Accumulated depreciation is the summation of the depreciation expense taken on the assets over time. It is a contra-asset account and is displayed together with the asset on the balance sheet. The acquisition cost refers to the overall cost of purchasing an asset, which includes the purchase price, the shipping cost, sales taxes, installation fees, testing fees, and other acquisition costs.
- Most tax systems provide different rules for real property (buildings, etc.) and personal property (equipment, etc.).
- Under the composite method, no gain or loss is recognized on the sale of an asset.
- Other systems allow depreciation expense over some life using some depreciation method or percentage.
Under the straight‐line method, the first full year’s annual depreciation expense of $16,000 is multiplied by five‐twelfths to calculate depreciation expense for the truck’s first five months of use. $16,000 of depreciation expense is assigned to the truck in each of the next four years, and seven months of depreciation expense is assigned to the truck in the following year. The straight-line depreciation is calculated by dividing the difference between assets pagal sale cost and its expected salvage value by the number of years for its expected useful life. Cost generally is the amount paid for the asset, including all costs related to acquiring and bringing the asset into use. In some countries or for some purposes, salvage value may be ignored. The rules of some countries specify lives and methods to be used for particular types of assets. However, in most countries the life is based on business experience, and the method may be chosen from one of several acceptable methods.
Suppose the truck is purchased on July 26 and the company’s annual accounting period ends on December 31. The company must record five months of depreciation expense on December 31 (August‐December). Companies use separate accumulated depreciation accounts for buildings, equipment, and other types of depreciable assets. Companies with a large number of depreciable assets may even create subsidiary ledger accounts to track the individual assets and the accumulated depreciation on each asset. At the end of year five, the $80,000 shown as accumulated depreciation equals the asset’s depreciable cost, and the $10,000 net book value represents its estimated salvage value.
It’s important to note that the depreciated cost is not the same as the market value. The market value is the price of an asset, based on supply and demand in the market. Another way to describe this calculation is to say that the asset’s depreciable cost is multiplied by the straight‐line rate, which equals one divided by the number of years in the asset’s useful life. The composite method is applied to a collection of assets that are not similar and have different service lives. For example, computers and printers are not similar, but both are part of the office equipment.
For example, a depreciation expense of 100 per year for five years may be recognized for an asset costing 500. Depreciation has been defined as the diminution in the utility or value of an asset and is a non-cash expense. It does not result in any cash outflow; it just means that the asset is not worth as much as it used to be. For financial reporting purposes, companies often select a depreciation method that apportions an asset’s depreciable cost to expense in accordance with the matching principle. For income tax purposes, companies usually select a depreciation method that reduces or postpones taxable income and, therefore, tax payments.
- If the machine’s life expectancy is 20 years and its salvage value is $15,000, in the straight-line depreciation method, the depreciation expense is $4,750 [($110,000 – $15,000) / 20].
- These may be specified by law or accounting standards, which may vary by country.
- The more units produced by the equipment, the greater amount the equipment is depreciated, and the lower the depreciated cost is.
- If the truck’s salvage value were $20,000, then depreciation expense would have been limited to $12,400 during year three, and no depreciation expense would be recorded during year four or year five.
- For income tax purposes, companies usually select a depreciation method that reduces or postpones taxable income and, therefore, tax payments.
Similar to the declining-balance method, the sum-of-the-year’s method also accelerates the depreciation of an asset. The asset will lose more of its book value during the early periods of its lifespan. The double declining-balance depreciation is a commonly used type of declining-balance method. If the machine’s life expectancy is 20 years and its salvage value is $15,000, in the straight-line depreciation method, the depreciation expense is $4,750 [($110,000 – $15,000) / 20].
To record depreciation expense on the truck each year, the company debits depreciation expense–vehicles for $16,000 and credits accumulated depreciation–vehicles for $16,000. Depletion and amortization are similar concepts for natural resources (including oil) and intangible assets, respectively. Assets are subject to depreciation because the cost spent on asset purchase is not recognized in the same year it was incurred but postponed to future years.
Assume that the company purchased the truck at the beginning of an annual accounting period. The previous table shows how depreciation expense was calculated during the truck’s first three years of use. The truck’s net book value of $42,000 at the end of year three is reduced by the new, $14,000 estimate of salvage value to produce a revised depreciable cost of $28,000. The revised depreciable cost is divided by the four years now estimated to remain in the truck’s useful life, yielding annual depreciation expense of $7,000. The useful life of some assets, particularly vehicles and equipment, is frequently determined by usage. For example, a toy manufacturer may expect a certain machine to produce one million dolls, or an airline may expect an airplane to provide ten thousand hours of flight time.
Calculation of Depreciated Cost
Methods of computing depreciation, and the periods over which assets are depreciated, may vary between asset types within the same business and may vary for tax purposes. These may be specified by law or accounting standards, which may vary by country. There are several standard methods of computing depreciation expense, including fixed percentage, straight line, and declining balance methods.
Although the two terms look similar, depreciated cost and depreciation expense come with very different meanings and should not be confused with one another. The depreciation expense refers to the value depreciated during a certain period. The depreciated cost can be used as an asset valuation tool to determine the useful value of an asset at a specific point in time. It can be compared with the market value to examine whether there is an impairment to the asset.