what is depreciation 
depreciation is an accounting practice used to spread the cost of a tangible or physical asset over its useful life depreciation represents how much of the asset s value has been used up in any given time period companies depreciate assets for both tax and accounting purposes and have several different methods to choose from investopedia jessica olahdepreciation overviewassets like machinery and equipment are expensive instead of realizing the entire cost of an asset in year one companies can use depreciation to spread out the cost and match depreciation expenses to related revenues in the same reporting period this allows the company to write off an asset s value over a period of time notably its useful life companies take depreciation regularly so they can move their assets costs from their balance sheets to their income statements when a company buys an asset it records the transaction as a debit to increase an asset account on the balance sheet and a credit to reduce cash or increase accounts payable which is also on the balance sheet neither journal entry affects the income statement where revenues and expenses are reported 1at the end of an accounting period an accountant books depreciation for all capitalized assets that are not yet fully depreciated the journal entry consists of a depreciation and taxesas noted above businesses use depreciation for both tax and accounting purposes under u s tax law they can take a deduction for the cost of the asset reducing their taxable income but the internal revenue servicc irs states that when depreciating assets companies must generally spread the cost out over time in some instances they can take it all in the first year under section 179 of the tax code 2 the irs also has requirements for the types of assets that qualify 3buildings and structures can be depreciated but land is not eligible for depreciation depreciation in accountingin accounting terms depreciation is considered a non cash charge because it doesn t represent an actual cash outflow the entire cash outlay might be paid initially when an asset is purchased but the expense is recorded incrementally for financial reporting purposes that s because assets provide a benefit to the company over an extended period of time but the depreciation charges still reduce a company s earnings which is helpful for tax purposes 4the matching principle under generally accepted accounting principles gaap is an accrual accounting concept that dictates that expenses must be matched to the same period in which the related revenue is generated depreciation helps to tie the cost of an asset with the benefit of its use over time in other words the incremental expense associated with using up the asset is also recorded for the asset that is put to use each year and generates revenue the total amount depreciated each year which is represented as a percentage is called the depreciation rate for example if a company had 100 000 in total depreciation over the asset s expected life and the annual depreciation was 15 000 the rate would be 15 per year different companies may set their own threshold amounts to determine when to depreciate a fixed asset or property plant and equipment pp e and when to simply expense it in its first year of service for example a small company might set a 500 threshold over which it will depreciate an asset on the other hand a larger company might set a 10 000 threshold under which all purchases are expensed immediately accumulated depreciation is a contra asset account meaning its natural balance is a credit that reduces its overall asset value accumulated depreciation on any given asset is its cumulative depreciation up to a single point in its life carrying value is the net of the asset account and the accumulated depreciation while salvage value is the carrying value that remains on the balance sheet after which all depreciation is accounted for until the asset is disposed of or sold salvage value is based on what a company expects to receive in exchange for the asset at the end of its useful life the irs publishes depreciation schedules indicating the number of years over which assets can be depreciated for tax purposes depending on the type of asset 4types of depreciation with calculation examplesthere are a number of methods that accountants can use to depreciate capital assets they include straight line declining balance double declining balance sum of the years digits and unit of production we ve highlighted some of the basic principles of each method below along with examples to show how they re calculated the straight line method is the most basic way to record depreciation it reports an equal depreciation expense each year throughout the entire useful life of the asset until the asset is depreciated down to its salvage value image by theresa chiechi the balance 2019let s assume that a company buys a machine at a cost of 5 000 the company decides that the machine has a useful life of five years and a salvage value of 1 000 based on these assumptions the depreciable amount is 4 000 5 000 cost 1 000 salvage value the annual depreciation using the straight line method is calculated by dividing the depreciable amount by the total number of years in this case it comes to 800 per year 4 000 5 years this results in an annual depreciation rate of 20 800 4 000 the declining balance method is an accelerated depreciation method that begins with the asset s book rather than salvage value because an asset s carrying value is higher in earlier years before it has begun to be depreciated the same percentage causes a larger depreciation expense amount in earlier years then declines each year thereafter this is the formula using the straight line example above the machine costs 5 000 and has a useful life of five years in year one depreciation would be 1 000 5 000 x 1 5 1 000 in year two it would be 5 000 1 000 x 1 5 or 800 in year three 5 000 1 000 800 x 1 5 or 640 and so forth the double declining balance ddb method is an even more accelerated depreciation method it doubles the 1 useful life multiplier making it essentially twice as fast as the declining balance method continuing to use our example of a 5 000 machine depreciation in year one would be 5 000 x 2 5 or 2 000 in year two it would be 5 000 2 000 x 2 5 or 1 200 and so on note that while salvage value is not used in declining balance calculations once an asset has been depreciated down to its salvage value it cannot be further depreciated the sum of the years digits syd method also allows for accelerated depreciation you start by combining all the digits of the expected life of the asset for example an asset with a five year life would have a base of the sum of the digits one through five or 1 2 3 4 5 15 in the first year 5 15 of the depreciable base would be depreciated in the second year 4 15 of the depreciable base would be depreciated this continues until year five when the remaining 1 15 of the base is depreciated the depreciable base in all of these cases is the purchase price minus the salvage value or 4 000 in the example we ve been using for example year one depreciation would be 1 333 4 000 x 5 15 1 333 in year two it would be 1 067 4 000 x 4 15 1 067 this method which is often used in manufacturing requires an estimate of the total units an asset will produce over its useful life depreciation expense is then calculated per year based on the number of units produced that year this method also calculates depreciation expenses using the depreciable base purchase price minus salvage value 