To illustrate what depreciation is and how it’s used in the accounting records and on the financial statements for your company, let’s look at this quick example:
You are the project manager in an IT company. Your company just won a bid for a new iOS software for a new game development project. To complete this project you need to purchase an expensive top-of-the-line Mac Pro computer with a 12-core CPU, two GPUs and several network accessories for $10,500. This purchase is planned to take place on July 1, 2014.
You estimate that the new computer will have a useful life of 4 years. At the end of its useful life, the company expects to sell the equipment for just $500 to any college in the local area.
You discussed with your company’s accountant and she wants the depreciation to be reported evenly over the 4-year life. She explained to you that depreciating assets for companies is different from the approach used for personal income taxes. The most common method, which she wants to use, is the straight-line method. Under this method, the depreciation for each full year is the same amount.
The depreciation expense for a full year when computed under the straight-line method is illustrated here:
- Cost of Asset = $10,500
- Expected salvage value = $500
- Depreciable cost (this is the amount to be depreciated for every full year over the estimated useful life) = $10,500 – $500 = $10,000
- Years of Useful Life = 4
- Depreciation expense per year = $10,000 / 4 = $2500
Assuming your company’s accounting year ends on December 31, the company will report the depreciation expense on the company’s income statement as shown in the following depreciation schedule:
- 2014: $2500 / 2 = $1250 (asset purchased on July 1, 2014 so used for half of the year only)
- 2015: $2500
- 2016: $2500
- 2017: $2500
- 2018: $1250
Actual Cash Flow
While the actual cash paid by the company for this equipment will occur as follows:
- 2014: $10,500
- 2015: $0
- 2016: $0
- 2017: $0
- 2018: $0
As you can see, your company paid $10,500 in 2014, but the 2014 income statement reports Depreciation Expense of only $1,250 (since the asset was acquired on July 1, 2014, only half of the annual depreciation expense amount of $2500 is recorded in 2014)
In each of the years 2015 through 2017 the company’s income statements will report $2,500 of Depreciation Expense for that Mac Pro, thereby reducing $2,500 of Depreciation Expense from the company’s revenues earned in each of those years. The remaining amount of $1250 is depreciated in 2018.
The company will not pay out any cash for this expense from 2015 to 2018.
The company’s net income before income taxes will be reduced in each of the years 2015 through 2018 by $2,500 or $1250. This explains why Depreciation Expense is sometimes referred to as a noncash expense.
How is This Calculated?
The straight line method assumes a specific life expectancy for any asset that is being amortized. It also assumes a salvage value at the end of that period. Using these two figures and the acquisition cost of the asset, the entry can be made.
If a computer costs $2,000, is expected to last for 3 years and can be sold for $200 at the end of that period, the calculation for amortization will be as follows:
(Cost of Asset at Acquisition – AssumedRecovery at Salvage) ÷ Assumed Life Period of Asset in years = Depreciation or Amortization Charges per Annum
For our example above, the amortization will be:
($2,000 – $200) ÷ 3 = $1,800 ÷ 3 = $600
Therefore, $600 worth of asset value is recorded in the books for each of the 3 years from the year of acquisition.
If another fixed asset costs you $5,000 to buy and you can sell it after its useful life of 2 years at $3,000, the formula would look like this:
($5,000 – $3,000) ÷ 2 = $2,000 ÷ 2 = $1,000
Theory and Assumptions
Generally Accepted Accounting Principles, or GAAP, is the reason any kind of depreciation method is used. Specifically, it is the Matching Principle that requires this; according to this principle, expenses incurred should be recorded in the same year (or accounting period) as the revenues they generate are recorded. Therefore, if your company buys a truck for delivery purposes, the cost of that truck will be calculated as above and the final figure will be the actual cost of that asset for each year that the truck is expected to be in service.
Accounting rules exist for assuming the useable life of any fixed asset and this is the guideline that must be followed at all times. However, depending on actual usage, that assumption may vary. For example, if the allowable useable life of a truck is 10 years, but you find that your company typically upgrades trucks in 7 years, then the latter is the figure that should be used to calculate depreciation. The shorter the period, the higher will be the depreciation value. For a truck worth $20,000 that will be used for 7 years and then sold for $5,000, the depreciation amount per year is $2,142.85; at 10 years, that figure will drop to $1,500.
Similarly, there are accepted practices to calculate the salvage value of an asset at the end of its useful life, and this must be in line with the set guidance for that asset type.
The difference between the value of an asset at the beginning of the year and its value at the end of the year (minus the depreciation amount) is known as the book value of that asset. At any point in time, the book value of the asset will be the original purchase price less the accumulated depreciation.