Depreciation expense is the gradual devaluation of fixed assets over their useful life, with methods including straight line, sum of years, declining balance, and units of production. Depreciation is a non-cash item and is divided into monthly expenses for consistent profit and loss statements. Different methods shift more depreciation to prior periods, with the simplest being straight line.
Depreciation expense is the percentage of the total value of a fixed asset that is determined to have been depleted during a specified accounting period. The purpose of depreciation expense is to gradually devalue items as they age and maintain wear and tear through regular use. Types of depreciation methods include straight line, sum of years, declining balance, and units of production.
When a company makes a major purchase, such as a vehicle or machine, the item is recorded as a fixed asset and an evaluation is made to determine the expected term of use of the asset. The item is depreciated over the years of its useful life to reflect the percentage of its value in each accounting period. Consumable items are considered expenses at the time of purchase. A piece of machinery with an expected useful life of five years, for example, will depreciate. Oil or gaskets used to maintain the machine are expensed immediately because they are used for only a short time and then replaced.
Depreciation expense is considered a non-cash item because it does not require a cash outlay in a given accounting period. The cash outlay occurs at the time the asset is purchased. To show a consistent profit and loss statement for monthly accounting periods, the annual depreciation expense is divided by twelve and posted as a monthly expense.
The simplest method of depreciation is on a straight line basis. The value of the asset less any expected salvage value is divided by the number of years in its expected useful life. For an asset with an expected life of five years, the depreciation expense will be 20% of the depreciable value each year.
The calculation for the method called digits of the years sum is based on fractional amounts. This depreciation method carries over more expenses to prior years than the straight-line method. For an asset with a useful life of five years, depreciation is divided into fractional amounts based on the sum of the numbers for each year (1 + 2 + 3 + 4 + 5 = 15). Recorded depreciation is 5/15 of the value in the first year, 4/15 in the second year, and so on.
The declining balance method shifts an even larger amount of depreciation to prior periods. It is usually calculated using twice the straight-line rate and is therefore called the double-declining-balance method. The formula for calculating double declining balance depreciation for a given year is to subtract the accumulated depreciation from the original value, then divide by the useful life in years and multiply by two. The salvage value is deducted in the last year.
Another method of depreciation is based on units of production. This depreciation formula subtracts the salvage value from the original value and then divides by the total expected production units and multiplies by the actual number of production units for the period. This method links recorded depreciation expense to actual production levels for the accounting period.
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