Depreciation

What is Depreciation Expense?

Depreciation Definition

Depreciation refers to the expense resulting from spreading the cost of an asset over its estimated useful life.

When a company purchases an asset such as a vehicle, furniture, equipment, or other form of fixed assets, the purchase price is recorded on the balance sheet at historical cost. Unlike land, which remains on the balance sheet at historical cost, depreciable assets are considered used up, or consumed, over time.

The concept of depreciation is thus based on the assumption that these depreciable assets have a useful life over which they are consumed. GAAP accounting requires that the expense associated with this consumption be properly allocated against the income the asset helped to generate.

Depreciation therefore follows the matching principle, in that the costs of consuming the asset over time should be taken against the same income in each period that that benefited from the use of the asset. Depreciation spreads the cost of the asset over the periods that the asset was used to generate the income, as opposed to charging the initial cost of the asset in one period.

What are the depreciation rules used to determine how the costs of assets are allocated? GAAP provides for several depreciation methods. These permitted depreciation methods are merely used to find a way to allocate the costs of the assets against the income, but are not a real reflection of the market value of the asset.

Property Depreciation vs. Property Valuation

Oftentimes, when people use the term property depreciation, they are referring to the declining value of property. For example, a new car owner may lament that his new car is depreciating at the rate of $3,000 per year, meaning that the trade in value dropped by $3,000 from the previous year. But in accounting terms, depreciation is not a reflection of the market value of an asset. In fact, an asset could be completely depreciated on the balance sheet, making the book value zero (acquisition cost less accumulated depreciation), yet still have market value.

Therefore, the goal of depreciation is not to value the asset, but to allocate the costs of the assets against income.

Property Depreciation vs. Property Valuation

Depreciation is a method of cost allocation, not a means of determining the actual value of an asset.

Property Depreciation and Cash Flow

Because depreciation is a method of allocating the original cost of a fixed asset against income, depreciation expense is not an actual use of cash. Though the original purchase price of the asset represents a use of cash, depreciation expense merely allocates this previously incurred cost against income over time, and does not represent a use or a source of cash. In fact, the cash flow statement adds depreciation expense back when reconciling net income to actual cash.

Property depreciation has an effect on cash flow in that it lowers net income and the reportable earnings on the tax return. Using an accelerated depreciation method results in greater tax savings during the earlier life of the asset since a greater expense is reported on the income statement, resulting in less reportable earnings. Simply applying a different depreciation method can result in lower reportable earnings, and greater tax savings.

This is why accelerated depreciation methods are preferred for tax reporting purposes. The asset depreciation expense is “accelerated” in the early years, taking a greater expense and consequently deferring taxes. Outside of this tax savings, depreciation expense itself does not affect cash flow.

GAAP accounting provides for several depreciation methods to allocate costs of fixed assets against income based on time.

The depreciation methods follow two main categories: asset depreciation that is a function of time such as normal wear and tear, deterioration, and obsolescence, or as a function of actual physical usage:

Depreciation Calculation

Depreciation Methods as a Function of Time Straight Line Depreciation Accelerated Depreciation Methods Sum of the Years’ Digits Double Declining Depreciation Tax Depreciation MACRS Depreciation Income Tax Reporting Only, not GAAP. Depreciation Methods as a Function of Production Units of Production

Business Accounting Home Page