Depreciation involves allocating the cost of a long-term asset to expense over the useful life of the asset. Long-term or long-lived assets that are used in a business (except land) must be depreciated in order to match the asset's cost to the accounting periods when revenues are earned from using the asset. Note that depreciation is not an attempt to value an asset.
The depreciation reported in the financial statements is based on the useful life of an asset. As a result, there can be different depreciation amounts from one company to another when using a similar asset. For example, a new machine might be useful for 10 years in a company that processes soft metals, but a similar machine might be useful for only 5 years in a company that processes hard metals. The result might be annual depreciation expense of $10,000 for 10 years at one company, while another company's financial statements will report $20,000 per year for 5 years. (The depreciation for tax purposes will likely be another amount, since tax depreciation is based on income tax regulations.)
There are different methods for calculating depreciation expense. Generally, companies use the straight-line method of depreciation for its financial statements. The straight-line method means the annual depreciation expense will be the same amount for each full year of use. Alternatively, some companies might use an accelerated method of depreciation such as the double-declining-balance method or sum-of-the-years' digits method. The accelerated methods mean greater depreciation expense in the early years of an asset's life and lesser amounts in the later years of an asset's life. Another method of calculating depreciation is the units of production or units of activity method. Under the units of activity method, more depreciation is recorded in the accounting periods when the asset's use is greater. In periods when the asset is used less, the amount of depreciation will be smaller.
The accounting entry for recording depreciation for financial purposes is a debit to Depreciation Expense and a credit to Accumulated Depreciation. Accumulated Depreciation is a contra asset account that is reported as part of the balance sheet classification Property, Plant and Equipment.
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Harold Averkamp (CPA, MBA) has worked as a university accounting instructor, accountant, and consultant for more than 25 years. He is the sole author of all the materials on AccountingCoach.com. Read more about the author.