Welcome to our lesson on depreciation in accounting. Depreciation is a fundamental concept that represents the systematic allocation of an asset's cost over its useful life. When a company purchases equipment, buildings, or vehicles, these assets gradually lose value due to wear and tear, technological obsolescence, or simply the passage of time. The graph shows how an asset's value typically decreases from its original cost down to its salvage value over its useful life.
To calculate depreciation, we need three key components. First is the original cost, which is the initial purchase price of the asset. Second is the salvage value, the estimated value of the asset at the end of its useful life. Third is the useful life, the expected period the asset will serve the company. The depreciable cost is calculated by subtracting the salvage value from the original cost. In our example, a machine costing one hundred thousand dollars with a salvage value of ten thousand dollars gives us a depreciable cost of ninety thousand dollars over ten years.
The straight-line method is the most common and simplest depreciation approach. It allocates an equal amount of depreciation expense each year over the asset's useful life. The formula is straightforward: subtract the salvage value from the original cost, then divide by the useful life in years. Using our example of a one hundred thousand dollar machine with a ten thousand dollar salvage value over ten years, we get nine thousand dollars of annual depreciation. The table shows how the book value decreases by nine thousand dollars each year, starting from one hundred thousand and ending at the salvage value of ten thousand dollars.
Recording depreciation requires a specific journal entry that affects two accounts. First, we debit Depreciation Expense for nine thousand dollars, which appears on the income statement and reduces net income. Second, we credit Accumulated Depreciation for nine thousand dollars, which is a contra-asset account on the balance sheet. This contra-asset account reduces the book value of the equipment without directly changing the original cost. On the balance sheet, we show the equipment at its original cost of one hundred thousand dollars, less accumulated depreciation of nine thousand dollars, giving us a net book value of ninety-one thousand dollars. This entry is repeated each accounting period throughout the asset's useful life.
While straight-line is the most common method, there are several alternatives. The declining balance method is an accelerated approach that records higher depreciation in the early years, which may better match the actual decline in asset value. The sum-of-years'-digits method is another accelerated technique that also front-loads depreciation expenses. The units of production method bases depreciation on actual usage rather than time, making it ideal for machinery or vehicles. The comparison table shows how these methods differ in their annual depreciation amounts. Although the total depreciation over the asset's life remains the same, the timing of expenses varies significantly. Companies must choose the method that best reflects the asset's usage pattern and maintain consistency once selected.