What is Depreciation Expense?
Depreciation expense is the percentage of the total value of a fixed asset that has been determined to be depleted during a specified accounting period. The purpose of depreciation expense is to gradually devalue items as they age and maintain the wear and tear of regular use. Types of depreciation methods include straight line, sum over years, declining balance, and units of production.
When a company makes a major purchase, such as a vehicle or machine, the item is recorded as property, plant and equipment and an assessment is made to determine the expected term of use of the asset. The item is depreciated over the years of its useful life to reflect the percentage of its value in each accounting period. Consumables are considered expenses at the time of purchase. A machine with an expected life of five years, for example, will be depreciated. The oil or gaskets used to maintain the machine are spent immediately because they are only used for a short time and then replaced.
Depreciation expense is considered a non-cash item because it does not require a cash outlay in a given accounting period. The cash disbursement occurs at the time of purchase of the asset. To show a consistent profit and loss statement for monthly accounting periods, the annual depreciation expense is divided by twelve and posted as a monthly expense.
The simplest method of depreciation is the straight line. The asset's value less any expected residual value is divided by the number of years of its expected useful life. For an asset with an expected useful life of five years, the depreciation expense will be 20% of the depreciable amount each year.
The calculation for the so-called sum of years digits method is based on fractional values. This depreciation method carries more expenses for prior years than the straight-line method. For an asset with a useful life of five years, depreciation is divided into fractional amounts based on the sum of the numbers for each year (1 + 2 + 3 + 4 + 5 = 15). Depreciation recorded is 5/15 of the value in the first year, 4/15 in the second year, and so on.
The declining balance method shifts an even greater amount of depreciation to earlier periods. It is usually calculated at twice the straight-line rate and is therefore called the double declining balance method. The formula for calculating double declining balance depreciation for a given year is to subtract the accumulated depreciation from the original amount and then divide by the useful life in years and multiply by two. The residual value is deducted in the last year.
Another method of depreciation is based on production units. This depreciation formula subtracts the salvage value from the original value and divides it by the total expected production units and multiplies by the actual number of production units for the period. This method links recorded depreciation expense to actual production levels for the accounting period.