Depreciation is an accounting method, by which firms account for the cost of certain assets, over time instead of immediately at purchase. For these assets, owners charge a depreciation expense against income, each year of the asset's depreciable life.
Charging this expense impacts both the Income statement and the Balance sheet.
- Depreciation expense adds to Accumulated depreciation on the Balance sheet. This, in turn, lowers the book value of the firm's assets.
- Depreciation expense—like other expenses—lowers bottom line reported income (profit) on the Income statement. And, this lowers the firm's income tax liability.
What is the Purpose of Depreciation?
Depreciation expense helps realize a basic principle in accrual accounting: Firms report expenses in the period they are incur them. And, this enables asset owners to implement another universally recognized accounting principle—the matching concept. Matching means that firms report revenue earnings along with the expenses that bring them, in the same period.
Companies in fact incur many kinds of expenses in the course of operating and doing business. And, all expenses ultimately "go to the bottom line," that is, all expenses lower profits. However, they do not handle the purchase of an expensive, long-lasting capital asset as an expense for a single period—even if the firm buys it with a single cash expenditure.
Instead, these assets incur expenses over time, as they lose their value to the firm. Under accrual accounting, that is, assets incur expenses as they are worn out, used up, or depleted. As a result, owners come closer to reporting expenses as they incur them by charging depreciation expense, each year, across the asset's depreciable life. This means also that owners receives the tax benefits of paying for the asset over those years instead of all at once.
Explaining Depreciation In Context
Sections below further define, explain, and illustrate depreciation. Note especially that the term appears in context with related terms and concepts from the fields of accounting, finance, and asset management. Important context terms include the following:
- What is depreciation expense?
- How does depreciation lower income and tax liability?
- Which assets depreciate?
- Is there a difference between cash flow and depreciation expense?
- What are the major factors in determining depreciation expense?
- Defining time-basis depreciation schedules.
- Schedules not based on time.
- Depreciation expense: Spreadsheet implementation.
Each year in the life of a depreciable asset, owners charge part of its original cost against income on the Income statement. The yearly charge is depreciation expense—a method by which tax authorities allow owners to account for the cost of expensive assets over time, as the asset loses value. The annual charge depends on several factors, including a depreciation schedule for the asset (see Schedules, below).
From the owner's point of view, depreciation expense serves two purposes. Firstly, in the interest of accounting accuracy, depreciation lets owners charge expenses for the asset as the expenses are incurred. Secondly, depreciation expense allows owners to realize tax savings across the asset's life instead of all at once.
Example: Tax Savings From Depreciation Expense
On the Exhibit 1 Income statement, below, Grande Corporation reports income before extraordinary items of $2,737,000. With a 35% tax rate, the firm pays $957,950 in taxes on this income. Exhibit 1 rounds this figure up to $958 thousand.
Contributing to the firm's expenses, however, are three depreciation items totaling $659,000. Were these depreciation expenses not on the statement, the firm would report a before-tax operating income of $3,396,000 and an income tax of $1,188,600.
|Grande Corporation Figures in $1,000's
Income Statement for Year Ended 31 December 20YY
Gross sales revenues
Less returns & allowances
Net sales revenues
Cost of goods sold
Depreciation, mfr equipment
Other mfr overhead
Net mfr overhead
Net cost of goods sold
Depreciation, Store equip
Other selling expenses
Total selling expenses
General & Admin expenses
Other general & admin expenses
Total general & admin exp
Total operating expenses
Operating Income Before Taxes
|Financial revenue & Expenses
Revenue from investments
Less interest expense
Net financial gain (expense)
Income before tax & ext items
Less income tax on operations
Income before extraordinary items
Sale of land
Less initial cost
Net gain on sale of land
Less income tax on gain
Extraord items after tax
|Net Income (Profit)||2,126|
Exhibit 1. Sample Income Statement showing depreciation expense in three locations. Placement of an asset's depreciation expense depends on how the firm uses the asset. However, all depreciation expenses lower bottom line Net Income, which lowers the income tax liability.
Calculating Tax Savings From Depreciation
What is Grande's tax savings from depreciation? Using two income figures from above, the tax savings from depreciation are $230,000. That is:
$1,188,600 – $957,950 = $230,000.
In practice, owners can estimate tax savings from depreciation directly and more accurately , simply by multiplying the depreciation expense total by the marginal tax rate. With a 35% tax rate on income, for example:
Tax savings = 0.35 * $659,000
Notice also that an asset's depreciation expense can appear under any of the Income statement expense headings. Where the expense appears depends on how the firm uses the asset. Here, depreciation expenses appear under:
- Cost of goods sold, as Manufacturing overhead, for manufacturing equipment assets.
- Selling expenses for store equipment.
- General and administrative expenses for computers.
Generally, assets eligible for depreciation meet three criteria:
- Firstly, the asset has a useful life of one year or more.
- Secondly, the asset supports the business.
- Thirdly, the asset wears out, decays, becomes obsolete, or otherwise loses value over its useful life.
Tangible assets meeting these criteria may include, for instance, factory machines, vehicles, computer systems, office furniture, aircraft, and buildings. Land, however, is an example of an asset that does not meet the third criterion (losing value). Land assets, therefore, do not depreciate in the same way.
Limited Freedom to Choose Costs for Depreciation
Tax authorities sometimes permit owners to decide for themselves whether or not a given purchase qualifies as a capital expenditure, eligible for depreciation. That freedom of choice is limited, however.
So-called capital projects, for instance, result in capital assets such as buildings, computing systems, or production lines. After the project, the asset itself goes onto the Balance sheet with a value equal to historical cost—the actual cost of acquiring the asset. Note, however, that capital projects include many activities and purchases. And, some of these would not, on their own, qualify as capital expenditures. As part of a larger capital-creation project, however, their costs may qualify.
The creation of a capitalized IT system, for instance, might include systems integration or software development services. Firms normally report these costs as expenses for the period. As part of a capital project, however, owners can sometimes "bundle" these services into total asset cost. And, in that case, total asset cost depreciates across a series of years.
Asset Accounting Errors Can Have Serious Legal Consequences
Tax authorities, however, provide specific criteria designating which costs can add to asset cost in this way. The criteria, moreover, are legally binding. In 2005, for example, at Worldcom, Inc., a US-based firm, four senior executives were convicted of fraudulent reporting. Worldcom overstepped the boundaries by classifying certain services costs as assets, rather than as expenses, as they should have been. As a result, Worldcom's CEO, CFO, Controller, and Director of General accounting received lengthy prison sentences.
Tax Authorities Write the Rules
Not surprisingly, rules and methods for depreciating assets are provided by country tax authorities—not by GAAP or accounting standards bodies. For detailed guidance on what qualifies for depreciation, one must therefore consult government publications. For example, most of the following are available online and as PDF documents for download:
- Australia: Australian Taxation Office, "Guide to Depreciating Assets 2016"
- Canada: Canada Revenue Agency, "Classes of Depreciable Property."
- Ireland: Irish Tax and Customs, Search site by asset class for Depreciation Guidance.
- India :Income Tax India, Search site by asset class for Depreciation guidance.
- New Zealand: NZ Inland Revenue, "Depreciation - a guide for businesses IR260."
- United States: US Internal Revenue Service IRS publication 946, "How to Depreciate Property."
- United Kingdom: HM Revenue & Customs publications. Search site by asset class for Depreciation guidance.
When a firm buys a long-lasting asset outright, with cash, cash flows at once. Consequently, the full cash cost appears on the current period's cash flow statement under "Uses of Cash". On the Income statement, however, the total expense spans several years or more, across the asset's depreciable life. Note especially that these depreciation charges are non cash expenses.
"Non cash" means that the Income statement charge does not bring a corresponding cash flow anywhere in the accounting system. Business people sometimes ask, therefore: "Is depreciation legitimately called an expense? The answer is "Yes." This is because depreciation meets the accountant's formal definition:
"An expense is a decrease in owner’s equity caused by using up assets."
Cash purchases can be expenses because they use up cash assets. Depreciation charges are also expenses because they use up asset book value (through accumulated depreciation).
The depreciation expense for an asset each year normally depends on four factors:
- Asset depreciable life.
- The asset's initial cost.
- Asset residual value (salvage value).
- A depreciation schedule for the asset's depreciable life.
What is Depreciable Life? And, How Long is Life?
In the practice of asset lifecycle management, depreciable life is just one of four asset lifespans in view:
- Firstly, an asset's depreciable life is the number of years over which the asset fully depreciates. For most assets, tax authorities prescribe depreciable lives for different asset classes. In the US, for instance, computing hardware has a prescribed life of 5 years, and depreciation must follow the MACRS (Modified Accelerated Cost Recovery System) schedule.
- Secondly, an asset's economic life is the time period during which the asset earns more than it costs to maintain and use it. When an asset is beyond its economic life, it is cheaper to replace or scrap it, than to continue using it.
- Thirdly, an asset's service life is the number of years the asset is actually in use or in service.
- Fourthly, an asset's ownership life is the time period over which an asset brings financial impact of any kind. A fully depreciated, out of service asset, for instance, is still within its ownership life if (a) its residual value still contributes to the firm's asset base, or (b) it will bring further expenses, such as the cost of decommission or disposal.
Not surprisingly, all four lives can be different for a given asset. For reporting depreciation, only depreciable life is especially relevant. However, all four lives are important considerations in the broader scope of asset life cycle management.
How Do Depreciation Calculations Use Initial Cost, Depreciable Cost, and Residual Value?
Almost all assets enter the Balance sheet asset base with a value equaling actual cost. The book value of most assets, in other words, conforms with the historical cost convention in accounting.
In order to calculate depreciation expenses each year, accountants first divide original cost into two components:
Original Cost of Asset = Depreciable Cost + Residual Value
Depreciable cost is the maximum part of Original cost that can be depreciated. Residual value (or salvage value), in most cases, is what owners expect to receive for the asset after it is fully depreciated. In practice, accountants normally derive an asset's original depreciable cost from known residual value and original cost figures as:
Original Depreciable Cost = Original Cost – Residual Value
Example: Depreciable Cost Decreases Over Time
Exhibit 2 shows how available depreciable cost decreases over time, leaving only the residual value at the end of depreciable life. Note especially that only the depreciable cost component contributes to depreciation expense each year.
Most depreciation schedules apply to the depreciable cost rather than total cost. However, the double declining balance method (DDB) is an exception, as is MACRS, a special case of DDB (see Schedules, below, for more on these methods). Under DDB and MACRS, the expense percentages apply instead against total original cost.
When using any schedule besides DDB and MACRS, residual value plays an important role in determining several results:
- Yearly depreciation expenses.
- Tax savings.
- Cash inflow value at the end of depreciation (if any).
Note two further points on residual value:
- Normally, an asset may not depreciate below its residual (salvage) value.
- If, at the end of depreciable life, the firm realizes salvage value different from the stated value, the firm makes a tax adjustment.
Defining Time-Basis Depreciation Schedules
Depreciation schedules prescribe asset depreciable life length and also the amount of depreciation to charge each year. And, the country's tax laws specify which schedules apply for various asset classes. Note, however, that owners sometimes have a limited range of schedule choices.
Straight line depreciation (SL)is the simplest depreciation schedule. SL depreciation spreads expenses evenly across an asset’s depreciable life.
Consider, for instance, a $1,000 asset that depreciates over 5 years, and has no residual value. Depreciable cost is therefore $1,000. Under a 5-year Straight line schedule, owners claim 1/5 of the depreciable cost ($200) as depreciation expense each year.
Other time-base schedules are called accelerated schedules because they accelerate depreciation, compared to a straight line schedule. Accelerated schedules, therefore, charge relatively more in early years and relatively less in later years. As a result, acceleration enable owners to claim relatively more of an asset's related tax savings early in the asset's depreciable life. Accelerated schedules below include MACRS, DDB and SOYD methods.
Many US companies use the 1986 modification of the 1981Accelerated Cost Recovery System (ACRS) for certain asset classes. The current version is known as the Modified Accelerated Cost Recovery System, or MACRS. This schedule applies only in the United States.
MACRS provides different schedules for depreciation expense for several kinds of assets. Computing equipment falls into the "5-year class" of property, along with most other office equipment and automobiles. MACRS therefore calls for a 60 month depreciable life for computing systems. Depreciation is spread across 6 fiscal years because the 60 month period starts at the midpoint of year 1.
There are several variations and options on MACRS schedules but the primary use applies the double declining balance (DDB) method (see below), using a mid year-1 start. MACRS ignores residual value.
MACRS rules in fact provide two possible schedules for different asset classes: a General Schedule (GDS) which is most frequently used, and an Alternative Schedule (ADS) which may be used in some cases. A few of the GDS and ADS schedules include:
Office Furniture: GDS 7 Years, ADS 10 Years
Computers: GDS 5 Years, ADS 6 Years
Construction Assets: GDS 5 Years, ADS 6 Years
Railroad cars & Locomotives: GDS 7 Years, ADS 15 Years
For the full set of MACRS schedules and rules for various asset classes, see the US IRS Publication 946, "How to Depreciate Property."
The double declining balance schedule (DDB) is another popular time-base schedule. Under the DDB method, twice the straight line rate is applied each year to the remaining depreciable value of the asset.
The five-year SL rate, for instance, sets depreciation expense at 20% of the original depreciable cost. The DDB schedule, however, applies as follows:
- Year 1: The 5 Year DDB method sets year 1 depreciation at 40% of original depreciable cost.
- For year 2, therefore, depreciable cost is down to 60% of the original depreciable cost. DDB again prescribes 40% of this for depreciation. 40% of 60% is 24%. Year 2 DDB depreciation is thus 24 % of original cost.
- For year 3, only 36% of the original depreciable cost remains. This is because the Year 2 remaining depreciable cost (60%), less 24%. is 36%. Under DDB, the year 3 depreciation expense is 40% of 36%, that is, 14%
- And so on. The table in Exhibit 3 below shows that DDB year 4 expense is 8.64% of original depreciable cost, while year 5 depreciation is 5.18%.
It is easy to see from the line chart in Exhibit 4 that DDB is brings the most severe acceleration of the schedules appearing here.
The sum-of-the-years'-digits schedule (SOYD) is an accelerated method based on a scale of total digits for the years of depreciable life.
For five years of life, for example, the digits 1,2,3,4 and 5 add to produce 15. The first year’s rate becomes 5/15 of the depreciable cost (33.3%), the second year’s rate is 4/15 of that cost (26.7%), while the third year’s rate 3/15, and so on.
Composite depreciation is a method for depreciating a group of related assets as a whole rather than individually. This can reduce unnecessary record keeping and reporting. As a result, firms often use composite depreciation (or group depreciation) for their office furniture and office equipment.
See Composite Depreciation for more explanation and examples.
The Exhibit 3 table below compares depreciation percentages for each year for an asset having a 5-year life depreciable life. Figures in the table show percentage depreciated per year. Acceleration is easier to see in the line chart comparison in Exhibit 4, below.
|Schedule||Year 1||Year 2||Year 3||Year 4||Year 5||Year 6|
|Double Decl. Bal.||40.00||24.00||14.40||8.64||5.18||—|
|Sum of Years Digits||33.33||26.67||20.00||13.33||6.67||—|
Exhibit 3. Comparing 5-year versions of four depreciation schedules. Table values are the percentage of original depreciable cost to charge for depreciation expense.
Note that MACRS here refers to a 5-year depreciable life that is spread across 6 fiscal years, beginning at the midpoint of year 1.
All of the schedules above are time basis schedules because they treat "asset life" as a fixed period of time, charging a given percentage of depreciable cost each year as an expense. Note, however, that tax authorities sometimes allow so called usage-base depreciation instead.
A vehicle under this plan, for instance, might have its life defined not in years, but in terms of total miles or kilometers driving during its life. The depreciation expense each year would reflect the distance traveled that year as a percentage of the lifetime total. Similarly, other kinds of assets might have a scheduled life defined by a quantity that will be used up. In those cases, the depreciation percentage each year reflects the quantity used up.
Finding the depreciation expense for one asset, each year, is simply a matter of multiplying its depreciable cost by table-given percentage for that year. Calculating total expenses can be challenging—even with a spreadsheet—when the total involves multiple assets and schedules across several years or more.
Consider, for instance building a spreadsheet summary of total depreciation expenses for each of five years, with the following assets and schedules:
- Asset-A, 4 year life, SL schedule, acquired Year 1.
- Asset-B, 5 year life, MACRS schedule, acquired Year 2.
- Asset-C, 8 year life, DDB schedule, acquired Year 3.
- Asset-D,10 year life, SL schedule, acquired Year 4.
Calculating total depreciation expense becomes more complex each year:
Year 1 Total expense:
= (Asset-A deprec. cost ) * ( SL percentage for Year 1 of 4 )
Year 2 Total expense:
= (Asset-A deprec. cost ) * ( SL percentage for Year 2 of 4 ) +
(Asset-B deprec. cost ) * (MACRS percentage for Year 1 of 6 )
By Year 4, Total expense:
= ( Asset-A deprec. cost ) * ( SL percentage for Year 4 of 4 ) +
( Asset-B deprec. cost ) * ( MACRS percentage for Year 3 of 6 ) +
( Asset-C deprec. cost ) * ( DDB percentage for Year 2 of 8 ) +
( Asset-D deprec. cost ) * ( SL percentage for Year 1 of 10 )
The principles behind these calculations are simple. However, the bookkeeping task for the spreadsheet analyst can be tedious and cumbersome. It becomes especially so as the number of years, assets, and schedules increase.
You can review and try out working examples of these calculations across multiple years, in either