Why depreciation is charged

The term depreciation refers to an accounting method used to allocate the cost of a tangible or physical asset over its useful life or life expectancy.

Depreciation represents how much of an asset's value has been used. Depreciating assets helps companies earn revenue from an asset while expensing a portion of its cost each year the asset is in use.

Not accounting for depreciation can greatly affect a company's profits. Companies can also depreciate long-term assets for both tax and accounting purposes. Assets such as machinery and equipment are expensive.

Instead of realizing an asset's entire cost in year one, companies can use depreciation to spread out the cost and generate revenue from it. This is done through depreciation , which allows a company to write off an asset's value over a period of time, notably its useful life.

It may be used to account for declines over time in the carrying value , which represents the difference between the original cost and the accumulated depreciation of the years.

Depreciation is taken regularly so a company can move the asset's cost from the balance sheet to the income statement. When a company buys an asset, it records the transaction as a debit to increase an asset account on the balance sheet and a credit to reduce cash or increase accounts payable , which is also on the balance sheet. Neither journal entry affects the income statement, where revenues and expenses are reported.

At the end of an accounting period, an accountant books depreciation for all capitalized assets that are not fully depreciated. The journal entry consists of a:. As noted above, businesses can take advantage of depreciation for both tax and accounting purposes.

This means they can take a tax deduction for the cost of the asset, reducing taxable income. But the Internal Revenue Service IRS states that when depreciating assets, companies must spread the cost out over time. The IRS also has rules for when companies can take a deduction.

The IRS publishes depreciation schedules detailing the number of years an asset can be depreciated for tax purposes, based on various asset classes. Depreciation is considered a non-cash charge since it doesn't represent an actual cash outflow. The entire cash outlay might be paid initially when an asset is purchased, but the expense is recorded incrementally for financial reporting purposes. That's because assets provide a benefit to the company over a lengthy period of time.

But the depreciation charges still reduce a company's earnings , which is helpful for tax purposes. The matching principle under generally accepted accounting principles GAAP is an accrual accounting concept that dictates that expenses must be matched to the same period in which the related revenue is generated.

Depreciation helps to tie the cost of an asset with the benefit of its use over time. In other words, the asset is put to use each year and generates revenue —the incremental expense associated with using up the asset is also recorded. The total amount depreciated each year, which is represented as a percentage, is called the depreciation rate.

The depreciation rate is used in both the declining balance and double-declining balance calculations. Accumulated depreciation is a contra asset account , meaning its natural balance is a credit that reduces the net asset value NAV.

Accumulated depreciation on any given asset is its cumulative depreciation up to a single point in its life. As stated earlier, carrying value is the net of the asset account and the accumulated depreciation.

The salvage value is the carrying value that remains on the balance sheet after which all depreciation is accounted for until the asset is disposed of or sold.

It is based on what a company expects to receive in exchange for the asset at the end of its useful life. Depreciating assets using the straight-line method is the most basic way to record depreciation. It reports equal depreciation expense each year throughout the entire useful life until the entire asset is depreciated to its salvage value.

The annual depreciation using the straight-line method is calculated by dividing the depreciable amount by the total number of years. The declining balance method is an accelerated depreciation method.

This method depreciates the machine at its straight-line depreciation percentage times its remaining depreciable amount each year. Because an asset's carrying value is higher in earlier years, the same percentage causes a larger depreciation expense amount in earlier years, declining each year. The double-declining balance DDB method is another accelerated depreciation method.

Although the rate remains constant, the dollar value will decrease over time because the rate is multiplied by a smaller depreciable base for each period. To start, combine all the digits of the expected life of the asset. This method requires an estimate for the total units an asset will produce over its useful life.

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Fixed assets have a debit balance on the balance sheet. By having accumulated depreciation recorded as a credit balance, the fixed asset can be offset. In other words, accumulated depreciation is a contra-asset account, meaning it offsets the value of the asset that it is depreciating. As a result, accumulated depreciation is a negative balance reported on the balance sheet under the long-term assets section.

However, the fixed asset is reported on the balance sheet at its original cost. Accumulated depreciation is recorded as well, allowing investors to see how much of the fixed asset has been depreciated. The net difference or remaining amount that has yet to be depreciated is the asset's net book value. In short, by allowing accumulated depreciation to be recorded as a credit, investors can easily determine the original cost of the fixed asset, how much has been depreciated, and the asset's net book value.

When an asset is retired or sold, the total amount of the accumulated depreciation associated with that asset is reversed, completely removing the record of the asset from a company's books. Below we see the running total of the accumulated depreciation for the asset. The balance sheet would reflect the fixed asset's original price and the total of accumulated depreciation.

Since accumulated depreciation is a credit entry, the balance sheet can show the cost of the fixed asset as well as how much has been depreciated. Financial Analysis. Financial Statements. Your Privacy Rights. To change or withdraw your consent choices for Investopedia. At any time, you can update your settings through the "EU Privacy" link at the bottom of any page. These choices will be signaled globally to our partners and will not affect browsing data.

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