Depreciation Expenses: Definition, Methods, and Examples

depreciation expense meaning

The straight-line depreciation method gradually reduces the carrying balance of the fixed asset over its useful life. Instead of recording an asset’s entire expense when it’s first bought, depreciation distributes the expense over multiple years. Depreciation quantifies the declining value of a business asset, based on its useful life, and balances out the revenue it’s helped to produce. Tax depreciation follows a system called MACRS, which stands for modified accelerated cost recovery system. MACRS is a form of accelerated depreciation, and the IRS publishes tables for each type of property.

  • Instead of recording an asset’s entire expense when it’s first bought, depreciation distributes the expense over multiple years.
  • Thus, the methods used in calculating depreciation are typically industry-specific.
  • But instead of doing it all in one tax year, you write off parts of it over time.
  • The main advantage of the units of production depreciation method is that it gives you a highly accurate picture of your depreciation cost based on actual numbers, depending on your tracking method.
  • It might not sound like a glamorous topic, and it’s often forgotten about until tax time, but depreciation is an integral part of how a business accounts for expenses and income.

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. Depreciation provides a way for businesses and individual investors to measure the decline in value of tangible fixed assets over their useful lives.

Double declining balance depreciation

To do so, the accountant picks a factor higher than one; the factor can be 1.5, 2, or more. When a long-term asset is purchased, it should be capitalized instead of being expensed in the accounting period it is purchased in. Assuming the asset will be economically useful and generate returns beyond that initial accounting period, expensing it immediately would overstate the expense in that period and understate it in all future periods.

Most companies use a single depreciation methodology for all of their assets. Thus, the methods used in calculating depreciation are typically industry-specific. The formula to calculate the annual depreciation expense under the straight-line method subtracts the salvage value from the total PP&E cost and divides the depreciable base by the useful life assumption.

Accounting for Depreciation Expense

To claim depreciation expense on your tax return, you need to file IRS Form 4562. Our guide to Form 4562 gives you everything you need to handle this process smoothly. You divide the asset’s remaining lifespan by the SYD, then multiply the number by the cost to get your write off for the year. That sounds complicated, but in practice it’s pretty simple, as you’ll see from the example below.

depreciation expense meaning

For example, the IRS might require that a piece of computer equipment be depreciated for five years, but if you know it will be useless in three years, you can depreciate the equipment over a shorter time. From our modeling tutorial, our hypothetical scenario shows depreciation expense meaning the method by which depreciation, PP&E, and Capex can be forecasted, and illustrates just how intertwined the three metrics ultimately are. The depreciation expense comes out to $60k per year, which will remain constant until the salvage value reaches zero.

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