Accounting for depreciation may seem mysterious to those outside the accounting field, but it does not have to be! Accounting for depreciation is an important practice because depreciation directly reduces net income and this means less money owed to the government for taxes. Depreciation is a legitimate deduction, but many businesses fail to declare it.
What is depreciation?
Depreciation is often confused with valuation. Accounting for depreciation is the process where fixed assets (also called long-term assets) are expensed over the life of the asset. Assets that are used quickly like office supplies are written off as an expense when purchased. A fixed asset may last for many years and this is where depreciation comes into the picture. Depreciation is spreading the cost of an asset over its useful life. One of the primary concepts in accounting is matching benefits to expenses. Things like paper and pens provide a benefit for just a short time and this is why they are written off immediately. A machine or vehicle may provide benefits for years and so the cost of the item is written off over a longer period. Understanding depreciation fully is critical to the process.
The first step in accounting for depreciation is calculating the amount of depreciation expense. There are many methods to calculate depreciation. One of the most common and simplest methods to calculate is straight line depreciation. This method declares an equal amount each and every year until the asset has been totally expensed. Other acceptable methods are accelerated methods and declare more depreciation during the earliest years of the assets life. Some of these methods are declining balance or double declining balance. The math to calculate these methods is more complex, but still reasonable.
Once the amount of depreciation has been declared, the accounting for depreciation can begin. Depreciation is an expense but a non-cash one. A debit is made to a Depreciation Expense account and a credit to Accumulated Depreciation. Since depreciation is a non-cash expense, the Accumulated Depreciation account is actually a contra-asset account. Confused? A contra-asset account belongs on the Balance Sheet and serves to reduce the book value of an item. For example, a truck is purchased for $20,000. If the first year's depreciation is $2000, then the asset when reported on the balance sheet will have a net book value of $18,000. The entry for the year would have been a debit to Depreciation Expense - Vehicle for $2000 and a credit to Accumulated Depreciation Expense - Vehicle for $2000. At the end of the year, the Depreciation Account is closed, but not the Accumulated Depreciation account. The next year if $2000 is declared for Depreciation, the Accumulated Depreciation account would now have a balance of $4000 and the truck would have a net book value on the Balance Sheet of $16,000. This process would continue until the truck has been fully depreciated to a book value of $0 (or the truck is sold or retired from service).
Tax vs Book Depreciation
One of the primary reasons for accounting for depreciation is to offset income for tax purposes. The government has specific rules for the amount of depreciation that businesses are able to declare on certain assets for tax purposes. This can mean that depending upon what method of depreciation is used by a business that it may have a deferred tax asset or deferred tax liability that is carried forward. This is a more advanced concept and beyond the scope of a basic overview.
Accounting for depreciation is a valuable tool for any business and is well worth learning. This tool can save money on taxes for many years. Any business that maintains fixed assets needs to have a proper accounting for depreciation in the form of depreciation schedules in place.