Depreciation

You know that when you take a brand new computer out of its box it is no longer as valuable as the price you paid for it. Fixed assets depreciate in value. The difference between what you bought an asset for and what is it now worth is depreciation.

Depreciation is an expense. It is also a contra-account against fixed assets.
Example
This is what the Fixed Assets section of a Balance Sheet might look like: The journal entry for this might have been
Machinery and Equipment $ 50,000
Buildings 100,000
Less: Accum. Dep. (20,000)
=======
Total Fixes Assets $130,000

Depreciation Expense (debit) 5,000
Accumulated Depreciation (credit) 5,000

Tip
Make only one journal entry for all your assets. Use only one Depreciation Expense amount in your Income Statement and one Accumulated Depreciation amount in your Balance Sheet. These amounts should be the total of all your depreciation calculations.

This is easier on both the accountant and the readers of the financial statements. Few people want to go into all the details of depreciation and it just makes them look more complicated than they need to be.

Tip
Separate listings of Depreciation Expense and Accumulated Depreciation should be in the financial statements for each category of assets. This gives the user valuable information on the aging of a company’s plant and equipment. Together with the Cash Flow Statement’s section on which assets have been bought and sold, an analyst can form useful conclusions about a company’s present and future capital needs.

Most users couldn’t be bothered. If a user wants to know all that, then provide them the depreciation schedule that gives them even more information. Otherwise why assault users with additional information when financial statements are complicated enough?

What about the other $15,000 in Accumulated depreciation (the 20,000 less the 5,000)? Accumulated depreciation is the total of all depreciation for the current period and all prior periods.

Not all of the amount of an asset is depreciated at one time. The idea of depreciation is that depreciation goes up as the asset’s value goes down.

So how are the amounts determined? There are a variety of methods. Here are the two most common.

The Straight Line Method
Take the total cost of an asset. Estimate how much it will be worth when you dispose it. The difference between its starting amount and the ending amount is going to have to be depreciated.

Now estimate its total useful life. Divide the total difference by the total life. That is the amount to depreciate this period.
Example
Assume a widget that costs $10,500. Its useful life is 10 years. Its value at the end will be $500.
Over the next 10 years you will need to adjust this widget’s book value from $10,500 down to $500. In other words, you’ve got to decrease it by $10,000 over 10 years. This works out to an average of $1,000 per year.
The straight line method is to just use the average.

The IRS Method
This is not generally accepted accounting principles (GAAP). It is for accounting on the Tax Basis of accounting which is an Other Comprehensive Basis of Accounting (OCBOA). The IRS has tables that you use to look up the deductable depreciation amounts. Remember that these tables like all IRS rules are the result of politics not any accounting theory.