Is Depreciation an Expense?

Is Depreciation an Expense? | Accounting Smarts
Charles Hall

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Charles Hall

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March 1, 2021

Depreciation is an operating expense found on the income statement but is uniquely different from other expenses because it is considered noncash.

Depreciation is an operating expense found on the income statement but is uniquely different from other expenses because it is considered noncash. This means no money was spent to incur the expense.

This idea of an expense without spending money isn’t completely accurate so keep reading to understand the complexities of depreciation.

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What is depreciation?

Depreciation is a component of almost every business. It is an operating expense. It is a debit on the income statement. And, it is tax deductible. If the IRS recognizes depreciation, then it must be a legitimate expense.

So, what really is depreciation or what makes depreciation and expense?

Depreciation is the periodic expensing of certain types of assets such as:

  • Vehicles
  • Buildings
  • Computers
  • Furniture
  • Office equipment
  • Machinery

Depreciable assets are called fixed assets. Each of these assets has value, is purchased with money, and is expensed over time as the asset is used or worn out. So, in this sense, depreciation is a cash outflow, but the expense on the income statement does not match the timing of the cash outflow.

The theory is, an asset loses value over time as it is used. Depreciation represents the estimated cost of that usage.

Why is depreciation an expense?

Depreciation is rightly categorized as an expense because it relates to the partial cost of an asset used during the year.

Depreciation is directly connected to an asset listed on the balance sheet. As depreciation expense of the asset is recognized the value of the asset is reduced through a contra account called accumulated depreciation.

Example:

Company XYZ purchased a new desktop computer for $900 on January 1, 20xx. The estimated life of the computer is 3 years. Since the computer is a depreciable asset the entry to record the purchase of the asset is as follows:

Office Equipment (Computers) $900

Cash $900

Since the computer has a 3-year life, it needs to be expensed over the 3 years. Each year the following entry would be made to recognize the expense:

Using a straight-line method of depreciation, the depreciation calculation per is $900 / 3 years = $300

Depreciation Expense $300

Accumulated Depreciation $300

Notice that the asset was not directly reduced, rather accumulated depreciation was increased by $300 for the depreciation expense that year. Since accumulated depreciation is a contra account it has a credit balance which offsets the corresponding asset account.

How do you calculate depreciation?

There are 3 methods of depreciation.

1. Straight-Line Depreciation

Is the simplest method and evenly spreads the depreciation over the life of the asset? Straight-line depreciation is calculated by taking the asset value divided by the asset life. This produces an equal amount to depreciate each year. Asset life is a set time frame based on the type of asset. Here are some examples.

  • Vehicles – 5-year life
  • Computers – 3-year life
  • Furnitures and Fixtures – 7-year life

A vehicle that cost $25,000 would be depreciated annually at $5,000 per year ($25,000 / 5)
A computer that cost $900 would be depreciated annually at $300 per year ($900 / 3)
A desk that cost $700 would be depreciated annually at $100 per year ($700 / 7)

Straight-line depreciation is the typical method used for accounting purposes or book purposes. The IRS allows other accelerated depreciation methods to reduce tax exposure and these will be discussed below.

2. Declining Balance Depreciation

Is an accelerated method of depreciation used when an asset is expected to have greater utility in the first few years. So, unlike the straight-line method that evenly expenses over time, the declining balance allows greater depreciation expense in the early years. Another method similar is the double-declining balance which is an even more accelerated method.

Declining balance depreciation is calculated by taking the net book value x the declining rate.

Assuming the same example above if a vehicle is purchased for $25,000 with a 5-year life and a declining rate of 30% depreciation for each year would be as follows:

Year 1: $25,000 * .3 = $7,500

Year 2: ($25,000 - $7,500 year 1) * .3 = $5,250

Year 3: ($25,000 - $12,750 year 1,2) * .3 = $3,675

And so on….

3. Sum of the Years’ Digits Depreciation

Is an accelerated method and depreciates more quickly than straight line, but is less than the declining balance method. Sum of the years digits takes the sum of the asset life and depreciates on a prorated basis. So, if a particular asset has a 3-year life, the sum of the years would be (3 + 2 + 1) = 6. Year 1 would then be depreciated at 3/6ths, year 2 would be depreciated at 2/6ths and year 3 would be depreciated at 1/6th. 

Can all assets be depreciated?

No, only assets that lose their value can be depreciated. Assets such as land, collectible art, coins or memorabilia typically increase in value therefore are not depreciated.

When do I start depreciating an asset?

Assets that have a life longer than 1 year should begin depreciation in the year acquired.

XYZ company purchased a computer in October for $900. The computer has a 3-year life and you depreciate using the straight-line method. Under this scenario you would record 3 months’ worth of depreciation in the current year since the asset was in operation for 3 months (Oct/Nov/Dec).

The calculation would be $900 / 3 years = $300 per year * 3/12 = $75 and the entry would look like this:

Depreciation Expense $75

Accumulated Depreciation $75

Many companies set fixed asset thresholds for depreciation. In other words, any asset under $500 is immediately expense rather than treated as an asset and depreciated.

How do I track depreciable assets?

Depreciation is a manual transaction required every month. Because of this most companies will create a fixed asset schedule to track and calculate depreciation expense. A typical fixed asset schedule will include the following items:

  • Asset description
  • Date acquired
  • Method of depreciation
  • Asset life
  • Asset cost
  • Asset depreciation per month by asset
  • Total depreciation per month all assets combined

This report should match the asset value listed on your balance sheet for each type of asset.

Charles Hall

Charles Hall

Charles has spent 25 plus years in the world of accounting and business. His experience includes working as a CPA/Auditor international accounting firms. He has worked as a controller and as a COO for small to medium sized companies.

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