What is Depreciation?

what-is-depreciationDepreciation is the decline in value of the asset. Instead of deducting depreciation from the asset’s T-account, it is common practice to create an additional T-account (called contra T-account) where the depreciation is added to. Thus, every year the depreciation is credited to this T-account. Technically, a T-account with a credit balance can be included on the debit side of the balance sheet.

In that case, the sign flips. Thus, accumulated depreciation is subtracted from the cost, resulting in the ‘carrying value’, which is also called ‘net value’ or ‘book value’. (Presenting accumulated depreciation on the credit side would of course result in a balanced balance sheet. However, it would imply that accumulated depreciation is a liability, which it is not.)

Depreciation methods

During the economic lifetime the value of the asset is reduced (expensed). This expense is called depletion for natural resources, depreciation for other tangible long term assets, and amortization for intangible long term assets.

Although other methods exist, I consider the two most common depreciation methods: the straight line method and the declining balance method.

Straight Line Depreciation

As the name suggests, the straight line method results in a fixed amount for each period of the asset’s economic life time. The depreciable amount is the amount that needs to be expensed in total, which is the cost minus the residual value. The residual value is the amount that the firm expects to receive when the asset is disposed of at the end of the economic lifetime. Thus, the yearly depreciation expense is the depreciable amount divided by the economic lifetime.


Straight Line Depreciation Example

At the beginning of the year, the firm buys new equipment for 10,000 cash with an estimated residual value of 1,000 and an economic lifetime of 4 years. The firm uses the straight line method.

Recording the purchase:

T-account Debit Credit
Equipment 10,000
Cash 10,000

Alternative 1: recording depreciation expense without a contra T-account:

T-account Debit Credit
Depreciation expense 2,250
Equipment 2,250

Alternative 2: recording depreciation expense with a contra T-account:

T-account Debit Credit
Depreciation expense 2,250
Accumulated depreciation, equipment 2,250

The presentation on the balance sheet after 3 years is as follows:

Alternative 1 (without a contra T-account)
Equipment, net 3,250
Alternative 2 (with a contra T-account)
Equipment, cost 10,000
Accumulated depreciation, equipment -6,750
______
Equipment, net 3,250

Declining Balance Depreciation Method

An alternative method is the declining balance method. Where the straight line method is a percentage of the depreciable amount, with the declining balance method the depreciation expense is a percentage of the book value of the asset. As the book value declines over time, so does the depreciation expense. In the year that applying this rule would result in a book value below the residual value, the firm switches to straight line deprecation for the remaining year(s).


Declining Balance Depreciation Example

At the beginning of the year, the firm buys a new machine for 20,000 cash with an estimated residual value of 4,000 and an economic lifetime of 6 years. The firm uses the declining balance method using 40%.

The depreciation in year 1: 40% x 20,000 = 8,000
The depreciation in year 2: 40% x 12,000 = 4,800
The depreciation in year 3: 40% x 7,200 = 2,880
The depreciation in year 4: 40% x 4,320 = 1,728 106.66
The depreciation in year 5: 106.66
The depreciation in year 6: 106.67

In the fourth year the firm switches to straight line depreciation as an additional depreciation of 1,728 would result in a book value below the residual value of 4,000.


Double Declining Balance Depreciation Method

The double declining balance is a special case of the declining balance method, where the percentage used is 200% divided by the economic lifetime.

Double Declining Balance Depreciation Example

The firm has purchased equipment with an economic lifetime of 10 years. The percentage that would be used with the double declining balance method would be 20% (=200% / 10 years).


Depreciation Explained

Key points:

– the depreciable amount is the total depreciation over the economic lifetime and equals cost minus the residual value

– usually separate T-accounts are used to record historic cost and cumulative depreciation

– carrying value (book value, or ‘net’ value of assets) equals cost minus cumulative depreciation

– with the straight line method the yearly depreciation is constant: the depreciable amount divided by the number of years

– with the declining balance method the yearly depreciation equals a percentage of the book value

– the double declining balance method uses 200% divided by the economic lifetime as the percentage

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