The accounting depreciation definition is the allocation of the cost of a tangible asset over its useful life. The idea is to match the cost of the asset to the revenues it helps to generate over its useful life.
Depreciation represents the declining value of a physical asset over time, due to usage, or obsolescence. Record it as an expense on the income statement. Also record it as a non-cash expense, added back to net income, on the cash flow statement. And it is accumulated in a separate contra-asset account on the balance sheet. Depreciation expenses reduce taxable income without reducing cash flows, so companies often want to incur as much depreciation as possible as soon as possible for the benefit of the tax savings. There are several methods of accounting depreciation (see below).
Two related accounting terms are amortization and depletion. Amortization refers to the depreciation of intangible assets, whereas depletion refers to the declining value or availability of natural resources.
To calculate the depreciation schedule for an asset, know the asset’s purchase price, salvage value, and useful life. The salvage value is the amount the asset is worth at the end of its useful life. And the depreciable base is the purchase price minus the salvage value. Depreciation continues until the asset value declines to its salvage value.
Use the following formulas to calculate depreciable base and the straight-line depreciation expense:
Depreciable Base = Purchase Price – Salvage Value
Straight-Line Depreciation Expense = Depreciable Base / Useful Life
For example, if an asset was purchased for $100, then its salvage value is $0, and its useful life is 10 years, then, the annual depreciation expense for the asset would be $10 using the straight-line method of depreciation. After 10 years, the asset will have depreciated to its salvage value $0. Thus, depreciation for the asset will no longer occur.
The depreciation rate is the rate at which an asset is depreciated each period. If you want to calculate the depreciation rate, then divide the depreciation expense by the depreciable base. Then to find the depreciation expense using the deprecation rate, multiply the depreciable base by the depreciation rate.
Depreciation Rate = Depreciation Expense / Depreciable Base
Depreciation Expense = Depreciation Rate x Depreciable Base
In the above example, the straight line depreciation rate would be 10% (10% = 10/100).
Modified accelerated cost recovery system (MACRS) method of depreciation is required by the IRS but is not approved by GAAP. Other GAAP approved methods of depreciation for external reporting purposes include the following:
If you want to increase the value of your organization, then click here to download the Know Your Economics Worksheet.
[box]Strategic CFO Lab Member Extra
Access your Strategic Pricing Model Execution Plan in SCFO Lab. The step-by-step plan to set your prices to maximize profits.
Click here to access your Execution Plan. Not a Lab Member?