Depreciation explained

If you buy a long-lived asset, you will expense the cost of that asset over its useful life.  This is called depreciation.

For example, suppose that Your Airline buys an Airbus A380 for $400 million dollars.  You do not need to record an expense for the cost of this aircraft in the year that you buy it.  Instead, you can spread out the cost over its useful life.

taken with my dads pockets casio camera
Airbus A380taken with my dads pockets casio camera by Daz /SWAN MAN, on Flickr
You estimate that the A380 has a useful life of 25 years.  Using a system of depreciation called “straight-line,” you would record depreciation expense of $16 million per year ($400 million/25 years), reducing your net income by $16 million per year.
There are many different depreciation methods.  Most common is “straight-line,” which takes equal amounts of depreciation ever year.  Another approach is called “accelerated,” which takes more depreciation when the asset is newer, and less depreciation when it is older.
To compute depreciation for US income taxes, businesses usually use a system called MACRS.  When the asset is newer, MACRS usually allows you to record more depreciation than you might record under straight-line or even accelerated.  It would then increase your depreciation expense deductions, decrease your taxable income, and decrease taxes due.  On your taxes, you can’t depreciate an asset already written off with a Section 179 deduction.
When depreciating for financial statements (rather than for taxes), you will need to estimate the useful life of the asset and also its salvage value, which is your estimate of the asset’s fair value at the end of its useful life. Then the formula for annual depreciation would be:
(Cost – Salvage Value)/Useful life in years = Depreciation expense
Land is never depreciated.

Accounting Trivia: For accountants, “depreciation” does not mean “decline in value.”  We call that “impairment” or “unrealized loss.”  Rather, depreciation refers to this system of allocating the cost of a long-lived asset to the time periods when it is used.

About Mark P. Holtzman

Chair of Accounting Department at Seton Hall University. PhD from The University of Texas at Austin. Worked at Deloitte's New York Office. BSBA from Hofstra University.

One Response to “Depreciation explained”

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