Depreciation: Reducing Asset Value Through Use

The value of a physical asset goes down over time. Why? Let’s think about this. Over time physical assets break down because of normal wear and tear. Even if an asset isn’t used, better technology and newer models are coming out all the time. So over time physical assets decline in value. The exception to this is land which does not deteriorate over time and actually increases in value over time.

This is the technical definition: depreciation is the systematic allocation of an asset’s cost over its useful life. Let’s break this up into three pieces.

1. Asset cost is the purchase price plus costs to get the asset in place and ready to use. You already know how to calculate asset cost!
2. An asset’s useful life describes how long a company intends to hold an asset before discarding it.
3. Systematic allocation means that a company chooses an accounting method to transfer the asset cost to an expense. That’s what this section is about: different methods of depreciation.

Why does the asset cost need to be expensed over time? We can think about this question in two ways. First, let’s take a Statement of Financial Position perspective. All PPE except for land decreases in value over time because of wear and tear. Think about a vehicle. What is a vehicle worth new compared to the same vehicle two years later? Its value declines over time, and we need to decrease the balance of PPE to reflect this reduction in value.

The second perspective on depreciation prioritizes the income statement. This is where we find the value that PPE creates, because companies use PPE to generate revenue. A company uses PPE assets to generate revenue, thereby reducing the asset’s value through wear and tear, so it makes sense that the asset cost moves to expenses. After all, our assets are an input in creating value just as much as cost of goods sold, utilities, or wages.

Hopefully you get the rationale for depreciation, whether as a reduction of the PPE balance on the Statement of Financial Position or as an expense necessary to create profit. Let’s talk terminology:

• Cost is the historical price we paid to purchase the asset and get it in place and ready for use. Once the asset is in use, we do not change the cost value until the asset is sold.
• Then we have the accumulated depreciation account. This account is a contra account which means it naturally has a credit balance even though it is technically an asset account. Can you see why this is necessary? Because the accumulated depreciation account has to reduce the balance of the asset on the Statement of Financial Position. The asset cost account is a debit, so to reduce the balance we need an account that is a credit position.

Here’s a sample Statement of Financial Position:

Now that we know how the cost and accumulated depreciation are presented on the Statement of Financial Position, let’s take a look at how depreciation and accumulated depreciation are calculated.

At the end of every fiscal year, we’ll record the following journal entry for depreciation:

The amount journalized ($$) is calculated using a depreciation method. Before we get to the calculations, let’s look at some useful concepts:

Useful Life:

the number of years we expect to use the asset, or the number of units we expect the asset to produce while we own it.

Residual ValueResidual Value:
The amount an asset is expected to be worth at the end of its useful life. This is typically the expected selling price of the asset less costs of disposal, whether the asset will be sold to another person or put into salvage (recycled).:

the amount we expect the PPE asset will be worth at the end of its useful life. In other words, how much do we expect we can sell the asset for once we’re done using it?

Depreciable AmountDepreciable Amount:
The total amount of depreciation to be taken on an asset over its useful life. Calculated as asset cost less its expected residual value.:

the cost of an asset less its residual value. This is the amount we’ll depreciate during its useful life, using the journal entry above.

Let’s look at three methods of calculating depreciation: straight-lineStraight-Line Depreciation:
Systematic allocation of an asset’s cost over its useful life calculated as the asset’s depreciable amount divided by its useful life., declining balanceDeclining Balance Method:
The systematic allocation of asset cost over its useful life calculated as an asset’s net book value (NBV) multiplied by the straight-line rate and a multiplier. Also called diminishing balance or reducing balance., or units of production. A company will choose a method when they purchase an asset and continue with the same method until the asset is sold/disposed of.

Pattern of UsePattern of Use:
Describes how a long-lived asset, like PPE, wears out over time: linearly, rationally, or through use in production. is what determines depreciation method used. It tells us how quickly we should depreciate an asset. The pattern of use, or pattern of wear, is important to identify so we can choose the best depreciation method. The following three questions may indicate pattern of use, and help a company decide which depreciation method to use:

• Does the asset decrease in value steadily over its useful life? If so, depreciation should be the same every period. The straight-line method would therefore be appropriate.
• Does the asset depreciate at a much higher rate in the years following purchase and slowly thereafter? Then use the declining balance method.
• Does the asset depreciate with use rather than over time? If so, you might want to use the units of production method.

You might hear the term asset class. Some companies have many PPE assets, so the companies may group similar PPE assets together. For example, delivery vehicles may be grouped as an asset class, or maybe all production equipment. Companies can group assets into classes however they like, as long as all the assets in the class have the same pattern of use. All assets in a class use the same depreciation method. And this makes sense because, for example, all vehicles will lose value in the same pattern; all computers will lose value in the same pattern; same with production equipment and furniture. Let’s do some calculations to give you some context on potential patterns of use.

We are trying to calculate the amount of depreciation for the company’s depreciation journal entry: