What Is Depreciation?
The method of accounting used to allocate the cost of a tangible asset over its useful life and is used to account for declines in value is called depreciation. A long-term asset is depreciated for tax and accounting purposes. Business can deduct the cost of the tangible asset they purchase off their taxes but how and when the company can deduct depreciation is dictated by IRS rules.
For example, if a company buys a delivery van costing $100,000 and it is expected to be used for 5 years, the company might have a depreciation expense of $20,000 in each of the five years. Each year there will be an adjusting entry with a debit to Depreciation Expense for $20,000 and a credit to Accumulated Depreciation for $20,000. This depreciation expense is referred to as noncash expense because the adjusting entries do not involve cash.
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How to Calculate Depreciation?
Depreciation can be calculated on a monthly basis in two different ways.
Determining monthly accumulated depreciation for an asset depends on the asset’s useful lifespan as defined by the IRS, as well as which accounting method you use.
The useful lifespan of an asset can range from three to 20 years for personal property, 15 to 20 years for land improvements, and are fixed at 27.5 years for residential real estate and 39 years for business real estate. The IRS has information about the depreciation and lifespan of assets.
The IRS currently uses the Modified Accelerated Cost Recovery System (MARCS) is the depreciation system that allows depreciation to be calculated by either the straight-line method or the declining balance method.
To do the straight-line method, you choose to depreciate your property at an equal amount for each year over its useful lifespan.
Use the following steps to calculate monthly straight-line depreciation:
- Subtract the asset’s salvage value from its cost to determine the amount that can be depreciated
- Divide this amount by the number of years in the asset’s useful lifespan
- Divide by 12 to tell you the monthly depreciation for the asset
Declining Balance Method
This method is used to recognize the majority of an asset’s depreciation early in its lifespan. There are two variations of this: the double-declining balance method and the 150% declining balance method.
The depreciation amount changes from year to year using either of these methods, so it more complicated to calculate than the straight-line method.
For the double declining balance method, the following formula is used to calculate each year’s depreciation amount:
To convert this from annual to monthly depreciation, divide this result by 12.
What Is the Purpose of Depreciation?
The purpose of depreciation is to match the cost of a productive asset, that has a useful life of more than a year, to the revenues earned by using the asset. The asset’s cost is usually spread over the years in which the asset is used. Over the asset’s useful life, depreciation systematically moves the asset’s costs from the balance sheet to expenses on an income statement.
Depreciation is an allocation process in order to achieve the matching principle. It is not a technique for determining the fair market value of an asset.
What Are the Causes of Depreciation?
Depreciation allocates the cost of a tangible asset over its useful life and is used to account for declines in value is called depreciation. The causes of depreciation are:
Wear and Tear
Any asset gradually breaks down over a certain time while using it, as parts wear out and need to be replaced. Eventually, must be disposed of because it can no longer be repaired. This is most prevalent for production equipment, which usually has a manufacturer’s recommended lifespan that is based on a certain number of units produced. Other assets, such as buildings, can be repaired and upgraded for long periods of time.
Some assets have an extremely short lifespan. This condition is most applicable to inventory, rather than fixed assets.
A fixed asset such as software or a database might only usable to your business for a certain period of time. Its lifespan terminates when the usage rights expire. Depreciation must be completed by the end of the usage period.
Natural Resource Usage
With natural resources assets, such as an oil or gas reservoir, the depletion of the resource causes depreciation. In this case, it is called depletion, rather than depreciation. The pace of depletion changes when a company alters its estimate of reserves remaining.
When more efficient equipment becomes available, old equipment might become obsolete. This reduces the usability of the original equipment.