Depreciation is the periodic, systematic expiration of the cost of all fixed assets except land. (Land does not depreciate.)
Over the course of time, all fixed assets gradually lose their ability to provide service. Because of this, the cost for that fixed asset needs to be transferred to an expense account in a structured manner over the useful life of the asset. This transfer is called depreciation.
Causes of Depreciation
An asset can lose its ability to provide service for two basic reasons:
— includes the inappropriateness of the asset for performing the required functions. This can happen due to increased demands for productivity that exceed the asset's capacity. Another example of functional depreciation is obsolescence, where the asset becomes obsolete over time. This occurs where technological advances cause the asset's output to be no longer needed, or result in newer assets that can produce a higher quality output at the same or lower price.
— is the normal "wear and tear" of the asset over time. As the asset is used, it becomes more costly to operate (due to repairs, increased levels of defective output, etc.). Eventually, given enough time, most assets will cease being productive at all because of physical depreciation.
Common Misconceptions About Depreciation
— Contrary to what many non-accounting business majors might think, depreciation in the accounting sense does not refer to the decline in the market value of an asset. Indeed, the value of a fixed asset on the balance sheet may not ever be the same as its resale value at that point in time. Rather, depreciation is simply the unexpired cost of the fixed asset.
— Depreciation does not contribute anything to the cash flow of a business. Remember, depreciation is a non-cash expense that spreads out the cost of an asset over time. It is not a payment plan, nor does it provide cash to eventually replace the asset.
Accounting For Depreciation
There are three factors a company must consider when trying to determine a fixed asset's depreciation expense — the initial cost, the useful life, and the expected salvage value at the end of its useful life. In cases where an asset is expected to have little or no salvage value, a company will want to spread the entire initial cost over the life of the asset, using depreciation. Otherwise, the difference between the initial value and its eventual salvage value is what should be spread over the life of the asset, using depreciation.
A company can estimate the useful life and salvage value of a fixed asset by a variety of sources, including insurance data and trade publications. However, it is impossible to determine exactly what the useful life and salvage value are until the asset's useful life is over. At that point, adjustments may need to be made to the balance sheet to reflect reality.
Once the depreciation cost (the amount that needs to be depreciated) is determined, a depreciation method must be chosen from the five most prevalent methods — Straight-Line, Units-Of-Production, Declining Balance, Double Declining Balance, and Sum-Of-The-Years'-Digits.
Depreciation expense is recorded as a debit to the Depreciation Expense account and a credit to the Accumulated Depreciation account. Accumulated Depreciation is an example of a contra-asset account, so called because they record deductions from the related asset account.