Depreciation: Spreading the Cost of Long-Lived Assets
When a business buys equipment, a vehicle, or a building, it would distort the income statement to expense the full cost in the year of purchase. Instead, depreciation systematically allocates the asset’s cost over its useful life — matching the expense to the periods the asset generates revenue.
Key Terms
- Cost — The original purchase price plus any costs to bring the asset into use (installation, delivery).
- Useful Life — Estimated period the asset will generate economic benefits (3 years for a laptop; 30 years for a building).
- Residual (Salvage) Value — Estimated amount recoverable at end of useful life.
- Depreciable Amount = Cost − Residual Value.
- Carrying (Book) Value = Cost − Accumulated Depreciation.
Depreciation Methods
1. Straight-Line Method (SLM)
Equal depreciation charge every year. Simple and widely used.
Annual Depreciation = (Cost − Residual Value) ÷ Useful Life
Machine cost: $500,000 | Residual value: $50,000 | Life: 5 years
Annual depreciation = ($500,000 − $50,000) ÷ 5 = $90,000/year
2. Declining Balance / Written Down Value (WDV) Method
Applies a fixed percentage to the carrying value each year. Produces higher depreciation in early years and lower in later years — mirrors how many assets actually lose value (vehicles, computers).
Machine cost: $500,000 | Rate: 40% (WDV)
Year 1: $500,000 × 40% = $200,000. Closing book value: $300,000.
Year 2: $300,000 × 40% = $120,000. Closing book value: $180,000.
3. Units of Production Method
Depreciation is based on actual usage rather than time. Ideal for machinery where wear-and-tear depends on output.
Per-Unit Depreciation = Depreciable Amount ÷ Total Expected Units
Journal Entry for Depreciation
Dr. Depreciation Expense $90,000
Cr. Accumulated Depreciation $90,000
Accumulated Depreciation is a contra-asset — it offsets the asset’s cost on the balance sheet.
Disposal of an Asset
When an asset is sold or scrapped, remove both the cost and accumulated depreciation from the books and record any gain or loss on disposal.
Machine (cost $500,000 accumulated depreciation $400,000) sold for $120,000:
Dr. Cash $120,000
Dr. Accumulated Depreciation $400,000
Cr. Machine (Asset) $500,000
Cr. Gain on Disposal $20,000
Lesson Summary
- Depreciation matches long-lived asset costs to the periods they benefit (matching principle).
- Three main methods: straight-line (equal charges), declining balance (front-loaded), units of production (usage-based).
- Accumulated depreciation reduces the asset’s carrying value on the balance sheet.
Three Depreciation Methods Compared
All three methods allocate the same total depreciable cost ($45,000 = $50,000 − $5,000 salvage) over the asset’s life. They just do it differently each year.
| Year | Straight-Line | DDB | Units of Production (2,000/9,000 hrs) |
|---|---|---|---|
| 1 | $9,000 | $20,000 | $10,000 |
| 2 | $9,000 | $12,000 | $9,000 (est.) |
| 3 | $9,000 | $7,200 | varies |
| 4 | $9,000 | $4,320 | varies |
| 5 | $9,000 | $1,480* | varies |
| Total | $45,000 | $45,000 | $45,000 |
*DDB switches to SL in final year(s) to avoid going below salvage value.
Depreciation Impact on Financial Statements
| Statement | Effect of Depreciation |
|---|---|
| Income Statement | Increases Depreciation Expense → reduces net income |
| Balance Sheet | Increases Accumulated Depreciation → reduces Book Value of asset |
| Cash Flow Statement | Added back to net income (non-cash item) in operating activities |
| Tax Return | Higher depreciation expense → lower taxable income → lower taxes now |
Disposal of Depreciable Assets
Example: A truck cost $80,000, has $60,000 accumulated depreciation (book value $20,000), and is sold for $25,000.
| Account | Debit | Credit |
|---|---|---|
| Cash | $25,000 | |
| Accumulated Depreciation | $60,000 | |
| Truck (Asset) | $80,000 | |
| Gain on Disposal | $5,000 |
The $5,000 gain appears on the income statement as other income.
For tax returns, US businesses typically use MACRS (Modified Accelerated Cost Recovery System), which front-loads depreciation for faster tax deductions. This creates a temporary difference between GAAP book income and taxable income — tracked as Deferred Tax Liability on the balance sheet.
Depreciation Practice Worksheet — Download, print, and complete to reinforce this lesson.