Methods of Calculating Depreciation

• Straight-Line Method: Equal expense each year.
• Units-of-Activity Method: Based on asset's output.
• Double-Declining-Balance Method: Accelerated depreciation, more expense early in life.
• Sum-of-the-Years-Digits Method: Accelerated, more expense early in life.

Straight-Line Depreciation Example

• Equipment purchased for $10,500, useful life 5 years, $500 salvage value.
• Annual expense: $2,000.

Depreciation Adjustments and Changes

• Based on estimates, changes may affect future depreciation but not past records.

Special Cases

• Units-of-Activity: Depreciation based on use rather than time.
• Double-Declining-Balance: More early-life expense, stops when book value equals salvage value.
• Sum-of-the-Years-Digits: Accelerated, based on sum of years' digits.

Selling Depreciable Assets

• Record depreciation up to sale date.
• Compare book value with sale price to determine gain or loss.

Additional Considerations

• Manufacturing assets' depreciation initially recorded in manufacturing overhead.
• Distinction between repairs (expense) and improvements (capitalized).
• Depreciation as allocation, not valuation.
• Impairment can adjust book value when market value declines.

Conclusion

• Depreciation is crucial for financial reporting, aligning asset costs with income.
• Various methods offer flexibility based on company needs and asset usage.
• Important to consult professionals for specific accounting and tax guidance.