Depreciation involves allocating the historical cost of a long-term asset to expense over the useful life of the asset. Long-term or long-lived assets that are used in a business (except land) must be depreciated in order to match the asset's cost to the accounting periods when revenues are earned from using the asset. In other words, depreciation is not an attempt to value an asset. Rather, depreciation is an attempt to achieve the matching principle.
Since the depreciation reported in the financial statements is based on the useful life of an asset, there can be different depreciation amounts from one company to another using a similar asset. For example, a new machine might be useful for 10 years in a company that processes soft metals, but a similar machine might be useful for only 5 years in a company that processes hard metals. The result might be annual depreciation expense of $10,000 for 10 years for one company, while another company's financial statements will report $20,000 per year for 5 years. (The depreciation for tax purposes will likely be still another amount, since tax depreciation is based on income tax regulations.)
There are different methods for calculating depreciation expense. Generally, companies use straight line depreciation for its financial statements. The straight line method means the annual depreciation expense will be the same amount for each full year of use. Alternatively, some companies might use an accelerated method of depreciation such as double-declining balance or sum-of-the-years' digits. The accelerated methods mean more depreciation expense in the early years of an asset's life and less in the later years of an asset's life. Another method of calculating depreciation is the units of production or units of activity method. Under the units of activity method, more depreciation is recorded in the accounting periods when the asset's use is greater. In periods when the asset is used less, the amount of depreciation is smaller.
The accounting entry for recording depreciation for financial purposes is a debit to Depreciation Expense and a credit to Accumulated Depreciation. Accumulated Depreciation is a contra asset account that is reported in the balance sheet classification Property, Plant and Equipment.
Sample Depreciation Questions
1) Instead of the physical life of an asset, depreciation is based on the _________ life of the asset.
2) This is to natural resources as depreciation is to constructed assets used in a business.
3) When the cash proceeds from the sale of an asset used in the business is less than the asset's book value at the time of the sale, it results in a ________ being reported on the income statement.
4) The cost of an asset minus the asset's accumulated depreciation is the asset's ___________ value.
5) A change in an estimate will not change the amounts reported in _____________ years.
6) Changing the useful life of an asset will change the reported amounts of depreciation for the current year and the ___________ years.
7) An estimated value used in computing depreciation.
8) The cost of an asset minus the estimated salvage value is the asset's ________________ cost.
9) The sum-of-the-years' __________ is an accelerated depreciation method.
10) Another name for the estimated scrap or salvage value of an asset at the end of its useful life.