Introduction
Depreciation is the systematic allocation of an asset’s cost over its useful life. It represents the consumption, wear and tear, or obsolescence of an asset over time. Proper depreciation accounting is essential for:
- Accurately representing the true value of assets on the balance sheet
- Matching expenses with revenue in the appropriate accounting periods
- Calculating accurate net income for financial reporting
- Tax planning and optimization
- Capital budgeting and replacement decisions
Core Concepts & Terminology
| Term | Definition |
|---|---|
| Cost Basis | The original acquisition cost plus all costs to put the asset into service |
| Useful Life | The estimated period an asset will be productively used in operations |
| Salvage Value | The estimated residual value at the end of the asset’s useful life |
| Depreciable Base | Cost basis minus salvage value |
| Book Value | Original cost minus accumulated depreciation |
| Accumulated Depreciation | The total depreciation expense recognized to date |
| Straight-Line Rate | 1 ÷ Useful life in years |
| Accelerated Depreciation | Methods that expense more in early years and less in later years |
| Impairment | Permanent decline in value requiring write-down beyond normal depreciation |
Depreciation Methods Comparison
| Method | Formula | Advantages | Disadvantages | Best For |
|---|---|---|---|---|
| Straight-Line | (Cost – Salvage) ÷ Useful Life | Simple, consistent expense, widely used | Doesn’t reflect higher productivity in early years | Assets with consistent utility over time (buildings, furniture) |
| Declining Balance | Book Value × Rate | Accelerated write-off, tax benefits | Complex calculations, unpredictable expense pattern | Technology, vehicles, equipment that loses value quickly |
| Double Declining | 2 × Straight-line rate × Book Value | Fastest write-off in early years | Must switch to straight-line eventually for salvage value | Assets with rapid obsolescence |
| Sum-of-Years’-Digits | (Remaining life ÷ SYD) × Depreciable Base | Moderate acceleration, systematic pattern | Complex calculations | Assets with moderate productivity decline |
| Units of Production | (Units produced ÷ Estimated total production) × Depreciable Base | Matches expense to actual usage | Requires production estimates, tracking | Manufacturing equipment, vehicles, natural resources |
Step-by-Step Calculation Processes
1. Straight-Line Method
- Calculate depreciable base: Cost – Salvage value
- Determine useful life in years
- Divide depreciable base by useful life
- Record same amount each year
Example:
Asset cost: $10,000
Salvage value: $1,000
Useful life: 5 years
Annual depreciation = ($10,000 - $1,000) ÷ 5 = $1,800 per year
2. Declining Balance Method
- Determine rate (typically 1.5 or 2 times straight-line rate)
- Apply rate to beginning book value each year
- Switch to straight-line when it yields larger deduction
- Stop when book value equals salvage value
Example:
Asset cost: $10,000
Salvage value: $1,000
Useful life: 5 years
Rate: 2 × (1 ÷ 5) = 40%
Year 1: $10,000 × 40% = $4,000
Year 2: ($10,000 - $4,000) × 40% = $2,400
Year 3: ($10,000 - $4,000 - $2,400) × 40% = $1,440
Year 4: ($10,000 - $4,000 - $2,400 - $1,440) × 40% = $864
Year 5: Remaining $296 to reach salvage value
3. Sum-of-Years’-Digits (SYD) Method
- Calculate SYD: n(n+1) ÷ 2 (where n = useful life)
- For each year, depreciation = (Remaining life ÷ SYD) × Depreciable base
Example:
Asset cost: $10,000
Salvage value: $1,000
Useful life: 5 years
SYD = 5(5+1) ÷ 2 = 15
Year 1: (5 ÷ 15) × $9,000 = $3,000
Year 2: (4 ÷ 15) × $9,000 = $2,400
Year 3: (3 ÷ 15) × $9,000 = $1,800
Year 4: (2 ÷ 15) × $9,000 = $1,200
Year 5: (1 ÷ 15) × $9,000 = $600
4. Units of Production Method
- Calculate depreciable cost per unit: (Cost – Salvage) ÷ Total estimated units
- Multiply units produced by depreciable cost per unit
Example:
Asset cost: $50,000
Salvage value: $5,000
Total estimated production: 100,000 units
Depreciation per unit = ($50,000 - $5,000) ÷ 100,000 = $0.45 per unit
Year 1 (15,000 units): 15,000 × $0.45 = $6,750
Year 2 (25,000 units): 25,000 × $0.45 = $11,250
Year 3 (30,000 units): 30,000 × $0.45 = $13,500
Year 4 (20,000 units): 20,000 × $0.45 = $9,000
Year 5 (10,000 units): 10,000 × $0.45 = $4,500
Tax Depreciation Systems
Modified Accelerated Cost Recovery System (MACRS) – U.S.
| Property Class | Examples | Recovery Period |
|---|---|---|
| 3-year | Specialized manufacturing tools | 3 years |
| 5-year | Computers, office equipment, cars | 5 years |
| 7-year | Office furniture, manufacturing equipment | 7 years |
| 10-year | Boats, fruit trees | 10 years |
| 15-year | Land improvements | 15 years |
| 20-year | Farm buildings | 20 years |
| 27.5-year | Residential rental property | 27.5 years |
| 39-year | Commercial real estate | 39 years |
Key MACRS Features:
- No salvage value consideration
- Half-year convention (treat as placed in service mid-year)
- Predetermined percentages by recovery period
- Optional straight-line election
- Section 179 immediate expensing for qualifying property
International Financial Reporting Standards (IFRS)
- Component approach required (depreciate significant parts separately)
- Annual review of depreciation method, useful life, and residual value
- Impairment testing when indicators present
- Revaluation model permitted (upward adjustments allowed)
Journal Entries for Depreciation
Basic Depreciation Entry
Depreciation Expense $XXX
Accumulated Depreciation $XXX
Asset Disposal – Fully Depreciated
Accumulated Depreciation $XXX
Equipment $XXX
Asset Disposal – With Gain
Cash $XXX
Accumulated Depreciation $XXX
Equipment $XXX
Gain on Disposal $XXX
Asset Disposal – With Loss
Cash $XXX
Accumulated Depreciation $XXX
Loss on Disposal $XXX
Equipment $XXX
Common Challenges and Solutions
| Challenge | Solution |
|---|---|
| Estimating useful life | Research industry standards, manufacturer specifications, and historical data. Document basis for estimates. |
| Determining salvage value | Use market data for similar used assets, consider disposal costs, and document assumptions. Update periodically. |
| Mid-year acquisitions | Apply conventions (half-year, mid-month, mid-quarter) consistently based on policy or tax requirements. |
| Component vs. whole asset | For complex assets, consider component approach where significant parts have different useful lives. |
| Change in estimates | Apply prospectively to current and future periods. No restatement of prior periods. |
| Impairment | Test when indicators present. Write down to recoverable amount. Cannot reverse under U.S. GAAP. |
| Idle assets | Continue depreciation unless asset is classified as held for sale. |
| Fully depreciated assets still in use | Reevaluate estimates. If significant, adjust prospectively. Consider disclosing in notes. |
Best Practices and Tips
- Documentation: Maintain detailed fixed asset records including acquisition date, cost, estimated life, salvage value, and method
- Consistency: Apply methods consistently to similar asset classes
- Regular Reviews: Periodically review depreciation rates, useful lives, and salvage values
- Component Approach: Consider depreciating significant components separately for more accurate reporting
- Capitalization Policy: Establish minimum thresholds for capitalizing vs. expensing
- Physical Inventory: Conduct periodic fixed asset counts and reconcile to accounting records
- Tax Planning: Consider available tax incentives (bonus depreciation, Section 179)
- Software: Utilize specialized fixed asset software for complex asset portfolios
- Disclosure: Ensure financial statement disclosures include methods, useful lives, and significant assumptions
- Replacement Planning: Use depreciation schedules to anticipate and plan for asset replacements
Special Considerations
Land and Depreciation
- Land is not depreciable under GAAP or tax rules
- Land improvements (parking lots, landscaping) are depreciable separately
- Buildings are depreciable separate from land
Intangible Assets
- Amortization rather than depreciation (same concept, different term)
- Finite vs. indefinite useful lives (indefinite not amortized but tested for impairment)
- Common methods: straight-line, pattern of economic benefits
Leased Assets
- Capital/finance leases: Recognize asset and depreciate over lease term or useful life
- Operating leases: No depreciation (rent expense only)
- ASC 842/IFRS 16: Right-of-use assets subject to depreciation
Resources for Further Learning
Professional Organizations
- American Institute of Certified Public Accountants (AICPA)
- Financial Accounting Standards Board (FASB)
- International Accounting Standards Board (IASB)
- Institute of Management Accountants (IMA)
Key Accounting Standards
- ASC 360 (U.S. GAAP): Property, Plant, and Equipment
- IAS 16 (IFRS): Property, Plant, and Equipment
- IRC Section 167 & 168: Depreciation
Recommended Books
- Intermediate Accounting by Kieso, Weygandt, and Warfield
- Financial Accounting Theory and Analysis by Schroeder, Clark, and Cathey
- J.K. Lasser’s Guide to Tax Deductions (updated annually)
Online Resources
- IRS Publication 946: How to Depreciate Property
- FASB Accounting Standards Codification Database
- IFRS Foundation Technical Resources
- CPA Review Course Materials
Software Tools
- QuickBooks Fixed Asset Manager
- Sage Fixed Assets
- Bloomberg BNA Fixed Assets
- Oracle Fixed Assets Module
- SAP Asset Accounting