Definition of depreciation in accounting
Depreciation is a common accounting term. Using this practice, you spread the cost of the physical or tangible item you have purchased for a business over the duration of its effective life or its life expectancy. By using this method of accounting, businesses can expense a part of the value of the asset each year over its useful life. Companies do this not just for accounting purposes, but also to reduce their taxable income each year the item is depreciated.
Why this method is useful
Depreciating assets enables a company to spread out the costs of an item over its life of the asset. Some assets, such as machinery and other equipment businesses use are expensive.
Realising the costs of assets in the same year when they have been purchased is not always best from an accounting perspective. By spreading the value of equipment over a few years, businesses can generate revenue from it and deduct part of the value each year.
Businesses begin to depreciate a fixed asset when the expense of an asset such as a plant and equipment, machinery, or a property crosses a certain amount threshold. For example, small and medium-sized businesses may set $500 as the threshold, while large businesses may set a $10,000 threshold when they will start to depreciate an asset. This will also depend on tax regulations regarding the minimum amount of an asset before depreciation applies.
The practice is helpful when it comes to linking the cost to acquire an asset to the benefits that come from it over a period. In a nutshell, what this implies is that the company is using the equipment every year to generate revenue. Companies also record the incremental expenses that are associated with the asset. The depreciation rate is the percentage that represents the total amount from the asset each year.
For example, if the total depreciation amount or cost of depreciable assets of a company is $100,000 during its effective life. And, if the annual or accumulated depreciation amount is $10,000, then the depreciation rate is 10% each year.
Instant asset write-off
In Australia, business with less than $500 million in annual turnover can write off the full amount of an asset. This means that the full cost of the item can be deducted in the year it was purchased, so depreciation doesn’t apply if a business chooses to write off the full cost in one year. Find out more in How to Unlock the Full Benefit of the Instant Asset Write-Off.
How to record depreciation
Companies record the amount spent on purchasing an asset under the asset account section on the balance sheet. It later appears as a credit on the balance sheet. Doing this helps to reduce cash as well as increase accounts payable.
It won’t affect the income statement no matter which side of the journal it appears on. Regularly checking on depreciation helps a company to move the cost of an asset to the income statement from their balance sheet.
At the end of the accounting period, an accountant will calculate depreciation on all the capitalised assets that they haven’t depreciated yet. In the accounting journal, this is done by debiting depreciation expense, which flows into the income statement. After this, the accountant posts a credit to the accumulated depreciation section that appears on a balance sheet.
Questions to ask before depreciating an asset
If you’re planning to depreciate an asset, these are some questions that you should first ask and check with your accountant:
- Is the item you are planning to depreciate covered under the ATO’s uniform capital allowance (UCA)?
- Are you still holding the depreciating asset?
- Can you claim deductions for the depreciating asset for the decline in its value?
- When does an item start to depreciate or decline in value?
- What’s the useful life of the particular asset?
- What are some methods you can use to calculate depreciation or decline in value?
Straight-line: Straight-line depreciation is one of the basic methods that accountants use to record or show depreciation. In the straight-line method, accountants report the expense equally every single year throughout its life.
For example, a business invested in equipment that costs $10,000. Let’s assume the salvage value of the asset is around $2,000 after its lifetime, which is five years. Based on these assumptions, the depreciable amount is approximately $8,000 (After deducting salvage value $2000 from $10,000, which is the actual cost of the asset).
We use this formula: Depreciable amount ÷ Number of useful years, which is $8000/5 years. The depreciation amount will be $1,600 per year and the depreciation rate will be 20% ($1,600 ÷ $8,000). The depreciation rate is also useful in the declining balance as well as the double-declining balance methods as well.
Salvage value is simply the book value of an item or an asset after depreciation. It’s a crucial component to consider when calculating depreciation schedules.
Declining Balance: The other name for declining balance is accelerated depreciation. With this method, you depreciate the value of an asset by calculating the total amount of the asset with the straight-line depreciation percentage during each year of its total lifecycle. The assets value is a lot higher initially than in the later years.
For example, using the case above, if a company invested in equipment that costs $10,000, the salvage value of the item after its five-year lifecycle is $2,000, and the depreciation rate is 20%. In the declining balance method, the first year, the expense is going to be reported as $1,600 ($8,000 x 20%); in the second year it is operating, they are going to record it as $1,280 (($8,000 − $1,600) x 20%), and so on for each year.
Here are a few other methods that most of the accountants follow to calculate an asset’s depreciation:
- Double Declining Balance (DDB)
- Sum-Of-the-Year’s-Digits (SYD)
- Units of Production
Note: See the ATO’s Guide to Depreciating Assets. It contains information on how many years a company can depreciate specific equipment and provides general rules for companies to follow when depreciating assets.