What Is Depreciation Expense and How It Works

Purchasing assets isn’t a decision to take lightly. You need to perform some calculations to ensure your investment is worthwhile in the long run. One is depreciation expense, which helps your business plan its budget and estimate future returns.

This article aims to provide a clear understanding of what depreciation expense is, why it matters in accounting, and how to calculate it accurately and effectively.

What Is Depreciation Expense?

Depreciation expense is a non-cash cost that experiences a decrease in the value of an asset over time due to usage, wear and tear, or even obsolescence. To sum it up, depreciation expense is part of the asset’s cost which is used up during a specific time.

When you purchase an asset, you expect to use its potential to the fullest. However, just like anything else, assets lose value over the years. And unfortunately, it is inevitable.  

Difference Between Depreciation Expense and Accumulated Depreciation

It is quite common to confuse depreciation expense with accumulated depreciation, as both terms relate to the reduction in an asset’s value over time. At a glance, they may appear similar since they both deal with the concept of asset loss. However, it is important to understand that they serve different purposes in financial reporting and should not be used interchangeably.

As stated above, depreciation expense is part of the asset’s cost which is used up during a specific time, typically annually. This figure appears on the income statement and reflects the cost of using the asset for that given time frame.

In contrast, accumulated depreciation reflects the total depreciation that has been built up since it was first placed into service. It is a cumulative figure that increases over time and appears on the balance sheet, reducing the asset’s book value.

To put it simply, depreciation expense answers the question, “How much value did we lose this year?”, while accumulated depreciation addresses the broader picture: “How much value has been lost in total, up to now?” Both figures provide valuable insight into different aspects of financial analysis and decision-making.

Methods of Calculating Depreciation

Numerous methods can be implemented to calculate the decline in value. Nonetheless, three methods are generally used considering their feasibility and comprehensibility with accounting standards: the straight-line method, the declining balance method, and the units-of-production method. Each serves different types of assets and financial strategies.

Methods of Calculation: Straight-Line

Certain electronic devices, such as laptops, experience a decline in worth over time. This depreciation is largely due to the frequent release of newer, more advanced models that offer improved performance and updated features. Hence, existing styles may appear less captivating in the market. Nevertheless, the depreciation of laptops typically occurs at a gradual pace. A laptop that is one year old does not instantly become obsolete or unusable. Provided it has been properly maintained, it can continue to function effectively for its intended purpose.

In these conditions, where the asset loses worth steadily over its lifespan, the straight-line method is most likely the appropriate approach. This method allows for an even distribution of depreciation expense across each year, making it easier to predict and manage the asset’s worth over time.

Example:

Suppose a company purchases a laptop for $2,000 with an estimated useful life of 4 years.

Using the straight-line method:

$2,000 ÷ 4 years = $500 depreciation expense per year.

For that reason, after one year of usage, the value would be:

$2,000 – $500 = $1,500

This method provides a systematic and straightforward way to allocate and is particularly effective for assets that do not lose worth abruptly, but rather decrease steadily with age and use. It is commonly applied in financial reporting to maintain consistency and transparency in asset valuation.

Methods of Calculation: Double Declining Balance 

Let us take cars as an example. The value of a car is particularly intriguing, as the market is frequently updated with newer models. These new releases often make older vehicles appear outdated or less desirable. However, it is important to note that this does not necessarily mean that the basic functionality of the car is compromised. Regardless of its age, a car that is routinely maintained can continue to operate efficiently. Even a car that is ten years old, provided it has been properly cared for, can still perform its intended function effectively.

However, it is widely observed that a car’s value decreases significantly in the first few years following its purchase, primarily due to the introduction of newer models and technological advancements. This rapid loss is particularly noticeable in the initial years of ownership. After this period, it tends to slow down, and the car’s value stabilizes to some extent.

In cases like this, where an asset loses its value more quickly in the earlier years and at a slower rate as time progresses, the declining balance method proves to be particularly effective. This method allows for a higher diminishing worth expense in the initial years, which reflects the sharp decline in price that many cars experience soon after purchase. In the long run, the car’s worth diminishes more consistently.

Example:

Imagine you purchase a car worth $30,000, and its prime is estimated to be useful in 10 years.

The calculation method will be:

2 ÷ 10 = 20% per year

Year 1:

Expense: $30,000 × 20% = $6,000

Value: $30,000 – $6,000 = $24,000

Year 2:

Expense: $24,000 × 20% = $4,800

Value: $24,000 – $4,800 = $19,200

This process continues each year, with the depreciation amount decreasing as the car’s worth diminishes. Eventually, the vehicle will reach its initial price. This reflects the lowest worth the car can obtain while further assuming it retains any residual worth. The method is useful for assets like vehicles, where the value decreases more steeply in the early years and stabilizes later on.

Methods of Calculation: Unit of Production 

This method differs somewhat from the previous methods. The situation does not rely on the duration to determine an asset’s depreciation. On the contrary, it relates to the amount of units produced. This approach is efficient for assets that wear and tear is more directly correlated with the amount of work they perform, rather than the number of years they have been in service.

The units of production method is most widely applied to assets such as factory machinery or equipment, where the deterioration depends on the volume of units produced rather than the duration of usage. For instance, in manufacturing settings, a machine may operate for several years. However, its diminishing worth is more accurately measured by how much it is utilized in production, as each unit the machine produces adds to the overall wear and tear.

Example:

Think of a company that owns a machine worth $50,000. This machine is expected to have a residual value of $1,000 after it has produced a total of 30,000 units throughout its useful life.

The calculation method will be:

($50,000 − $1,000) ÷ 30,000 units = $1.63 per unit

This shows that for every unit the machine produces, it loses $1.63 in value. The regression in worth is correlated to the level of production. Hence, the more the machine is operated, the higher the depreciation expense. This method provides a more accurate reflection of an asset’s value decline when the usage plays a significant role in its deterioration, making it ideal for industries to calculate the outcome of the machinery and equipment.

When to Use the Right Depreciation Methods?

Before calculating the loss in value of an asset, it’s important to understand what kind of asset you’re dealing with. Selecting the accurate method depends largely on how the asset loses its worth over time. Does it maintain a consistent price? Does it depreciate rapidly within the early years? Or does its worth depend on how much it’s operated? Answering these fundamental questions will provide insight to decide the most appropriate method to calculate your asset.

Depreciation of Assets with Consistent Value Over Time

Assets with consistent worth usually, though not always, come with a long period of usage. For instance, real estate tends to hold its value over the years due to sustained use and relatively low wear. However, cars don’t maintain a consistent worth even though they also have a lengthy service period. This shows that not everything long-term equals stable value. That’s why it’s important to do proper market research on the asset you’re eyeing to see if it makes sense to apply the straight-line method, which spreads depreciation evenly across the asset’s useful life.

Assets with Rapid Depreciation

As stated earlier, assets such as cars experience considerable depreciation, even though they are considered long-term assets. Correspondingly, high-end smartphones, or what we usually call flagships,  tend to lose worth quickly due to the fast-moving characteristics of the technology. Types of assets like these are better suited to accelerated depreciation methods, like the declining balance method, which accounts for larger drops in value early on its usage time. While it’s often wiser to invest in assets with stable value, there are some advantages to investing in assets that lose quickly. For instance, such assets may provide high short-term utility, allow for faster return on investment, or even offer tax benefits depending on how diminishing worth is accounted for. So, while rapid loss can seem like a red flag, it’s not always as straightforward as it appears.

Depreciation Based on Production Output

In some cases, the worth of an asset isn’t tied to time, but to how much it produces. This method is most commonly implemented in mining and manufacturing industries with machinery as the primary asset. While machines may have prolonged usage, they don’t necessarily fit the straight-line method because their worth depends on the number of units they generate. Given this situation, the units-of-production method is more appropriate, as it correlates depreciation precisely to the asset’s outcome rather than its age.

Conclusion

Accurately calculating depreciation is crucial for businesses. It can support effectively managing their assets and making informed financial decisions. Acknowledging the differences in methods outlined above, asset owners can ensure that their financial statements reflect the true worth of what they invest over time.

Deciding on the right method relies on the characteristics of the asset, its rate of value loss, and how it’s used. Assets with consistent worth, like real estate, are better suited to the straight-line method, while assets that experience rapid loss, such as cars or smartphones, may benefit from accelerated methods like the declining balance. In industries like manufacturing, where wear and tear are linked to production, the units-of-production method offers the most accurate reflection of a decline in worth.

By carefully selecting the appropriate method, businesses can optimize their asset management, improve financial planning, and ensure their investments yield the best possible returns over time.