Basic Accounting: What is Depreciation Expense?

Mention depreciation in front of the vast majority of the American public, and expressions of distaste right on down to a pure dislike of the word, will emerge. For the majority of the public, however, depreciation never applies to their situation, except when the get ready to trade their vehicle and it has depreciated too much for their liking.

What is depreciation, and why does it produce the looks of drinking soured milk? Depreciation is defined as the decline in value, according to the book value of the asset, over a specific period of time. The reason for the looks of disgust and dismay is the fact that depreciation can be very confusing, even for the most learned individual, sometimes even an accountant.

The many ways that we depreciate assets, the manner in which we account for that decline in value, and the variance between book value and actual resale value, make for a very confusing equation. For the depreciation section of accounting, you really need to be a mathematician, also. For only could a true numbers person find any joy in the calculation and computation of depreciation. Since we’re addressing the masses with this article, we’re going to keep depreciation as simple as possible. The purpose here is to provide an understanding, not an attempt to teach you accounting.

A simple understanding of depreciation works best if you can relate to mechanics and machinery. You purchase a lawn mower for $50 in the summer of 04. If you’re going to use straight-line depreciation, that lawn mower will decline in value the same amount every year over its expected life. If it’s supposed to last 5 years, it will lose $10 (or 20%) in value every year.

If you use what’s called the declining balance method, this one is a little more confusing. You double the straight line percentage. If the life of the mower is 5 years, the percentage would then be 40%. The next year, you would take the original value of $50, subtract the first year’s depreciation of $20, and then begin the calculation of depreciation at 40%.

Depreciation is not quite as confusing as it would first seem, if you simply follow the step-by-step methods I’ve discussed above. Dissecting a process often makes it much simpler, and more easily understood. Why would you want to understand how to depreciate? That answer should already be apparent: you need to know how to correctly asses the value of your equipment. Understanding how to value your assets is helpful in determining your net worth, but also in the process of establishing actual resale values. If you’re not prepared to correctly assess the value of an asset, how can you possibly be sure you’re getting a fair market price?

The other form of depreciation that we are not going to address here is for the purpose of figuring the tax allowance on asset depreciation and it is known as Modified Accelerated Cost Recovery System or MACRS. This is not a true method of actual asset depreciation, and would concern only your tax preparer, not your daily bookkeeping records.

Categories Accounting

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