Basic Principle of Depreciation
One of the tenets of accounting is to FAIRLY present the financial information related to business operations. If a business takes as an expense a significant one time value such as the purchase of a fixed asset it would greatly distort the actual profit during that particular accounting period. In addition, the particular asset is utilized over more than one year. So future periods of profits will be overstated because there is no allocation of utility value for that asset to those periods. In effect, the business will have an instant loss equal to the value paid for the fixed asset and greater profits in the future. To resolve this, accounting uses depreciation to level this cost over the expected utility period (lifetime) of the asset. To illustrate this principle, let’s assume the profit before depreciation is $12,000 per month. In January the company purchases a $60,000 piece of equipment good for 60 months of use. The following schedule illustrates the profit and loss for January, the remaining 11 months of year one and the profit for years two through five (all 60 months) without depreciation and then with depreciation. Notice the total profit in the aggregate is exactly the same five years later.
. Year 1
. Jan Feb – Dec Year 2 Year 3 Year 4 Year 5 Total
W/O Depreciation ($48,000) $132,000 $144,000 $144,000 $144,000 $144,000 $660,000
With Depreciation $11,000 $121,000 $132,000 $132,000 $132,000 $132,000 $660,000
January of Year 1 is simply $12,000 of profit (one month’s worth) less a charge of $60,000 for the purchase of the asset for a loss of $48,000. February through December has $12,000 per month of profit for a total of $132,000.
Notice without depreciation that the entire capital outlay of $60,000 is deducted from the $12,000 profit in January and then no deductions for equal amounts in the following 59 months. Whereas with depreciation, the profit is leveled over the expected life of the asset (60 months or 5 years). The total profit in the aggregate is the same under both methods. With the traditional expensing at time of purchase a reader would interpret the information incorrectly for January of Year 1 and would be influenced differently for the remaining 59 months.
Depreciation levels the cost over the expected lifetime utilization of the asset. Depreciation more FAIRLY represents the associated actual cost per accounting period and therefore levels the profit of business operations.
In the example above I use a $60,000 asset that is expected to last 60 months. The result is equal amounts per month. This is known as straight line depreciation.
This is just one of many methods used to allocate the initial capital outlay over the life of the asset. There are other methods.
The most basic depreciation method is straight line. This is a simple mathematical application. Simply take the asset’s cost and divide it by the expected number of months of use. As an example, a truck is purchased for $28,000 and is expected to last seven years (84 months). $28,000 is then divided by 84 for the depreciation mount per month ($333 per month). This seems reasonable, but let’s explore what most likely unfolds with the physical ownership of the truck over seven years.
At first, it is new and everybody wants to drive it or be assigned the truck. Within a few years it has its share of dings and fender benders. The inside has a few broken items and it isn’t really clean. There is less desire to drive this truck over the newer models. It is driven less. By the seventh year it breaks down frequently, nobody wants to drive it and it looks like a junk heap. Yet the depreciation amount in the last month is exactly the same as the first month under straight line depreciation convention. To adjust for this utility rate, accountants advocate one of several accelerated methods.
This method shifts more depreciation in earlier years than in later years. So using the truck example above, the sum of the digits for seven years is equal to the
7+6+5+4+3+2+1 = 28
Effective amounts per year are greater in year one as the strongest rate of 7 with the numerator is used against 28 for the denominator. The schedule is as follows:
Year Fraction Basis Yearly Amount Monthly
. 1 7/28ths $28,000 $7,000 $583
. 2 6/28ths $28,000 $6,000 $500
. 3 5/28ths $28,000 $5,000 $417
. 4 4/28ths $28,000 $4,000 $333
. 5 3/28ths $28,000 $3,000 $250
. 6 2/28ths $28,000 $2,000 $166
. 7 1/28ths $28,000 $1,000 $83
Notice that in years one through three the depreciation amount per month is greater than straight line. In year four, it is the same and in years five through seven it is less than straight line. Does this schedule appear more in line with the utility of the truck? It does, therefore sum-of-the-year’s-digits is a more appropriate depreciation method. There many other forms of accelerated depreciation and I’ll cover two of the more commonly used ones below.
Double Declining Balance
This method of depreciation shifts depreciation expense too much higher percentages during earlier years of use over later years. It is an ideal method for equipment excessively abused and exposed to harsh conditions. Good examples of this are marine craft, dump trucks, railroad equipment and logging/mining equipment.
The equation starts out with straight line depreciation. Then in the first year, double the depreciation amount. In the second year, start all over, except now the straight line formula has one less year in its calculation. The following is a schedule illustrating this method. The asset is a floating crane used in pile and inserting pier and dock poles. The cost is $135,000 and the asset is expected to last nine years.
Account Balance: $135,000
Remaining Life: 9 Years
Straight Line Value: $15,000 (1/9th of $135,000)
Double the Value: $30,000 – Depreciation Amount
Remaining Balance: $105,000 ($135,000 – $30,000)
Account Balance: $105,000
Remaining Life: 8 Years
Straight Line Value: $13,125 (1/8th of $105,000)
Double the Value: $26,250 – Depreciation Amount
Remaining Balance: $78,750
Account Balance: $78,750
Remaining Life: 7 Years
Straight Line Value: $11,250 (1/7th of $78,750)
Double the Value: $22,500 — Depreciation Amount
Remaining Balance: $56,250
Account Balance: $56,250
Remaining Life: 6 Years
Straight Line Value: $9,375 (1/6th of $56,250)
Double the Value: $18,750 – Depreciation Amount
Remaining Balance: $37,500 27.77% of the original cost
As this method illustrates, by the time the asset reaches the halfway point in its life only a quarter of the original cost value is available for depreciation. This method aggressively shifts depreciation to the very early years of an asset’s expected life. It is ideal for those assets that lose fair market value quickly due to abuse and weather.
Customarily the owner or the Certified Public Accountant recommends the appropriate method. Your job is to conduct the calculations and make the appropriate entries to the books of record.
Units of Production
This method is used with equipment that has a set production value. Many pieces of equipment come with engineered units of production capacity. For example, heavy construction equipment used in site development work or mining come with number of hours of expected life (use). For example a road grader may state in the specifications that this piece of equipment will last 11,000 hours before the first major overhaul. If in year one, the piece is operated 2,900 hours then 26.36% (2,900/11,000) of the cost is depreciated in that year. This pattern continues through the remaining life of asset.
Another variation of this is actual units utilized. For example, copiers have a range of output. Most mid-size office copiers will produce 300,000 copies before needing repairs. So if in year one the office makes 31,000 copies then 10.33% (31,00/300,000) of the purchase price is the depreciation value assigned.
The units of production method is a very effective and accurate depreciation tool in business. Many small business owners don’t use this method because it requires physical inspections to verify consumption. But by far it is one of the better depreciation methods.
For assistance with the various methods please reference the following articles:
- Depreciation – This is Weird Accounting
- Various Methods of Depreciation
- Accelerated Depreciation
- Section 179 Depreciation
Depreciation Entry Process
To appreciate how depreciation works you will first need to understand the account structure for both the balance sheet and income statement. Next I’ll explain the entry process along with a couple of examples. Finally I provide some insight to help you understand what you are reading when looking at the reports.
On the balance sheet the fixed assets section reports two distinct values. The first is of course the cost of the actual assets. This was explained in Lesson 49.
The second value is the depreciated value or referred to as the ‘Net Fixed Assets’. Basically it is the total cost of assets less the accumulated depreciation to date resulting in a net value. Some readers of this section falsely believe this net value is the fair market value of the assets. Ideally that is the goal, but in reality it only approximates fair market value as depreciation is merely an educated guess at the dollar value of utility (consumption). Here is an example of the presentation format for a plumber’s business.
. ABC PLUMBING INC.
. Limited Balance Sheet (Fixed Assets Only)
Office Technology 7,972
Assets at Cost 103,102
Accumulated Depreciation (44,605)
Net Fixed Assets $58,497
The accumulated depreciation account is a fixed assets type of account but is a contra account. It is reported with parenthesis as explained in Lesson 13.
The accumulated depreciation account is the offset in the entry process. Remember all assets customarily end in debit balances. Fixed assets at cost have debit balances. The accumulated depreciation account receives the credit side of the entry when generating the journal entry. The debit side goes to the income statement.
Surprisingly, there is no hard and set rule as to where depreciation expense is recorded on the income statement. Each industry uses different sections of the income statement to record depreciation. For example, in manufacturing depreciation is set up as one of accounts in cost of manufacturing (cost of sales section) to determine the gross profit. In real estate it is located in the costs of capital section of expenses to clarify cash income as illustrated in this condensed income statement of an apartment complex.
. BERKSHIRE GARDEN APARTMENTS
. Income Statement (Summary Format)
. Year Ending December 31, 2015
Net Rents $1,742,000
Other Income 197,400
Total Revenue $1,939,400
Facility Operations $793,200
Property Management 207,305
Insurance and Compliance 133,702
Operational Profit 698,875
. – Interest (Debt Service) 204,380
. – Depreciation 301,800
. – Amortization 37,900
. – Capital Expenditures 40,000
. – Subtotal Costs of Capital 584,080
The most common placement is as one of the last expense accounts in the chart of accounts to separate this cost from other expenses as it is commonly referred to as a non-cash expense, i.e. no check or payable is credited for the offsetting value as done with expenses.
Depreciation Entry Process
The actual entry process is straight forward. The value calculated for the particular asset’s depreciation is debited to depreciation expense and credited to accumulated depreciation on the balance sheet. As explained in Lesson 49, use the fixed assets journal to record the entry. Take note that there is not a separate accumulated depreciation account for each asset; there is simply one account for all the respective fixed assets.
As an example of the entry, go back to the illustration above for the truck under the sum-of-the-digits method of depreciation for the first year. Here is the entry:
Date ID Ledger Description DR CR
Today Schedule D-3 Depreciation 1st YR Deprc – Truck SYD Meth $7,000
. Schedule D-3 Accumulated Depr 1st YR Deprc – Truck SYD Meth $7,000
. $7,000 $7,000
In the description field identify the method, year of depreciation and the asset. Notice in the ‘ID’ field a schedule is referenced; this is elaborated on more in to the double declining balance method example. The fourth year entry looks like this:
Date ID Ledger Description DR CR
Today Schedule D-7 COS-Deprc Pile Driver, 16.66% 4th YR DDB $18,750
. Schedule D-7 Accum. Deprec. Pile Driver, 16.66% 4th YR DDB $18,750
. $18,750 $18,750
Again the schedule is identified and the description is detailed for future reference.
Insights to Depreciation
One of the more fascinating business thoughts expressed by owners is the desire to accelerate depreciation. In effect they want it higher. Why? Because they don’t to pay more income taxes. To understand this think of the income statement.
If expenses increase (depreciation is an expense), profit decreases and so does taxable income. But for investors and banks (that finance loans) they want higher profits to indicate strong performance.
To resolve this issue, accountants create a second set of books called ‘Tax Books’. The goal is to lower the profitability in order to reduce the corresponding tax
obligation. The Internal Revenue Code allows for accelerated depreciation in the filings for a business. I explain this more in the other articles on this site, specifically the income taxes section.
One last note about depreciation, this concerns land. In the mindset of both accountants and the Internal Revenue Service, land can not be used up or decrease in value over time. It has historically maintained its value. Therefore, land can not be depreciated. Furthermore land purchased for the purpose of mining or drilling has a separate system for determining the consumption of the natural resources (coal, ore, and other natural resources) located on the land. The process is called ‘Depletion’.
The book depreciation should match the best and most appropriate method given the nature of the industry, asset and its utility (usage). If depreciation is overstated, the profit is lower and this can mislead a reader of the financial reports. On the flip side, understated depreciation overstates profit and overstates the asset’s value on the balance sheet. Remember the goal is to FAIRLY present the value of the fixed assets. So use the most appropriate method to value each fixed asset of the business.
Summary – Depreciation
Depreciation is a process of allocating the cost of the fixed asset over time. Various methods are used to allocate value from one accounting period to the next. The goal is to FAIRLY present financial information related to the respective asset on both the balance sheet and the income statement.
There are several different methods of depreciation. They include:
- Straight Line – The most commonly used book method of depreciation.
- Sum-Of-The-Year’s-Digits – A method that shifts slightly more depreciation to the earlier years and less in the later years.
- Double Declining Balance – A very aggressive accelerated method for greater amounts in earlier years at the expense of later years. It is an appropriate method for excessively abused and weather exposed equipment.
- Units of Production – The most accurate and fair method.
To enter the information in the books of record use the fixed assets journal as the book of entry. Debits are entered into either cost of sales accounts or to expense accounts. The credit is assigned to a contra account (accumulated depreciation) in the fixed assets section of the balance sheet. Be sure to identify the particular schedules for the entry along with highly descriptive information in the description field. Act on Knowledge.
If you have any comments or questions, e-mail me at dave (insert the usual ‘at’ symbol) businessecon.org. I would love to hear from you. If interested in my services as an accountant/consultant; click on ‘My Services‘ in the footer of this article.