The financial accounting term depreciation is sometimes defined as a decline in tangible plant's service potential. Depreciation is a method of allocating the cost of a tangible asset in a systematic manner to those time periods that benefit from the use of the asset.
Straight line depreciation, the most common method used today, is calculated as follows:
Annual Depreciation = (Cost - Salvage Value) / Estimated Service Life
Depreciation is sometimes confused with the concept of valuation, or fair market value. Depreciation is an accounting method of cost allocation. It is used to allocate the cost of an asset over its useful life.
Depreciation is sometimes called a non-cash expense. This is because the cash used to purchase the asset was paid in year 0. Depreciation expense flows to the income statement over the depreciable life of the asset. This accounting practice allows a company to expense the cost of the asset over time, thereby avoiding a large impact to earnings in the year the asset is purchased.
Accelerated depreciation uses rules established by the Internal Revenue Service for income tax purposes. The most common of which is the Modified Accelerated Cost Recovery System, or MACRS.
Company A purchases a backup generator for $400,000. The estimated service life is expected to be 20 years. The generator has no residual value.
Company A would create an asset on its balance sheet for $400,000 in year 0. Each year, the company would depreciate the asset using the straight line method as follows:
= ($400,000 - 0) / 20, or $20,000 per year for 20 years.
Company A would show a depreciation expense of $20,000 on its income statement. After 12 months, the asset's net book value would be:
$400,000 - $20,000 or $380,000
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