Everything You Need to Know About Depreciation in Accounting

Accounting is governed by several mandatory regulatory rules known as accounting principles, including those related to the requirement to match expenses with revenues during each financial period. Depreciation allows the matching of asset depreciation expenses with the revenues generated by those assets over their productive life. 

It also serves other accounting and tax purposes, such as recovering the cost of the asset over its useful life and facilitating its replacement, among others. This article explains the meaning of depreciation and the different methods used to calculate it.  

What Is Depreciation?

Depreciation is an accounting method through which the cost of tangible assets is allocated over the years of their useful life during which those assets are productive. By allocating this cost, companies can accurately determine the loss in value of those assets, as well as the profits that can be generated from owning them.  
 

Basic Concepts of Accounting Depreciation

Before elaborating on depreciation methods and their accounting entries, it is useful to explain some basic concepts that help in understanding the details of depreciation discussed later. The most important of these concepts include: 

Salvage Value: 
The remaining value of an asset after accumulated depreciation is calculated until the asset is sold or disposed of. 

Depreciation Rate: 
The annual depreciation of an asset expressed as a percentage. Its monetary value can be calculated by allocating the cost of the asset using any of the different accounting methods that will be discussed later.  

What Are Depreciation Methods?

Assets lose value for several reasons, such as use or repairs for production purposes, the introduction of more advanced equipment into the market, or other indirect factors such as inflation. 

Depreciation methods are also referred to as types of depreciation. Although the basic principle of depreciation is the same, it can be calculated using several different methods. The most common methods are reviewed below:
 

1. Units of Production Method

When the units of production method is adopted, depreciation is calculated based on the rate of use of the asset. Depreciation increases as the asset’s usage increases during periods of higher production. The total number of units the asset is expected to produce over its useful life is estimated, and the depreciation cost is then allocated based on the number of units produced, taking the production rate into account.  
 

2. Straight-Line Method

Under the straight-line method, the asset is assumed to depreciate evenly over its useful life. Accordingly, the loss in the asset’s value is allocated equally over the years of its estimated useful life. 
 

Therefore, it is necessary to take into consideration that the salvage value is deducted from the cost of the asset before distributing the depreciation expense. This method is commonly used in depreciation calculations because it is the simplest.  
 

3. Declining Balance Method

This depreciation method is based on the assumption that the asset has a higher value in the earlier years of ownership compared to later years. Accordingly, depreciation in the early years results in a greater loss in the asset’s value, and the depreciation expense decreases over time.  
 

4. Double Declining Balance Method

This method is similar to the declining balance method, where depreciation is higher in the early years and lower in later years, but it operates at a doubled rate. This method is useful for calculating depreciation for assets that lose value rapidly, such as mobile phones and laptops.  
 

5. Sum-of-the-Years’-Digits Method

As with the declining balance and double declining balance methods, depreciation under this method is calculated at an accelerated rate and is primarily based on estimates of the asset’s useful life in years.  

Based on the above, it can be concluded that depreciation is considered a fixed cost when using most depreciation methods, except for the units of production method, where changes in the production rate affect the depreciation calculation.  

Download now a sample for calculating depreciation using the four different methods.  

How Is Depreciation Calculated?

As previously mentioned, depreciation can be calculated using several different methods, from which a company chooses the one that best suits its needs. For clarification, consider an example in which Company (S) purchases an asset with a cost of 50,000 pounds, a useful life of four years, and a salvage value of $10,000. 

The depreciation of the asset can be calculated by first deducting the salvage value, then dividing the remaining cost of the asset over the years of its useful life according to the selected depreciation method.

In this context, the Daftra Asset Management System helps you calculate depreciation of fixed assets through the depreciation settings available in the system’s dashboard. 

With just a few simple clicks, starting by selecting General Ledger from the Daftra dashboard, then choosing Assets, adding a new asset, and entering the asset’s depreciation details, you can select the depreciation method that suits the nature of the asset. The system will then automatically calculate depreciation and provide accurate results.  

Examples of Depreciation Calculations

There are several methods for calculating depreciation, as explained earlier. These methods help determine the cost of assets based on their period of use or useful life. Below are practical examples of applying depreciation calculation methods, which enhance accounting understanding and support efficient fixed asset management.  
 

1. Depreciation Using the Units of Production Method

When using the units of production method, it is necessary to estimate the total number of units the asset will produce over its useful life and to deduct the salvage value from the asset’s cost at the outset (50,000 − 10,000 = 40,000). 

Assuming the asset produces 5,000 units over its useful life and 1,000 units during the first year, the depreciation rate for the first year is: (1,000 ÷ 5,000 × 100 = 20%). 

The depreciation expense for the first year is calculated by multiplying the depreciation rate by the asset’s value after deducting the salvage value: (0.2 × 40,000 = 8,000). 

If production decreases to 500 units in the second year, the depreciation rate becomes: (500 ÷ 5,000 × 100 = 10%), and the depreciation expense equals: (0.1 × 40,000 = 4,000). 

This method is considered the most accurate because the annual depreciation expense changes in line with the actual rate of asset usage.  

2. Depreciation Using the Straight-Line Method

Under the straight-line method, the salvage value is deducted from the asset’s cost at the beginning: (50,000 − 10,000 = 40,000). 

The remaining cost is then divided by the number of years of the asset’s useful life, resulting in the annual depreciation expense: (40,000 ÷ 4 = 10,000). An amount of 10,000 pounds is recorded as depreciation expense, and 10,000 pounds is also recorded in the accumulated depreciation account each year over the asset’s useful life. 

In the event the asset is sold, the proceeds from the sale are recorded on the debit side, and accumulated depreciation is removed from the credit side. 

The difference between the two accounts determines whether a gain or a loss has been realized. 

Download a free template for calculating depreciation using the straight-line method and learn how to use it.  
 

3. Depreciation Using the Declining Balance Method

Depreciation under the declining balance method is calculated based on the asset’s useful life and depreciation rate, after deducting the salvage value: (50,000 − 10,000 = 40,000). 

Assuming the asset has a useful life of four years, the annual depreciation rate is 25%. 

The depreciation expense for the first year is: (40,000 × 0.25 = 10,000).

 In the second year, the depreciation of the first year is deducted before applying the depreciation rate: (30,000 × 0.25 = 7,500).  

4. Depreciation Using the Double Declining Balance Method

Depreciation under the double declining balance method is calculated in a manner similar to the declining balance method, relying on the annual depreciation rate and the asset’s useful life. 

The key difference is that the depreciation rate is doubled when calculating the annual expense. 

As with all depreciation methods, we begin by deducting the salvage value: (50,000 − 10,000 = 40,000). 

The annual depreciation rate is doubled to 50%, resulting in depreciation of: (40,000 × 0.5 = 20,000) In the first year, Which then declines to: (20,000 × 0.5 = 10,000) in the second year. 

You can download a free double-declining balance depreciation template without accounting expertise and easily calculate depreciation using this method.  

5. Depreciation Using the Sum-of-the-Years’-Digits Method

Similar to the units of production method, calculating depreciation using the sum-of-the-years’-digits method requires estimating the period during which the asset will be productive.

 After deducting the salvage value from the asset’s cost: (50,000 − 10,000 = 40,000), The digits of the estimated useful life (four years in this example) are summed: (1 + 2 + 3 + 4 = 10). 

The depreciation rate and amount are highest in the first year: (4 ÷ 10 × 40,000 = 16,000), And then decrease steadily in subsequent years: (3 ÷ 10 × 40,000 = 12,000) in the second year, (2 ÷ 10 × 40,000 = 8,000) in the third year, and finally (1 ÷ 10 × 40,000 = 4,000) in the fourth and final year.  

What Are Depreciation Entries?

Depreciation entries refer to the various accounting items and records related to how depreciation is treated from an accounting perspective. 

These items must be taken into consideration when recording depreciation accounts. There are different types of depreciation entries, including the following:  
 

1. Depreciation Entry

The depreciation entry reflects the decrease in the value of an asset and is recorded after one year of owning the asset. It is recorded as a credit from the asset account to the expense account, as follows: 

Debit: Accumulated Depreciation – Depreciation Expense 
Credit: Asset Account  
 

2. Fair Value Entry

The fair value entry is used when companies revalue their assets due to an increase or decrease in the company’s market value. 

The difference in the asset’s value is allocated over the asset’s productive useful life so that it is included in the depreciation accounts related to that asset.  
 

3. Transfer (Disposal) Entry

Accountants use the transfer entry when an asset is sold. The remaining accumulated depreciation of the asset is transferred to the accumulated depreciation account, and the book value of the asset is transferred to the sales account. The method of recording varies depending on the relationship between the selling price and the remaining book value of the asset.
 

• If the asset is sold at its remaining book value after depreciation, the entry is recorded as follows:

Debit: Cash Credit: Fixed Assets (under the name of the sold asset)  
 

• If the asset is sold at a price lower than its remaining book value, the entry is recorded as follows:

Debit: Cash Debit: Accumulated Depreciation Credit: Fixed Asset Credit: Capital Gains and Losses  
 

• If the asset is sold at a price higher than its remaining book value after depreciation, the entry is recorded as follows:

Debit: Cash 
Debit: Accumulated Depreciation 
Credit: Fixed Asset 
Credit: Capital Gains and Losses  
 

4. Tax-Related Entries

This entry helps ensure compliance with taxes related to assets, in addition to allocating such taxes over the depreciation period of the asset.  \

What Is the Importance of Depreciation Entries?

Depreciation entries are highly important due to their impact on a company’s accounts, legal standing, and market value. In addition to being one of the accounting standards that must be complied with, depreciation entries contribute to the following:
 

• Determining the true value of assets: Depreciation entries show how much value assets have lost due to use and the passage of time, making it easier to determine the actual value of the assets currently owned by the company. Accurate asset valuation is particularly crucial when a company sells its assets for any reason.
   
• Determining the company’s true profits: By allocating the cost of owning an asset and matching it with the period during which the asset is productive, depreciation provides a more realistic view of the company’s expenses and profits.
   
• Presenting the company at its true value in financial statements: Through recording depreciation entries, accuracy in asset valuation and net profit calculations can be maintained in the financial statements.

Depreciation of Fixed Assets and Its Rate

The cost of a fixed asset can be viewed as being paid in exchange for what the asset will produce over its useful life. Accordingly, for accounting purposes, the cost of the asset can be considered part of production expenses. 

By applying the matching principle between expenses and revenues, the depreciation of the asset is allocated over the years during which it is expected to generate revenue. 

Download the asset depreciation calculation template now and customize it for free from Daftra.  

What Is the Difference Between Accumulated Depreciation and Depreciation Provision?

The difference between accumulated depreciation and depreciation provision lies in the function and use of each. A depreciation provision is used to reflect the decline in an asset’s value over a specific period and appears as a periodic expense in the income statement. 

On the other hand, accumulated depreciation is used as a cumulative account to show the total depreciation charged on an asset since the beginning of its use. 

Accumulated depreciation appears in the balance sheet. Below are the key differences between accumulated depreciation and depreciation provision:  
 

1. Definition

According to the international accounting standard IAS 16, accumulated depreciation refers to the total actual depreciation expenses from the date the asset was purchased up to the date accumulated depreciation is calculated. 

Accumulated depreciation can be viewed as a representation of the portion of a tangible asset’s value that has been consumed during the period from acquisition to the date of accumulated depreciation. 

When referring to the total depreciation expense related to an intangible asset, the term accumulated amortization is used. On the other hand, a depreciation provision, in accordance with IAS 37, is used to represent an estimated depreciation-related amount. 

It is considered a provision (contingent liability) that the company may be required to settle as a result of past events. Provisions are uncertain in amount or timing. 

For example, companies may create a depreciation provision in cases involving lawsuits that may result in compensation payments, post-sale service obligations, or discount allowances.  

2. Impact on Financial Statements

Accumulated depreciation affects the balance sheet and results in a reduction in asset values, while a depreciation provision affects the income statement and leads to a reduction in profits.

The amount of a provision is estimated based on specialists’ assessments. A provision should not be recognized if it is not possible to reasonably estimate the amount of the potential obligation or if there is no dispute regarding the expected financial obligation.

For example, provisions should not be created for payable taxes, as they represent a definite liability.  

What Is the Difference Between Accounting Depreciation and Tax Depreciation?

Tax depreciation differs from accounting depreciation mainly in terms of purpose. Tax depreciation is used to reduce taxable income reported in company filings submitted to governmental tax authorities. Tax depreciation rules vary depending on the type of asset and the laws of the jurisdiction under which the entity operates. 

In contrast, for accounting depreciation, companies choose the depreciation method they apply based on several factors, such as salvage value and the expected useful life of the asset.

Difference Between Depreciation and Amortization

Depreciation differs from amortization in that depreciation applies to tangible assets such as production equipment, real estate, or machinery. Amortization, on the other hand, refers to the reduction in value of intangible assets that can be sold, such as intellectual property. 

Read more: What Is Amortization in Accounting?  

What Are the Controls and Standards for Depreciation?

Assets must meet several criteria to be eligible for depreciation. The most important of these criteria includes ownership of the asset and its use in a project or for production purposes. In addition, the asset’s useful life must be measurable and exceed one year.  

What Is the Depreciation Threshold?

Companies can determine a spending threshold for assets above which depreciation begins to be calculated. This threshold is usually set based on the size of the company’s operations and is directly proportional to it. For small businesses, depreciation is often calculated even for low-cost assets.  

What Does Depreciating Asset Maintenance Expenses Mean?

It is important to note that maintenance expenses intended to extend an asset’s useful life or increase its productive capacity are added to the asset’s value by the same amount as the maintenance costs.

Such maintenance expenses are included within the depreciation accounts of the asset. In contrast, maintenance expenses are not included in depreciation calculations if they are incurred merely to maintain the asset’s existing productive capacity. 

Maintenance expenses are recorded as follows:

Debit: Fixed Assets (under the name of the relevant asset) 
Credit: Maintenance Expenses  

Frequently Asked Questions

What is the purpose of depreciation?

In addition to applying the matching principle between revenues and expenses, depreciation enables the replacement of assets that are no longer fit for production by spreading the cost of assets over their useful life.  
 

What are the elements of depreciation?

Depreciation has four main elements:

• Asset cost: Includes all costs incurred to acquire the asset, such as purchase price, applicable taxes, shipping costs, and similar expenses.
• Useful life of the asset: The period during which the asset is expected to be productive.
• Depreciation rate: Varies depending on the depreciation method chosen by the company.
• Salvage value: The remaining value of the asset that can be recovered if it is sold after the end of its useful life.

Is depreciation recorded as a debit or a credit?

Depreciation is recorded as a debit because it is recognized as an expense in the company’s accounts.  
 

What are depreciation expenses?

Depreciation expenses refer to the amount of an asset’s depreciation during a specific accounting period and are reported in the financial statements for that period.  
 

Is a trademark depreciated?

Intangible assets are not depreciated; instead, they are subject to amortization, usually on a straight-line basis over their useful life.  
 

Do land assets depreciate?

No, land does not depreciate. Although it is classified as a fixed asset, its value does not decline over time. Depreciation applies to buildings, machinery, equipment, and devices that are subject to wear and tear through use 
 

What is meant by annual depreciation?

Annual depreciation refers to the gradual decrease in an asset’s value over one financial year.  
 

Do buildings depreciate?

Yes, buildings are subject to depreciation due to aging and wear over time.  
 

Does depreciation appear in the income statement?

Yes, depreciation appears as an expense in the income statement and affects net profit or loss for the specific accounting period in which it is calculated.  
 

Does accounting software depreciate?

Yes, accounting software is subject to depreciation (amortization) due to its use. Its cost is allocated over its operational life.  
 

What is accelerated depreciation?

Accelerated depreciation is an accounting treatment through which the value of assets is reduced more quickly during the early years of their useful life.

It is particularly important in supporting the growth and expansion of companies, especially startups and small businesses, by allowing higher tax deductions in the early years.  
 

Why is depreciation added back in the cash flow statement?

Depreciation is added back in the cash flow statement because it is a non-cash expense. Therefore, when preparing the cash flow statement using the indirect method, depreciation is added to show the cash flow generated from operating activities.  
 

What is the difference between depreciation and amortization?

The difference lies in the type of fixed assets involved. Depreciation is used to express the decline in value of tangible assets such as buildings and equipment, while amortization is used to describe the decline in value of intangible assets such as patents, trademarks, and intellectual property rights.  
 

Is depreciation the same as depletion?

Yes, both depreciation and depletion refer to a reduction in asset value. However, depreciation generally reflects a decrease in asset value due to use, while depletion refers to the decline in value due to aging, obsolescence, or lack of use.  
 

Summary

The term depreciation is used to describe an accounting method through which the decline in the value of fixed assets over their productive life is measured. In practice, asset depreciation can be calculated using several methods, such as the units of production method, straight-line method, declining balance method, and others. 

Depreciation calculations depend on various elements, including the asset’s cost and its expected productive life. The concept of depreciation is often associated with amortization, which also refers to changes in asset value but applies specifically to intangible assets.