Depreciation, meaning in accounting methods, is used by businesses to allocate the capital of tangible assets over the life. It represents the decrease in the value of an asset due to ups and downs.
Depreciation in accounting is calculated using various methods, such as straight-line depreciation, declining balance method, and units of production method, to distribute the asset’s cost evenly or according to its usage over time.
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What Is Depreciation Accounting?
Depreciation in accounting, refers to the systematic allocation of the cost of a tangible asset over its estimated useful life. When a company acquires a long-term asset the cost of the asset is not immediately recognized as an expense on the income statement. Instead, the cost is spread out over the asset’s useful life through depreciation.
Basically, Depreciation in accounting systematically records the decrease in the value of tangible assets over time, ensuring accurate financial reporting and tax compliance.
A trial Balance in accounting is a statement that lists the total debits and credits of all accounts to ensure that the accounting equation (assets = liabilities + equity) is in balance.
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Features of Depreciation Accounting
Below are the key features of the depreciation accounting:
- Allocation of Cost: Depreciation in accounting allocates the cost of tangible assets over their useful life.
- Financial Reporting: It provides accurate financial reporting by reflecting the true value of assets.
- Tax Compliance: Depreciation in accounting helps businesses comply with tax regulations and claim deductions appropriately.
- Different Methods: Various depreciation methods, like straight-line or declining balance, offer flexibility in calculating asset depreciation.
- Asset Management: It assists in tracking asset values and managing their useful life. It is also important to know the difference between cost accounting and management accounting
- Improved Decision-making: Businesses can make better financial decisions by accounting for asset depreciation. It is also essential to know the difference between cost accounting and financial accounting
- GAAP and IFRS Compliance: Depreciation meaning in accounting follows generally accepted accounting principles and international financial reporting standards.
Depreciation in Accounting Formula
The formula to calculate depreciation using the straight-line method is:
Depreciation Expense = (Initial Cost – Salvage Value) / Useful Life
Where:
- Initial Cost is the original cost of the asset.
- Salvage Value is the asset’s estimated value at the end of its useful life.
- Useful Life is the estimated number of years or units of production the asset will use.
Types of Depreciation in Accounting
Below are the major types of depreciation in accounting:
- Straight-Line Depreciation
- Declining Balance Depreciation
- Units of Production Depreciation
- Sum-of-the-Years’-Digits Depreciation
- Double Declining Balance Depreciation
Straight-Line Method (SLM)
Straight-Line Method (SLM) is one of the types of depreciation in accounting that allocates equal depreciation expense over the useful life of an asset, spreading the cost evenly.Declining Balance Method
The declining Balance Method is one of the types of depreciation in accounting that applies a fixed percentage to the asset’s decreasing book value each year, resulting in higher depreciation in the early years.Units of production depreciation
Units of Production Depreciation is one of the types of depreciation in accounting that depreciates assets based on their usage or output, linking depreciation to the asset’s production volume.Double declining depreciation
Double Declining is one of the types of depreciation in accounting Depreciation accelerates depreciation by applying a double percentage to the asset’s book value each year, resulting in higher early-year depreciation.Sum-of-Years Digits Method
Sum-of-the-Years Digits Method is one of the types of depreciation in accounting that allocates more depreciation in the early years and less in the later years of an asset’s life, using a sum of the digits of the asset’s useful life.
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Example of Depreciation Accounting
Example of depreciation in accounting using the Straight-Line Method:
Let’s consider a company purchasing a piece of machinery for $20,000 with an estimated salvage value of $2,000 at the end of its useful life of 5 years.
Using the straight-line method:
Depreciation Expense per year = (Initial Cost – Salvage Value) / Useful Life
Depreciation Expense per year = ($20,000 – $2,000) / 5 = $3,600
Year 1:
Book Value at the beginning = $20,000
Depreciation Expense = $3,600
Book Value at the end of Year 1 = $20,000 – $3,600 = $16,400
Year 2:
Book Value at the beginning = $16,400
Depreciation Expense = $3,600
Book Value at the end of Year 2 = $16,400 – $3,600 = $12,800
And so on, until the end of Year 5, the asset’s book value will be reduced to the salvage value of $2,000.
Difference Between Depreciation Expense and Accumulated Depreciation in Accounting
Below are the key differences between depreciation expenses and accumulated depreciation in accounting:
| Aspect | Depreciation Expense | Accumulated Depreciation | |
|---|---|---|---|
| Definition | depreciation, in accounting, is the portion of an asset’s cost allocated as an expense in a specific accounting period. | The cumulative total of all depreciation expenses recognized over the life of an asset. | |
| Nature of Account | Income Statement Account | Balance Sheet Account | |
| Purpose | depreciation meaning in accounting is to spread the cost of an asset over its useful life. | To show the total depreciation charged on an asset since its acquisition. | |
| Reporting Frequency | Reported in each accounting period (e.g., monthly, quarterly, annual). | Continuously updated and carried forward over time. | |
| Impact on Net Income | depreciation means, in accounting, reducing Net Income by increasing expenses. | Does not impact Net Income directly (since it’s on the Balance Sheet). | |
| Account Type | Expense Account (normal debit balance). | Contra-Asset Account (normal credit balance). | |
| Presentation on Financial Statements | Presented on the Income Statement as a separate line item. | Presented on the Balance Sheet as a deduction from the related asset’s cost. | |
| Reset to Zero | Resets to zero at the end of the asset’s useful life. | Continues to accumulate until the asset’s carrying amount is reduced to its salvage value. | |
| Impact on Taxation | depreciation, meaning in accounting, can be used as a tax deduction to lower taxable income. | Reduces the value of the asset for tax purposes. | |
Conclusion
Depreciation in accounting is a vital accounting concept used to allocate the cost of tangible assets over their useful life. Various depreciation in accounting methods provides businesses with flexibility in managing their assets’ financial impact. One can enroll in the Financial Analysis, Valuation, & Risk Management course to enhance your skills and expertise in these crucial financial disciplines.
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Updated on July 8, 2024