Depreciation Expense

What Is Depreciation Expense?

The simple reduction in an asset's value throughout its useful life is known as depreciation expense. There are several reasons for this consistent decline in value, including deterioration, obsolescence, or just time.

Depreciation is considered a non-cash expense, meaning that depreciation expense does not involve any cash in-flows or out-flows. However, it is recorded in financial statements to allocate the cost of fixed assets over time accurately.

Accumulated depreciation is also considered a “contra asset,” meaning it offsets the recorded value of fixed assets (typically PP&E) on the balance sheet.

Understanding Depreciation Expense

On the income statement, depreciation expense is known as an operating expense, meaning that it is a cost incurred in the actual operations of the business. 

Depreciation will reduce net income on the income statement and oftentimes will be included within other line items like COGS (cost of goods sold) or SG&A (selling general and administrative).

On the balance sheet, depreciation oftentimes reduces the value of PP&E (property, plant, and equipment) and will likely appear as its own line item known as “accumulated depreciation,” and that amount will be subtracted from net income as decreasing the value of PP&E. 

While depreciation is a non-cash expense, it still significantly impacts the cash flow statement, specifically cash from operations and net income. When using the indirect method to calculate cash from operations, you start with net income, which depreciation directly impacts. 

In the cash flow statement, depreciation is added back under "operating activities" when using the indirect method to calculate cash flow from operations.

It is recorded on financial statements to adhere to the matching principle, ensuring expenses align with the revenues they help generate.

Since depreciation is regarded as a decrease in the cost of an asset over a specific time period, it can also be used as a tax write-off, lowering taxable income. This holds true for both accelerated depreciation and straight-line depreciation, as well as immediate expense write-offs.

Methods of Calculating Depreciation Expenses

There are a few methods through which organizations can calculate depreciation on their PP&E. Some of them include the Straight-line Method, Units of Production Method, and Accelerated Depreciation Method.

The accelerated depreciation method will include the Sum of Years Digits (SYD) and the Declining Balance Method. The most prevalent method to calculate non-accelerated depreciation is known as the straight-line method. 

Let’s understand them below:

Straight-Line Depreciation

Straight-line depreciation evenly distributes an asset’s cost over its useful life until it reaches its salvage value.

For example, say an asset worth $5,000 has a useful life of 3 years and a salvage value of $100. Under the straight-line depreciation method, you utilize the formula: 

(Market Value - Salvage Value)/Useful life of an asset 

(5,000 - 100)/(3) = 1,633.333

1633.33 * 0.25 = 408.333

Using this formula, we can see that the annual depreciation expense would be $1,633.33. Furthermore, assuming a tax rate of 25%, this business could write-off $408.33 in taxes each year due to a reduction in taxable income. 

Immediate expense write-offs can also be used to reduce taxable income. This is when, instead of depreciating an asset over a set period of time, a company can expense the full cost of assets that qualify. For an asset to qualify for immediate expense write-offs, it must be tangible.

For example, let’s assume a tax rate of 25%, and the company purchased the asset for $20,000. Under an immediate expense write-off, the company would save $5,000 in taxes during the fiscal year that the asset was purchased. 

20,000 * 0.25 = 5,000

Units of Production Method

Another method to calculate the depreciation expense is what is known as the Units of Production Method (UOP). The Units of Production method calculates depreciation based on how much the asset is used instead of the passage of time used in the other methods. 

Under this, depreciation is directly correlated to the usage of said asset, regardless of how much time passes. This method of calculating depreciation is quite ideal for assets such as certain tools, vehicles, and machines. 

To calculate depreciation using UOP, the formula you would use is:

(Original Cost - Salvage Value) * (Units Produced in the Period/ Total Estimated Units Produced)

For example, let's say that a company purchased a machine for $100,000 with no salvage value, a total estimated output of 5,000 units, and a total of 4,200 units produced in the period. Then, we can simply plug it into the formula to calculate depreciation under UOP.

((100,000 - 0)/5,000) * (4200/5000) = 16,800

Tax write-offs can also occur under the accelerated depreciation method, which allows businesses to depreciate assets faster than the straight-line method, thus saving more money on taxes. This is usually applicable when the asset depreciates faster in the early years of its useful life.

Accelerated Depreciation Methods

There are two methods of calculating accelerated depreciation: the first method is the sum of years digits (SYD), and the second method is the declining balance (DB). 

The Declining Balance Method applies a fixed percentage (e.g., 200% for Double Declining Balance) to the asset’s book value, resulting in higher depreciation in early years.

Declining Balance Method

Let’s start with the second method, declining balance. For declining balance, assuming that the factor is 2 (which means the asset depreciates twice as fast as the straight-line method), the formula would be:

Depreciation expense = (2 / Useful life) * Book Value at the beginning of the year. 

In this example, the book value represents the asset's value after accumulated depreciation has been subtracted. Furthermore, using the declining balance method, an asset depreciates significantly faster during the beginning years of its useful life. 

The Sum of Years Digits (SYD)

The other method to calculate accelerated depreciation is known as SYD (sum of years digits). The sum of years digits calculates more depreciation expense in the beginning years of an asset’s useful life, similar to a declining balance. 

To calculate SYD, sum the years of the asset’s useful life. For example, let’s say the asset has a useful life of 5 years. The sum of years digits would be 15 because 1+2+3+4+5=15. 

Then, we can implement the formula: 

(Remaining Life / Sum of Years Digits) * (Cost - Salvage Value)

For example, let’s say a company just bought an asset worth 100,000 that has a useful life of 10 years with no residual value. To calculate SYD, we do:

1+2…+9+10=55 

After we do that, we can plug the numbers into the formula:

(10 / 55) * (100,000 - 0)

This expression gives us the answer of $18,181.81, which is the asset's depreciation after one year. 

To calculate depreciation in later years using the Sum of Years Digits (SYD) Method, update the numerator in the fraction for each year. For example, in the second year:

(9 / 55) * (100,000 − 0)

and so on.

As previously mentioned, accelerated depreciation can only be used on tangible assets, which are included in PP&E (plant, property, and equipment) most of the time. However, some intangible assets, such as computer software, may also be eligible for accelerated amortization.

Free Resources

To continue learning and advancing your career, check out these additional helpful WSO resources:

• Accrued Expenses
• Depreciated Cost
• Depreciation Methods
• Equity Method
• Financial Assets