Concept of Depreciation

Accounting for Depreciation

Depreciation is an accounting concept used to keep track of the value of an asset over time. Over time, due to wear and tear, the value of assets goes down and businesses must determine the real value of assets for the best presentation of financial results. Therefore, every year, the value of assets must be written off of the "books." The amount to be written off is referred to as depreciation expense and the most popular method for calculating depreciation expense is the straight-line method.

Types of Systems

In accounting there are two types of systems: accrual and cash. Accrual accounting makes allowances for credit and certain other values that may not be real, such as depreciation. Cash accounting only records those transactions that occur as a result of an exchange of cash. Most businesses use some form of credit and have assets that must be written off over time due to tax considerations. Therefore, accountants use the concept of depreciation to give value to the wear and tear of assets over time.

Considerations

There are different line items that go along with all methods of calculating depreciation. The depreciation expense can be found on the income statement, whereas accumulated depreciation (the amount of depreciation to date) can be found on the balance sheet (or in the notes to the financial statements). Every year the book value of assets, as listed on the balance sheet, goes down by the amount of depreciation expensed on the income statement that year.

Straight-line Method

The most common method for calculating depreciation is the straight-line method. This method takes the cost of the asset and divides it by the useful life of the asset. For instance, if the cost of a truck is $50,000 and it has a useful life of 5 years then the company should depreciate $10,000 ($50,000/5) every year.

Variations

There are many different variations on depreciation. The most common variation is an accelerated approach, which essentially depreciates more of the assets value in the former years than in the latter years. This is ideal for certain cars that may appreciate faster in the beginning of their useful life.

Theories/Speculation

While depreciation is a commonly used concept in accounting, it can also be used to manipulate net income. That is, a higher depreciation expense will decrease net income while a lower depreciation will increase net income. The former is good for tax purposes, the latter is good for profitability. Due to this, companies must use the same depreciation methodology throughout the life of the asset.

References

• Investopedia: Appreciating Depreciation