## 11.3 Explain and Apply Depreciation Methods to Allocate Capitalized Costs

In this section, we concentrate on the major characteristics of determining capitalized costs and some of the options for allocating these costs on an annual basis using the depreciation process. In the determination of capitalized costs, we do not consider just the initial cost of the asset; instead, we determine all of the costs necessary to place the asset into service. For example, if our company purchased a drill press for \$22,000, and spent \$2,500 on sales taxes and \$800 for delivery and setup, the depreciation calculation would be based on a cost of \$22,000 plus \$2,500 plus \$800, for a total cost of \$25,300.

We also address some of the terminology used in depreciation determination that you want to familiarize yourself with. Finally, in terms of allocating the costs, there are alternatives that are available to the company. We consider three of the most popular options, the straight-line method , the units-of-production method , and the double-declining-balance method .

## Calculating Depreciation Costs

Liam buys his silk screen machine for \$10,000. He estimates that he can use this machine for five years or 100,000 presses, and that the machine will only be worth \$1,000 at the end of its life. He also estimates that he will make 20,000 clothing items in year one and 30,000 clothing items in year two. Determine Liam’s depreciation costs for his first two years of business under straight-line, units-of-production, and double-declining-balance methods. Also, record the journal entries.

Straight-line method : (\$10,000 – \$1,000)/5 = \$1,800 per year for both years.

Units-of-production method : (\$10,000 – \$1,000)/100,000= \$0.09 per press

Year 1 expense: \$0.09 × 20,000 = \$1,800

Year 2 expense: \$0.09 × 30,000 = \$2,700

Double-declining-balance method :

Year 1 expense: [(\$10,000 – 0)/5] × 2 = \$4,000

Year 2 expense: [(\$10,000 – \$4,000)/5] × 2 = \$2,400

## Fundamentals of Depreciation

As you have learned, when accounting for a long-term fixed asset, we cannot simply record an expense for the cost of the asset and record the entire outflow of cash in one accounting period. Like all other assets, when purchasing or acquiring a long-term asset, it must be recorded at the historical (initial) cost, which includes all costs to acquire the asset and put it into use. The initial recording of an asset has two steps:

• Record the initial purchase on the date of purchase, which places the asset on the balance sheet (as property, plant, and equipment) at cost, and record the amount as notes payable, accounts payable, or an outflow of cash.
• At the end of the period, make an adjusting entry to recognize the depreciation expense. Companies may record depreciation expense incurred annually, quarterly, or monthly.

Following GAAP and the expense recognition principle, the depreciation expense is recognized over the asset’s estimated useful life.

## Recording the Initial Purchase of an Asset

Assets are recorded on the balance sheet at cost, meaning that all costs to purchase the asset and to prepare the asset for operation should be included. Costs outside of the purchase price may include shipping, taxes, installation, and modifications to the asset.

The journal entry to record the purchase of a fixed asset (assuming that a note payable is used for financing and not a short-term account payable) is shown here.

Applying this to Liam’s silk-screening business, we learn that he purchased his silk-screening machine for \$5,000 by paying \$1,000 cash and the remainder in a note payable over five years. The journal entry to record the purchase is shown here.

## Concepts In Practice

Estimating useful life and salvage value.

Useful life and salvage value are estimates made at the time an asset is placed in service. It is common and expected that the estimates are inaccurate with the uncertainty involved in estimating the future. Sometimes, however, a company may attempt to take advantage of estimating salvage value and useful life to improve earnings. A larger salvage value and longer useful life decrease annual depreciation expense and increase annual net income. An example of this behavior is Waste Management , which was disciplined by the Securities and Exchange Commission for fraudulently altering its estimates to reduce depreciation expense and overstate net income by \$1.7 billion. 6

## Components Used in Calculating Depreciation

The expense recognition principle that requires that the cost of the asset be allocated over the asset’s useful life is the process of depreciation. For example, if we buy a delivery truck to use for the next five years, we would allocate the cost and record depreciation expense across the entire five-year period. The calculation of the depreciation expense for a period is not based on anticipated changes in the fair market value of the asset; instead, the depreciation is based on the allocation of the cost of owning the asset over the period of its useful life.

The following items are important in determining and recording depreciation:

• Book value : the asset’s original cost less accumulated depreciation.
• Useful life : the length of time the asset will be productively used within operations.
• Salvage (residual) value : the price the asset will sell for or be worth as a trade-in when its useful life expires. The determination of salvage value can be an inexact science, since it requires anticipating what will occur in the future. Often, the salvage value is estimated based on past experiences with similar assets.
• Depreciable base (cost) : the depreciation expense over the asset’s useful life. For example, if we paid \$50,000 for an asset and anticipate a salvage value of \$10,000, the depreciable base is \$40,000. We expect \$40,000 in depreciation over the time period in which the asset was used, and then it would be sold for \$10,000.

Depreciation records an expense for the value of an asset consumed and removes that portion of the asset from the balance sheet. The journal entry to record depreciation is shown here.

Depreciation expense is a common operating expense that appears on an income statement. Accumulated depreciation is a contra account , meaning it is attached to another account and is used to offset the main account balance that records the total depreciation expense for a fixed asset over its life. In this case, the asset account stays recorded at the historical value but is offset on the balance sheet by accumulated depreciation. Accumulated depreciation is subtracted from the historical cost of the asset on the balance sheet to show the asset at book value. Book value is the amount of the asset that has not been allocated to expense through depreciation.

In this case, the asset’s book value is \$20,000: the historical cost of \$25,000 less the accumulated depreciation of \$5,000.

It is important to note, however, that not all long-term assets are depreciated. For example, land is not depreciated because depreciation is the allocating of the expense of an asset over its useful life. How can one determine a useful life for land? It is assumed that land has an unlimited useful life; therefore, it is not depreciated, and it remains on the books at historical cost.

Once it is determined that depreciation should be accounted for, there are three methods that are most commonly used to calculate the allocation of depreciation expense: the straight-line method , the units-of-production method , and the double-declining-balance method . A fourth method, the sum-of-the-years-digits method, is another accelerated option that has been losing popularity and can be learned in intermediate accounting courses. Let’s use the following scenario involving Kenzie Company to work through these three methods.

Assume that on January 1, 2019, Kenzie Company bought a printing press for \$54,000. Kenzie pays shipping costs of \$1,500 and setup costs of \$2,500, assumes a useful life of five years or 960,000 pages. Based on experience, Kenzie Company anticipates a salvage value of \$10,000.

Recall that determination of the costs to be depreciated requires including all costs that prepare the asset for use by the company. The Kenzie example would include shipping and setup costs. Any costs for maintaining or repairing the equipment would be treated as regular expenses, so the total cost would be \$58,000, and, after allowing for an anticipated salvage value of \$10,000 in five years, the business could take \$48,000 in depreciation over the machine’s economic life.

## Fixed Assets

You work for Georgia-Pacific as an accountant in charge of the fixed assets subsidiary ledger at a production and warehouse facility in Pennsylvania. The facility is in the process of updating and replacing several asset categories, including warehouse storage units, fork trucks, and equipment on the production line. It is your job to keep the information in the fixed assets subsidiary ledger up to date and accurate. You need information on original historical cost, estimated useful life, salvage value, depreciation methods, and additional capital expenditures. You are excited about the new purchases and upgrades to the facility and how they will help the company serve its customers better. However, you have been in your current position for only a few years and have never overseen extensive updates, and you realize that you will have to gather a lot of information at once to keep the accounting records accurate. You feel overwhelmed and take a minute to catch your breath and think through what you need. After a few minutes, you realize that you have many people and many resources to work with to tackle this project. Whom will you work with and how will you go about gathering what you need?

## Straight-Line Depreciation

Straight-line depreciation is a method of depreciation that evenly splits the depreciable amount across the useful life of the asset. Therefore, we must determine the yearly depreciation expense by dividing the depreciable base of \$48,000 by the economic life of five years, giving an annual depreciation expense of \$9,600. The journal entries to record the first two years of expenses are shown, along with the balance sheet information. Here are the journal entry and information for year one:

After the journal entry in year one, the press would have a book value of \$48,400. This is the original cost of \$58,000 less the accumulated depreciation of \$9,600. Here are the journal entry and information for year two:

Kenzie records an annual depreciation expense of \$9,600. Each year, the accumulated depreciation balance increases by \$9,600, and the press’s book value decreases by the same \$9,600. At the end of five years, the asset will have a book value of \$10,000, which is calculated by subtracting the accumulated depreciation of \$48,000 (5 × \$9,600) from the cost of \$58,000.

## Units-of-Production Depreciation

Straight-line depreciation is efficient, accounting for assets used consistently over their lifetime, but what about assets that are used with less regularity? The units-of-production depreciation method bases depreciation on the actual usage of the asset, which is more appropriate when an asset’s life is a function of usage instead of time. For example, this method could account for depreciation of a printing press for which the depreciable base is \$48,000 (as in the straight-line method), but now the number of pages the press prints is important.

In our example, the press will have total depreciation of \$48,000 over its useful life of 960,000 pages. Therefore, we would divide \$48,000 by 960,000 pages to get a cost per page of \$0.05. If Kenzie printed 180,000 pages in the first year, the depreciation expense would be 180,000 pages × \$0.05 per page, or \$9,000. The journal entry to record this expense would be the same as with straight-line depreciation: only the dollar amount would have changed. The presentation of accumulated depreciation and the calculation of the book value would also be the same. Kenzie would continue to depreciate the asset until a total of \$48,000 in depreciation was taken after printing 960,000 total pages.

## Think It Through

Deciding on a depreciation method.

Liam is struggling to determine which deprecation method he should use for his new silk-screening machine. He expects sales to increase over the next five years. He also expects (hopes) that in two years he will need to buy a second silk-screening machine to keep up with the demand for products of his growing company. Which depreciation method makes more sense for Liam: higher expenses in the first few years, or keeping expenses consistent over time? Or would it be better for him to not think in terms of time, but rather in the usage of the machine?

## Double-Declining-Balance Depreciation

The double-declining-balance depreciation method is the most complex of the three methods because it accounts for both time and usage and takes more expense in the first few years of the asset’s life. Double-declining considers time by determining the percentage of depreciation expense that would exist under straight-line depreciation. To calculate this, divide 100% by the estimated life in years. For example, a five-year asset would be 100/5, or 20% a year. A four-year asset would be 100/4, or 25% a year. Next, because assets are typically more efficient and “used” more heavily early in their life span, the double-declining method takes usage into account by doubling the straight-line percentage. For a four-year asset, multiply 25% (100%/4-year life) × 2, or 50%. For a five-year asset, multiply 20% (100%/5-year life) × 2, or 40%.

One unique feature of the double-declining-balance method is that in the first year, the estimated salvage value is not subtracted from the total asset cost before calculating the first year’s depreciation expense. Instead the total cost is multiplied by the calculated percentage. However, depreciation expense is not permitted to take the book value below the estimated salvage value, as demonstrated in the following text.

Notice that in year four, the remaining book value of \$12,528 was not multiplied by 40%. This is because the expense would have been \$5,011.20, and since we cannot depreciate the asset below the estimated salvage value of \$10,000, the expense cannot exceed \$2,528, which is the amount left to depreciate (difference between the book value of \$12,528 and the salvage value of \$10,000). Since the asset has been depreciated to its salvage value at the end of year four, no depreciation can be taken in year five.

In our example, the first year’s double-declining-balance depreciation expense would be \$58,000 × 40%, or \$23,200. For the remaining years, the double-declining percentage is multiplied by the remaining book value of the asset. Kenzie would continue to depreciate the asset until the book value and the estimated salvage value are the same (in this case \$10,000).

The net effect of the differences in straight-line depreciation versus double-declining-balance depreciation is that under the double-declining-balance method, the allowable depreciation expenses are greater in the earlier years than those allowed for straight-line depreciation. However, over the depreciable life of the asset, the total depreciation expense taken will be the same, no matter which method the entity chooses. For example, in the current example both straight-line and double-declining-balance depreciation will provide a total depreciation expense of \$48,000 over its five-year depreciable life.

## IFRS Connection

Accounting for depreciation.

Both US GAAP and International Financial Reporting Standards (IFRS) account for long-term assets (tangible and intangible) by recording the asset at the cost necessary to make the asset ready for its intended use. Additionally, both sets of standards require that the cost of the asset be recognized over the economic, useful, or legal life of the asset through an allocation process such as depreciation. However, there are some significant differences in how the allocation process is used as well as how the assets are carried on the balance sheet.

IFRS and US GAAP allow companies to choose between different methods of depreciation, such as even allocation (straight-line method), depreciation based on usage (production methods), or an accelerated method (double-declining balance). The mechanics of applying these methods do not differ between the two standards. However, IFRS requires companies to use “component depreciation” if it is feasible. Component depreciation would apply to assets with components that have differing lives. Consider the following example using a plane owned by Southwest Airlines . Let’s divide this plane into three components: the interior, the engines, and the fuselage. Suppose the average life of the interior of a plane is ten years, the average life of the engines is fifteen years, and the average life of the fuselage is twenty-five years. Given this, what should be the depreciable life of the asset? In that case, under IFRS, the costs associated with the interior would be depreciated over ten years, the costs associated with the engines would be depreciated over fifteen years, and the costs associated with the fuselage would be depreciated over twenty-five years. Under US GAAP, the total cost of the airplane would likely be depreciated over twenty years. Obviously, component depreciation involves more record keeping and differing amounts of depreciation per year for the life of the asset. But the same amount of total depreciation, the cost of the asset less residual value, would be taken over the life of the asset under both US GAAP and IFRS.

Probably one of the most significant differences between IFRS and US GAAP affects long-lived assets. This is the ability, under IFRS, to adjust the value of those assets to their fair value as of the balance sheet date. The adjustment to fair value is to be done by “class” of asset, such as real estate, for example. A company can adjust some classes of assets to fair value but not others. Under US GAAP, almost all long-lived assets are carried on the balance sheet at their depreciated historical cost, regardless of how the actual fair value of the asset changes. Consider the following example. Suppose your company owns a single building that you bought for \$1,000,000. That building currently has \$200,000 in accumulated depreciation. This building now has a book value of \$800,000. Under US GAAP, this is how this building would appear in the balance sheet. Even if the fair value of the building is \$875,000, the building would still appear on the balance sheet at its depreciated historical cost of \$800,000 under US GAAP. Alternatively, if the company used IFRS and elected to carry real estate on the balance sheet at fair value, the building would appear on the company’s balance sheet at its new fair value of \$875,000.

It is difficult to determine an accurate fair value for long-lived assets. This is one reason US GAAP has not permitted the fair valuing of long-lived assets. Different appraisals can result in different determinations of “fair value.” Thus, the Financial Accounting Standards Board (FASB) elected to continue with the current method of carrying assets at their depreciated historical cost. The thought process behind the adjustments to fair value under IFRS is that fair value more accurately represents true value. Even if the fair value reported is not known with certainty, reporting the class of assets at a reasonable representation of fair value enhances decision-making by users of the financial statements.

## Summary of Depreciation

Table 11.2 compares the three methods discussed. Note that although each time-based (straight-line and double-declining balance) annual depreciation expense is different, after five years the total amount depreciated (accumulated depreciation) is the same. This occurs because at the end of the asset’s useful life, it was expected to be worth \$10,000: thus, both methods depreciated the asset’s value by \$48,000 over that time period.

The units of production method is different from the two above methods in that while those methods are based on time factors, the units of production is based on usage. However, the total amount of depreciation taken over an asset’s economic life will still be the same. In our example, the total depreciation will be \$48,000, even though the sum-of-the-years-digits method could take only two or three years or possibly six or seven years to be allocated.

## Ethical Considerations

Depreciation analysis requires careful evaluation.

When analyzing depreciation, accountants are required to make a supportable estimate of an asset’s useful life and its salvage value. However, “management teams typically fail to invest either time or attention into making or periodically revisiting and revising reasonably supportable estimates of asset lives or salvage values, or the selection of depreciation methods, as prescribed by GAAP.” 7 This failure is not an ethical approach to properly accounting for the use of assets.

Accountants need to analyze depreciation of an asset over the entire useful life of the asset. As an asset supports the cash flow of the organization, expensing its cost needs to be allocated, not just recorded as an arbitrary calculation. An asset’s depreciation may change over its life according to its use. If asset depreciation is arbitrarily determined, the recorded “gains or losses on the disposition of depreciable property assets seen in financial statements” 8 are not true best estimates. Due to operational changes, the depreciation expense needs to be periodically reevaluated and adjusted.

Any mischaracterization of asset usage is not proper GAAP and is not proper accrual accounting. Therefore, “financial statement preparers, as well as their accountants and auditors, should pay more attention to the quality of depreciation-related estimates and their possible mischaracterization and losses of credits and charges to operations as disposal gains.” 9 An accountant should always follow GAAP guidelines and allocate the expense of an asset according to its usage.

## Partial-Year Depreciation

A company will usually only own depreciable assets for a portion of a year in the year of purchase or disposal. Companies must be consistent in how they record depreciation for assets owned for a partial year. A common method is to allocate depreciation expense based on the number of months the asset is owned in a year. For example, a company purchases an asset with a total cost of \$58,000, a five-year useful life, and a salvage value of \$10,000. The annual depreciation is \$9,600 ([\$58,000 – 10,000]/5). However, the asset is purchased at the beginning of the fourth month of the fiscal year. The company will own the asset for nine months of the first year. The depreciation expense of the first year is \$7,200 (\$9,600 × 9/12). The company will depreciate the asset \$9,600 for the next four years, but only \$2,400 in the sixth year so that the total depreciation of the asset over its useful life is the depreciable amount of \$48,000 (\$7,200 + 9,600 + 9,600 + 9,600 + 9,600 + 2,400).

## Choosing Appropriate Depreciation Methods

You are part of a team reviewing the financial statements of a new computer company. Looking over the fixed assets accounts, one long-term tangible asset sticks out. It is labeled “USB” and valued at \$10,000. You ask the company’s accountant for more detail, and he explains that the asset is a USB drive that holds the original coding for a game the company developed during the year. The company expects the game to be fairly popular for the next few years, and then sales are expected to trail off. Because of this, they are planning on depreciating this asset over the next five years using the double-declining method. Does this recording seem appropriate, or is there a better way to categorize the asset? How should this asset be expensed over time?

## Special Issues in Depreciation

While you’ve now learned the basic foundation of the major available depreciation methods, there are a few special issues. Until now, we have assumed a definite physical or economically functional useful life for the depreciable assets. However, in some situations, depreciable assets can be used beyond their useful life. If so desired, the company could continue to use the asset beyond the original estimated economic life. In this case, a new remaining depreciation expense would be calculated based on the remaining depreciable base and estimated remaining economic life.

Assume in the earlier Kenzie example that after five years and \$48,000 in accumulated depreciation, the company estimated that it could use the asset for two more years, at which point the salvage value would be \$0. The company would be able to take an additional \$10,000 in depreciation over the extended two-year period, or \$5,000 a year, using the straight-line method.

As with the straight-line example, the asset could be used for more than five years, with depreciation recalculated at the end of year five using the double-declining balance method. While the process of calculating the additional depreciation for the double-declining-balance method would differ from that of the straight-line method, it would also allow the company to take an additional \$10,000 after year five, as with the other methods, so long as the cost of \$58,000 is not exceeded.

As a side note, there often is a difference in useful lives for assets when following GAAP versus the guidelines for depreciation under federal tax law, as enforced by the Internal Revenue Service (IRS). This difference is not unexpected when you consider that tax law is typically determined by the United States Congress, and there often is an economic reason for tax policy.

For example, if we want to increase investment in real estate, shortening the economic lives of real estate for taxation calculations can have a positive increasing effect on new construction. If we want to slow down new production, extending the economic life can have the desired slowing effect. In this course, we concentrate on financial accounting depreciation principles rather than tax depreciation.

## Fundamentals of Depletion of Natural Resources

Another type of fixed asset is natural resources , assets a company owns that are consumed when used. Examples include lumber, mineral deposits, and oil/gas fields. These assets are considered natural resources while they are still part of the land; as they are extracted from the land and converted into products, they are then accounted for as inventory (raw materials). Natural resources are recorded on the company’s books like a fixed asset, at cost, with total costs including all expenses to acquire and prepare the resource for its intended use.

As the resource is consumed (converted to a product), the cost of the asset must be expensed: this process is called depletion . As with depreciation of nonnatural resource assets, a contra account called accumulated depletion , which records the total depletion expense for a natural resource over its life, offsets the natural resource asset account. Depletion expense is typically calculated based on the number of units extracted from cutting, mining, or pumping the resource from the land, similar to the units-of-production method. For example, assume a company has an oil well with an estimated 10,000 gallons of crude oil. The company purchased this well for \$1,000,000, and the well is expected to have no salvage value once it is pumped dry. The depletion cost per gallon will be \$1,000,000/10,000 = \$100. If the company extracts 4,000 gallons of oil in a given year, the depletion expense will be \$400,000.

## Fundamentals of Amortization of an Intangible

Recall that intangible assets are recorded as long-term assets at their cost. As with tangible assets, many intangible assets have a finite (limited) life span so their costs must be allocated over their useful lives: this process is amortization . Depreciation and amortization are similar in nature but have some important differences. First, amortization is typically only done using the straight-line method. Second, there is usually no salvage value for intangible assets because they are completely used up over their life span. Finally, an accumulated amortization account is not required to record yearly expenses (as is needed with depreciation); instead, the intangible asset account is written down each period.

For example, a company called Patents-R-Us purchased a product patent for \$10,000, granting the company exclusive use of that product for the next twenty years. Therefore, unless the company does not think the product will be useful for all twenty years (at that point the company would use the shorter useful life of the product), the company will record amortization expense of \$500 a year (\$10,000/20 years). Assuming that it was placed into service on October 1, 2019, the journal entry would be as follows:

See Form 10-K that was filed with the SEC to determine which depreciation method McDonald’s Corporation used for its long-term assets in 2017.

• 6 U.S. Securities and Exchange Commission. “Judge Enters Final Judgment against Former CFO of Waste Management, Inc. Following Jury Verdict in SEC’s Favor.” January 3, 2008. https://www.sec.gov/news/press/2008/2008-2.htm
• 7 Howard B. Levy. “Depreciable Asset Lives.” The CPA Journal . September 2016. https://www.cpajournal.com/2016/09/08/depreciable-asset-lives/
• 8 Howard B. Levy. “Depreciable Asset Lives.” The CPA Journal . September 2016. https://www.cpajournal.com/2016/09/08/depreciable-asset-lives/
• 9 Howard B. Levy. “Depreciable Asset Lives.” The CPA Journal . September 2016. https://www.cpajournal.com/2016/09/08/depreciable-asset-lives/

As an Amazon Associate we earn from qualifying purchases.

This book may not be used in the training of large language models or otherwise be ingested into large language models or generative AI offerings without OpenStax's permission.

Want to cite, share, or modify this book? This book uses the Creative Commons Attribution-NonCommercial-ShareAlike License and you must attribute OpenStax.

• Authors: Mitchell Franklin, Patty Graybeal, Dixon Cooper
• Publisher/website: OpenStax
• Book title: Principles of Accounting, Volume 1: Financial Accounting
• Publication date: Apr 11, 2019
• Location: Houston, Texas
• Book URL: https://openstax.org/books/principles-financial-accounting/pages/1-why-it-matters
• Section URL: https://openstax.org/books/principles-financial-accounting/pages/11-3-explain-and-apply-depreciation-methods-to-allocate-capitalized-costs

© Dec 13, 2023 OpenStax. Textbook content produced by OpenStax is licensed under a Creative Commons Attribution-NonCommercial-ShareAlike License . The OpenStax name, OpenStax logo, OpenStax book covers, OpenStax CNX name, and OpenStax CNX logo are not subject to the Creative Commons license and may not be reproduced without the prior and express written consent of Rice University.

## Written by True Tamplin, BSc, CEPF®

Reviewed by subject matter experts.

Updated on March 06, 2023

## Fact Checked

Why Trust Finance Strategists?

Depreciation: definition.

Depreciation is the reduction in the value of a fixed asset due to usage, wear and tear, the passage of time, or obsolescence.

The loss on an asset that arises from depreciation is a direct consequence of the services that the asset gives to its owner.

Therefore, a reasonable assumption is that the loss in the value of a fixed asset in a period is the worth of the service provided by that asset over that period.

From an accounting perspective, depreciation is the process of converting fixed assets into expenses . Also, depreciation is the systematic allocation of the cost of noncurrent , nonmonetary , tangible assets (except for land) over their estimated useful life.

## Depreciation: Explanation

Depreciation is a systematic procedure for allocating the acquisition cost of a capital asset over its useful life.

Capital assets such as buildings, machinery, and equipment are useful to a company for a limited number of years. The entire cost of a capital asset is not charged to any one year as an expense; rather the cost is spread over the useful life of the asset.

Thus, the cost of the asset is charged as an expense to the periods that benefit from the use of the asset. The part of the cost that is charged to operation during an accounting period is known as depreciation.

Hence, the objective of depreciation is to achieve the matching principle (i.e., to offset the costs of the goods and services being consumed in an accounting period with the period's revenue , thereby determining the profit or loss made by the business ).

## Depreciation Accounting

Depreciation accounting is a system of accounting that aims to distribute the cost (or other basic values) of tangible capital assets less its scrap value over the effective life of the asset. Thus, depreciation is a process of allocation and not valuation.

The expenditure on the purchase of machinery is not regarded as part of the cost of the period; instead, it is shown as an asset in the balance sheet .

The expenditure incurred on the purchase of a fixed asset is known as a capital expense . Capital expenditure is a fixed asset that is charged off as depreciation over a period of years.

The decisions that are made about how much depreciation to charge off are influenced by the accountant's judgment.

## Measuring Depreciation

To measure the depreciation of an asset, the following must be known:

• Cost of asset
• Estimated residual value
• Estimated useful life

The purchase price of an asset is its cost plus all other expenses paid to acquire and prepare the asset to ensure it is ready for use.

Estimated residual value is also known as the salvage value or scrap value. This is the expected value of the asset in cash at the end of its useful life.

When calculating depreciation, the estimated residual value is not depreciation because the business can expect to receive this amount from selling off the asset.

The cost of the asset minus its residual value is called the depreciable cost of the asset. The depreciable cost is allocated over the useful life of the asset. However, if the asset is expected not to have residual value, the full cost of the asset is depreciated.

Estimated useful life is the number of years of service the business expects to receive from the asset.

## Causes of Depreciation

The causes of depreciation include physical deterioration and obsolescence. An overview of the main causes is given below.

## Physical Deterioration

Assets decline in value due to use and wear and tear. All assets have a useful life and every machine eventually reaches a time when it must be decommissioned, irrespective of how effective the organization's maintenance policy is.

## Obsolescence

An asset may become obsolete due to better designs, new inventions, or simply changing fashions. This may result in the asset being discarded even though it is still useful and in excellent physical condition.

An asset may be exhausted through work. This is the case for mineral mines, oil wells, and other similar assets. Due to the continuous extraction of minerals or oil, a point comes when the mine or well is completely exhausted—nothing is left.

Therefore, after a certain period, the value of the exhausted asset will be zero.

## Efflux of Time

The value of certain assets falls with the passage of time. Leasehold properties, patents , and copyrights are examples of such assets.

## Depreciation Is a Process of Cost Allocation

Depreciation is allocated over the useful life of an asset based on the book value of the asset originally entered in the books of accounts.

The market value of the asset may increase or decrease during the useful life of the asset. However, the allocation of depreciation in each accounting period continues on the basis of the book value without regard to such temporary changes.

Also, depreciation expense is merely a book entry and represents a " non-cash" expense . Therefore, depreciation is a process of cost allocation —not of valuation .

Suppose that a company purchases a weighing machine for \$1,000. After a year's use, the value of the machine is assessed at \$800.

In this example, we can say that the service given by the weighing machine in its first year of life was \$200 (\$1,000 - \$800) to the company.

It is in this sense that depreciation is considered a normal business expense and, consequently, treated in the books of account in more or less the same way as any other expense.

Fixed assets lose value throughout their useful life—every minute, every hour, and every day. It would, however, be impractical (and of no great benefit) to calculate and re-calculate the extent of this loss over short periods (e.g., every month).

As business accounts are usually prepared on an annual basis, it is common to calculate depreciation only once at the end of each financial year.

## Methods of Calculating Depreciation

There are three popular ways to calculate depreciation. These are:

• Fixed installment method
• Reducing installment method
• Revaluation method

## Depreciation FAQs

Why should depreciation be calculated.

The purpose of Depreciation is to allocate the cost of non-current assets over their useful life. This allocation is reflected in periodic expense entries. These expense entries reduce taxable income each year and hence result in tax savings. (Note: Taxable income = Net profit + Depreciation)

## What is a useful life?

The concept of useful life represents the period beyond which it would not be practical to use an asset anymore. Useful life is not equivalent to physical life.

## What if the useful life of an asset is short?

If the useful life is short, then calculated Depreciation will also be less in the early accounting periods. This means that there will be a large difference between tax expense and taxable income at the beginning of the accounting period. Because large losses are realized early, the tax benefit will be spread over a longer period.

## What is the difference between depreciation and amortization?

Amortization results from a systematic reduction in value of certain assets that have limited useful lives, such as intangible assets. Depreciation occurs when a non-current asset loses value due to use or passage of time. Depreciation does not result from any systematic approach but occurs naturally through the passage of time.

## What is an accounting loss?

An accounting loss results from expensing a revenue-generating asset instead of capitalizing it and thus, not creating any future value for the company. In this event, the book value of the asset becomes smaller each year. The accumulated Depreciation account will show a debit balance as a result.

## True Tamplin, BSc, CEPF®

True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.

True is a Certified Educator in Personal Finance (CEPF®), author of The Handy Financial Ratios Guide , a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University , where he received a bachelor of science in business and data analytics.

To learn more about True, visit his personal website or view his author profiles on Amazon , Nasdaq and Forbes .

## Our Services

• Estate Planning Lawyer
• Insurance Broker
• Mortgage Broker
• Retirement Planning
• Tax Services
• Wealth Management

## Ask a Financial Professional Any Question

We use cookies to ensure that we give you the best experience on our website. If you continue to use this site we will assume that you are happy with it.

At Finance Strategists, we partner with financial experts to ensure the accuracy of our financial content.

Our team of reviewers are established professionals with decades of experience in areas of personal finance and hold many advanced degrees and certifications.

They regularly contribute to top tier financial publications, such as The Wall Street Journal, U.S. News & World Report, Reuters, Morning Star, Yahoo Finance, Bloomberg, Marketwatch, Investopedia, TheStreet.com, Motley Fool, CNBC, and many others.

This team of experts helps Finance Strategists maintain the highest level of accuracy and professionalism possible.

## Why You Can Trust Finance Strategists

Finance Strategists is a leading financial education organization that connects people with financial professionals, priding itself on providing accurate and reliable financial information to millions of readers each year.

We follow strict ethical journalism practices, which includes presenting unbiased information and citing reliable, attributed resources.

Our goal is to deliver the most understandable and comprehensive explanations of financial topics using simple writing complemented by helpful graphics and animation videos.

Our writing and editorial staff are a team of experts holding advanced financial designations and have written for most major financial media publications. Our work has been directly cited by organizations including Entrepreneur, Business Insider, Investopedia, Forbes, CNBC, and many others.

Our mission is to empower readers with the most factual and reliable financial information possible to help them make informed decisions for their individual needs.

## How It Works

Step 1 of 3, ask any financial question.

Ask a question about your financial situation providing as much detail as possible. Your information is kept secure and not shared unless you specify.

## Step 2 of 3

Our team will connect you with a vetted, trusted professional.

Someone on our team will connect you with a financial professional in our network holding the correct designation and expertise.

## Step 3 of 3

A financial professional will offer guidance based on the information provided and offer a no-obligation call to better understand your situation.

## Just a Few More Details

We need just a bit more info from you to direct your question to the right person.

## Tell Us More About Yourself

Is there any other context you can provide.

Pro tip: Professionals are more likely to answer questions when background and context is given. The more details you provide, the faster and more thorough reply you'll receive.

Are you married, do you own your home.

• Owned outright
• Owned with a mortgage

## Do you have any children under 18?

• Yes, 3 or more

## What is the approximate value of your cash savings and other investments?

• \$50k - \$250k
• \$250k - \$1m

Pro tip: A portfolio often becomes more complicated when it has more investable assets. Please answer this question to help us connect you with the right professional.

## Would you prefer to work with a financial professional remotely or in-person?

• I would prefer remote (video call, etc.)
• I would prefer in-person
• I don't mind, either are fine

• I'm not in the U.S.

## Part 1: Tell Us More About Yourself

Do you own a business, which activity is most important to you during retirement.

• Giving back / charity
• Spending time with family and friends
• Pursuing hobbies

## Part 2: Your Current Nest Egg

Part 3: confidence going into retirement, how comfortable are you with investing.

• Very comfortable
• Somewhat comfortable
• Not comfortable at all

## How confident are you in your long term financial plan?

• Very confident
• Somewhat confident
• Not confident / I don't have a plan

## What is your risk tolerance?

How much are you saving for retirement each month.

• None currently
• Minimal: \$50 - \$200
• Steady Saver: \$200 - \$500
• Serious Planner: \$500 - \$1,000
• Aggressive Saver: \$1,000+

## How much will you need each month during retirement?

• Bare Necessities: \$1,500 - \$2,500
• Moderate Comfort: \$2,500 - \$3,500
• Comfortable Lifestyle: \$3,500 - \$5,500
• Affluent Living: \$5,500 - \$8,000
• Luxury Lifestyle: \$8,000+

What is your current financial priority.

• Getting out of debt
• Growing my wealth
• Protecting my wealth

Which of these is most important for your financial advisor to have.

• Tax planning expertise
• Investment management expertise
• Estate planning expertise
• None of the above

Submit to get your retirement-readiness report., get in touch with, great the financial professional will get back to you soon., where should we send the downloadable file, great hit “submit” and an advisor will send you the guide shortly., create a free account and ask any financial question, learn at your own pace with our free courses.

Take self-paced courses to master the fundamentals of finance and connect with like-minded individuals.

## Get Started

We want to make sure that all of our readers get their questions answered.

## Great, Want to Test Your Knowledge of This Lesson?

Create an Account to Test Your Knowledge of This Topic and Thousands of Others.

Create a free account and submit your question. We'll make sure a financial professional gets back to you shortly.

## To Ensure One Vote Per Person, Please Include the Following Info

Great thank you for voting..

## The Comprehensive Guide to Cost Allocation in Accounting

Accounting is a fascinating field, and cost allocation is one of the most important concepts in accounting. Whether you’re an accounting student or an accountant just starting out, it’s important to understand how to allocate costs.

In this comprehensive guide, we’ll cover everything from what it means to its pros and cons.

## How Can Costs Be Allocated Among Departments or Product Lines When There Is No Clear Source?

Allocation is distributing costs among different departments or product lines in an organization. Trying to accurately estimate the cost of producing a good or rendering a service is a common challenge for many businesses.

This is especially true when there is no apparent source of the costs, as it requires the use of various techniques and methods to distribute the expenses fairly and reasonably.

## What Is the Concept of Allocation?

Allocation (also known as “cost allocation”) is a process used to distribute the costs of a shared resource or expense among different departments, product lines, or activities within an organization.

This process is necessary to accurately determine the cost of producing a product, providing a service, or running a business. Allocation allows firms to identify the expenses incurred by each department or product line and helps make informed decisions about allocating resources.

The allocation concept has existed for centuries and is a fundamental part of modern accounting and financial management. The cost allocation process involves assigning costs to specific departments or product lines based on objective criteria, such as resource use or the benefit received from the expense.

The objective criteria used in the allocation process may vary depending on the type of business, but the goal is always to distribute the costs fairly and reasonably.

One of the main challenges of allocation is that many expenses cannot be traced directly to a specific department or product line. For example, the cost of electricity used to run a manufacturing plant cannot be directly traced to one particular product line.

In such cases, the cost of electricity must be allocated to different departments or product lines based on objective criteria, such as the number of hours each department uses the electricity or the production output of each product line.

There are different methods of allocation, each with its strengths and weaknesses. Some of the most common ways include direct allocation, step-down allocation, sequential allocation, and activity-based allocation. Each mode uses a different approach to allocating costs, but the goal is always to ensure that the costs are distributed fairly and reasonably.

## What Doesn’t the Term Allocation Mean?

The term allocation” is commonly used in various contexts, such as finance, economics, project management, and resource management. However, it’s essential to understand that allocation ” doesn’t mean “equal distribution” or “uniform distribution” of resources.

Allocation refers to assigning a portion of resources, such as time, money, or labor, to specific tasks or activities. The goal of allocation is to optimize the use of resources to achieve the desired outcomes.

One of the most common misunderstandings about allocation is that it means dividing resources equally among tasks or activities. However, this is only sometimes the case. Resources are often not distributed evenly because different tasks or activities have different requirements and priorities.

For example, in project management, some jobs may require more time, money, or labor than others. In such cases, the project manager must allocate more resources to these critical tasks to ensure the project’s success.

Another misunderstanding about allocation is that it means distributing resources inflexibly and rigidly. Allocation is a flexible process that can be adjusted based on priorities or changes in resource availability. For example, in a business setting, the budget allocation may change based on market conditions or changes in customer demand. In these situations, the business must be able to reallocate its resources to respond to these changes.

The allocation also doesn’t mean that the resources are assigned once and never adjusted. Allocation is an ongoing process requiring constant monitoring and adjustments to ensure that resources are used optimally.

For example, in finance, the allocation of investments must be reviewed regularly to ensure that the portfolio is aligned with the investor’s goals and objectives.

Another misconception about allocation is that it only applies to tangible resources, such as money or equipment. However, allocation also applies to intangible resources like time and labor. These intangible resources are often more critical and limited than tangible ones. For example, allocating time is crucial in project management to ensure that projects are completed on time and within budget.

As you can see, allocation is a complex and flexible process that requires careful consideration of multiple factors, such as resource availability, priorities, and goals. It’s essential to understand that allocation doesn’t mean equal distribution or limited distribution of resources.

Instead, it’s a dynamic process that requires ongoing monitoring and adjustments to ensure the optimal use of resources. By avoiding common misconceptions about allocation, individuals and organizations can more effectively allocate their resources and achieve their desired outcomes.

## Where the Term Allocation Originated From?

The word “allocation” comes from the Latin word “allocare.” The word allocation ” refers to setting aside or assigning a particular portion, amount, or portion of something for a specific purpose or recipient.

The allocation comes from the Latin prefix ad- (meaning “to”) and the noun loci (meaning “place”). The combination of these two words implies the idea of assigning a place, or portion of something, for a specific purpose.

In finance and economics, “allocation” refers to distributing resources, such as money, to different projects or initiatives based on their perceived importance and likelihood of success.

The allocation concept is ancient and can be traced back to the earliest civilizations, where resources were allocated based on the community’s needs. In early societies, central planning or direct control by the ruling class were common methods of allocation.

However, with the advent of market-based economies, the allocation has become more decentralized and is now primarily done through the market mechanism of supply and demand.

In modern economies, allocation is crucial in ensuring that resources are used efficiently and effectively. For example, in capital allocation, investors allocate their funds to different projects and businesses based on the perceived potential return on investment. This helps direct investment toward the most promising and profitable opportunities, thereby increasing the economy’s overall efficiency.

Similarly, prices play a crucial role in allocating goods and services in directing resources to where they are most needed. In a market economy, the interaction of supply and demand determines prices. When demand for a particular good or service is high, the price will increase, directing more resources toward its production. On the other hand, when demand is low, the price will decrease, reducing the allocation of resources to its production.

Government policies and regulations can also have an impact on allocation in addition to the market mechanism. For example, the government may allocate resources to specific sectors through funding or subsidies, such as education or healthcare.

Similarly, government regulations and taxes can also impact the allocation of resources by affecting the incentives for businesses and individuals to allocate their resources in a particular way.

## How Allocation Relates to Accounting?

In accounting, allocation determines the cost of producing a product or providing a service. This information is then used to create accurate financial statements and make informed decisions about allocating resources in the future.

For example, a company may allocate resources to a new product line based on the expected revenue it will generate or distribute costs to specific departments based on their usage of resources.

The allocation also plays a crucial role in cost accounting . Cost accounting involves analyzing the cost of production, including direct and indirect costs, and using this information to make decisions about pricing and resource allocation.

By accurately allocating costs, a company can determine the actual cost of production and make informed decisions about pricing , production volume, and resource allocation.

In addition, allocation is used to allocate the costs of long-term assets, such as property, plant, and equipment. This is done through the process of depreciation, which is a systematic allocation of the cost of an asset over its useful life. Depreciation is used to determine the value of an investment for financial reporting purposes and the amount of tax that a company must pay.

Finally, allocation is also used in the budgeting process. In budgeting, an organization allocates resources to various departments and activities based on their priorities and goals. By accurately allocating resources, a company can ensure that it has enough resources to meet its goals and objectives while staying within its budget.

## 3 Examples of Allocation Being Used in Accounting Practice

Example #1 of allocation being used in accounting practice.

Allocating the Cost of Goods Sold In accounting, “cost of goods sold” (COGS) refers to the direct costs associated with producing a product or providing a service. These costs include the raw materials, labor, and overhead expenses incurred to produce the goods. COGS is crucial in determining a company’s gross profit because it represents the cost of producing and selling a product.

One example of allocation in accounting practice is when a company allocates the cost of goods sold to each product. This is done to understand the cost of producing each product and identify the most profitable products.

The allocation process involves dividing the total COGS by the number of units sold to arrive at an average cost per unit. This average cost per unit is then applied to each unit of product sold to determine the COGS for that specific product.

This allocation process is vital because it allows the company to accurately determine the cost of producing each product. This information is then used to make informed business decisions such as pricing strategies, production decisions, and cost control measures.

For example, suppose a company realizes that the cost of producing one product is much higher than the cost of producing another. In that case, it may choose to discontinue the higher-cost product or find ways to reduce the cost of production.

## Example #2 of Allocation Being Used in Accounting Practice

One example of allocation in accounting practice is allocating indirect costs to different departments or products within a company. Indirect costs, such as rent, utilities, and office supplies, cannot be directly traced to a specific product or department. These costs must be allocated among different departments or products to calculate the cost of each accurately.

For example, consider a manufacturing company with three departments: production, research and development, and administration. The company has a total indirect cost of \$100,000 for the year, which includes rent, utilities, and office supplies.

The company might determine the proportion of space each department uses to allocate these costs. If production uses 40% of the total space, R&D uses 30%, and administration uses 30%, the company would allocate 40% of the indirect costs to production, 30% to R&D, and 30% to administration.

Next, the company might allocate indirect costs based on the number of employees in each department. If production has 20 employees, R&D has 15, and administration has 10, the company would allocate indirect costs based on the ratio of employees in each department.

Finally, the company might allocate indirect costs based on the number of products produced in each department. If production produces 1000 products, R&D produces 500, and administration produces none, the company would allocate indirect costs based on the ratio of products produced in each department.

## Example #3 of Allocation Being Used in Accounting Practice

Suppose a manufacturing company produces two products: Product A and Product B. To determine the cost of each product, the company must allocate the factory overhead costs, including utilities, rent, maintenance, and supplies, among other expenses. The overhead costs must be assigned to each product based on the proportion of total machine hours used to produce each product.

For example, if the company uses 60% of the total machine hours to produce Product A and 40% to produce Product B, then 60% of the factory overhead costs would be allocated to Product A and 40% to Product B. The company would then use the allocated overhead costs and the direct costs of material and labor to calculate the total cost of each product.

The allocation of overhead costs to each product is critical for the company to accurately determine the cost of goods sold and price its products competitively. The company can use an allocation method to ensure a fair and accurate picture of the costs of producing each product.

## How to Do Cost Allocation in Simple Steps?

Cost allocation can be complex, but it doesn’t have to be. Here are five simple steps for cost allocation:

## Step 1: Identify the Costs That Need to Be Allocated

The first step in cost allocation is identifying the costs that need to be allocated. This includes both direct and indirect costs. Direct costs can be easily traced to specific products or services, while indirect costs, such as rent and utilities, cannot.

## Step 2: Choose the Appropriate Method of Cost Allocation

Once you have identified the costs that need to be allocated, the next step is to choose the appropriate cost allocation method. The most common methods include direct cost allocation, step-down allocation, sequential allocation, and activity-based costing. The method chosen will depend on the nature of the costs and the objectives of the cost allocation process.

## Step 3: Determine the Allocation Base

The allocation base is the basis on which the costs will be allocated. This can be the number of units produced, the number of employees, or any other relevant factor that can be used to determine the cost of goods or services.

## Step 4: Allocate the Costs

Once you have determined the allocation base, the next step is to allocate the costs. This can be done by dividing the total cost by the number of units, employees, or another relevant factor and multiplying this by the number of units, employees, or another relevant factor for each product, service, or department.

## Step 5: Review and Adjust the Cost Allocation

Once the costs have been allocated, the final step is to review and adjust the cost allocation as necessary. This may involve reallocating costs based on new information or changes in the business.

## Which Industries Can Cost Allocation Be Applied?

With the proper guidance, cost allocation can be applied to almost any industry. It’s all about the data you have and how you use it.

Let’s take a look at some of the industries that could benefit from cost allocation:

The healthcare industry is one of the most expensive in the world. It is also one of the most heavily regulated. These factors make cost allocation a necessity for many healthcare providers.

Healthcare organizations have many different costs, but the most significant sources are labor and supplies. Labor costs can be very high in this industry because it requires highly skilled people to perform various tasks, including surgery, patient care, and patient education. Supplies like bandages and IV bags are also expensive because they have to be sterile and meet regulatory requirements.

A hospital’s supply department has much control over its budget, but it also has little control over what happens in other departments, such as surgery or patient care. This makes it difficult to allocate costs accurately when they don’t know how much they will spend on supplies or how many patients they’ll see each year.

Cost allocation helps solve these problems by allowing managers to see which departments are consuming the most resources. They can adjust accordingly without guessing what’s happening behind closed doors (or behind locked doors).

## Manufacturing

The manufacturing industry is one of the most common places where cost allocation can be applied. In this industry, it is crucial to know how much it costs to make each product and how much it costs to produce goods (including materials and labor) for sale.

With this information, manufacturers can determine how much they need to charge for their products to cover all of their expenses, including overhead costs like rent or electricity bills.

Cost allocation can also help manufacturers determine which products are more profitable than others so that they can focus on those areas instead of wasting time and money on less popular lines of goods. For example, suppose a company produces clothing and electronics but finds its clothing line more popular among consumers than its electronics line.

In that case, it may want to stop producing electronics altogether because there would need to be more demand for these products for them to make any money off of them.

This is an industry that benefits from cost allocation. Energy companies have long been able to allocate costs to different projects and branches, but they often face challenges when assigning overhead expenses. That’s because overhead costs are shared among the company’s functions, making them difficult to track.

Cost allocation software can help energy companies assign overhead expenses in a way that makes sense for each project or branch. The software also allows them to better understand where their money is going and gives them more flexibility in budgeting and forecasting future expenses.

Retailers are a great example of an industry that can benefit from cost allocation.

Retailers are often sold on the idea of one-stop shopping: you go to a store and buy everything you need, from clothing to food to furniture. But in reality, there are many different types of retailers, such as grocery stores, department stores, clothing stores, etc. And each has its own distinct set of costs for running that type of business. So how do these retailers know how much each product line contributes to their overall profits? They use cost allocation.

Cost allocation is a technique for allocating overhead costs across product lines based on their relative importance to the company’s overall performance. This way, retailers can determine which products contribute most (or least) to their bottom line and make decisions accordingly.

## Information Technology

Information technology (IT) is one of the most significant cost allocation areas. IT costs are often divided into two categories: direct costs and indirect costs. The former refers to those costs that can be directly attributed to a particular project or product, while the latter refers to those costs that cannot be directly attributed.

Cost allocation in IT has many benefits. It helps managers determine how much it costs to develop a new product or service and where inefficiencies lie in their IT departments.

It also allows them to understand better how much revenue they’re generating from each product or service line, which will help them make better decisions about future investments in the company’s infrastructure.

## Construction

This is one of the most apparent industries to apply cost allocation. Construction projects are often massive and complex, with many different stakeholders involved in the planning, execution, and completion of a project. It’s common for construction projects to have hundreds or thousands of contracts with hundreds or thousands of different suppliers.

Cost allocation helps ensure that those involved in the project are paid what they’re owed without overpaying anyone else who participated. It’s also used to ensure that a company only spends a little money on a project by ensuring that every expense is only charged once.

## Transportation

This is the industry that can benefit the most from cost allocation.

Transportation has many parts that must work in unison to transport goods or passengers. It can be difficult to determine which part of a vehicle’s operation should be allocated to specific parts, and it usually requires a lot of math.

Cost allocation can make it easier for companies in this industry to understand which parts are costing them more than they expected so that they can make changes accordingly.

## Food and Beverage

Food and beverage companies can benefit significantly from cost allocation. These companies are typically comprised of many different departments that must be managed to ensure the entire business runs smoothly. Each department has specific costs that it incurs, so allocating those costs among all of the departments will help you understand where your money is going and how it can be used most effectively.

Cost allocation is also helpful when dealing with food or beverage products because it allows you to track the costs associated with each product line and make sure you profit on every product line. This way, you know what kinds of products are selling well, which ones aren’t selling as well, and how much money each product line has made for your company.

## Real Estate

This is one of the most common industries to use cost allocation methods. Real estate developers often create multiple project phases, which must be accounted for separately. The costs of these phases are usually allocated to determine how much profit (or loss) will be made in each phase.

This lets developers decide which phases should be completed first and what incentives may be offered to convince buyers to purchase units from those phases.

Utilities are another excellent example of an industry where cost allocation can be used.

They must deal with various costs, including purchasing raw materials, paying for labor, and buying equipment. The type of utility and the sector it operates in determine the cost of each of these. For example, a water utility may have very high costs for purchasing raw materials but low costs for labor and employee benefits because they only need a few employees or benefit packages.

Cost allocation can help utilities determine how much money they should spend on each part of their business so that they’re not overspending on one part while underinvesting in another.

## Pros of Cost Allocation

Cost allocation is a common business practice. Companies use it to help determine the profitability of individual products, services, and departments within a company. Here are the pros of cost allocation:

## Improved Decision Making

Cost allocation helps businesses make informed decisions by accurately determining the cost of goods or services. Companies can make informed decisions on pricing, production, and marketing strategies with a better understanding of the costs associated with producing a product or offering a service.

## Better Resource Allocation

Cost allocation helps businesses to determine the costs associated with different departments, products, or services. This information can then be used to allocate resources more efficiently and allocate more resources to more profitable areas.

## Increased Profitability

By allocating costs accurately, businesses can identify less profitable areas and make changes to improve profitability. This could involve reducing costs, improving efficiency, or adjusting pricing.

## Better Budget Planning

Cost allocation helps businesses to create more accurate budgets. Companies can plan their budgets more effectively as they understand the costs associated with each product, service, or department.

## Improved Internal Control

Cost allocation helps businesses to maintain better internal control over their operations. By allocating costs accurately, companies can track expenses and identify improvement areas. This helps to prevent fraud and embezzlement and increases accountability within the company.

## Better Understanding of Overhead Costs

Overhead costs can be challenging to understand and allocate accurately. Cost allocation helps businesses to understand these costs better and allocate them to the proper departments or products. This allows companies to make informed decisions on pricing and production.

## Improved Cost Reporting

Cost allocation helps businesses to produce more accurate cost reports. This allows companies to make informed pricing, production, and marketing strategies decisions. Cost reports are also essential for tax purposes and to meet regulatory requirements.

## Better Negotiations

Cost allocation helps businesses to understand their costs better, which can be used in negotiations with suppliers and customers. Companies can better understand costs and negotiate better prices, terms, and conditions with suppliers and customers. This helps businesses to maintain better relationships and increase profitability.

## Cons of Cost Allocation

Cost allocation can be an excellent tool for helping you understand where your money is going and how to save it, but this method has some drawbacks.

## Time-Consuming Process

Cost allocation can be time-consuming and requires significant effort from various departments within the company. This can divert resources from other important tasks and may slow down other processes.

## Increased Complexity

Cost allocation can be complex, especially for large organizations with multiple departments and products. This complexity can result in errors and misunderstandings, negatively impacting the accuracy of cost reports and other important financial information.

Implementing a cost allocation system can be expensive and require a significant investment in technology, software, and training. This cost can be a barrier for smaller organizations or those with limited resources.

## Unreliable Data

Cost allocation is only as accurate as the data used in the process. Poor quality data, errors in data entry, and outdated data can all result in inaccurate cost reports and inefficient resource allocation.

## Resistance to Change

Some employees may resist implementing a cost allocation system, especially if they feel the process may negatively impact their department or lead to job loss.

## Limited Flexibility

Cost allocation systems are often rigid and lack the flexibility to adapt to changes in business conditions. This can result in inefficiencies and limit the ability of the company to respond to new opportunities or challenges.

## Potential for Misallocation

If not implemented correctly, cost allocation can misallocate costs, negatively impacting decision-making and profitability.

## Dependence on Cost Allocation

Overreliance on cost allocation can lead to a lack of creativity and initiative within departments. Employees may become too focused on cost allocation and need to be more focused on driving innovation and growth for the company. This can limit the ability of the company to adapt to changing market conditions.

## Frequently Asked Questions- Cost Allocation in Accounting

What are the main objectives of cost allocation.

The main objectives of cost allocation are to accurately determine the cost of goods or services, improve resource allocation, increase profitability, create more accurate budgets, improve internal control, and provide better cost reporting.

## What Is Direct Cost Allocation?

Direct cost allocation refers to assigning costs directly to specific products or services. This method is used when the costs can be easily traced to specific business areas.

## What Is Step-Down Allocation?

Step-down allocation refers to allocating costs from one department to another department or product. This method is used when costs cannot be directly traced to specific products or services.

## What Is Sequential Allocation?

Sequential allocation refers to allocating costs based on the sequence in which they are incurred. This method is used when costs cannot be directly traced to specific products or services.

## What Is Activity-Based Costing?

Activity-based costing refers to allocating costs based on the activities involved in producing a product or offering a service. This method is used when multiple activities are involved in creating a product or service.

## Why Is Cost Allocation Important for Businesses?

Cost allocation is essential for businesses as it helps them understand the costs associated with each business area and make informed pricing, production, and resource allocation decisions. This leads to improved profitability and better resource allocation.

## How Does Cost Allocation Impact Resource Allocation?

Cost allocation helps companies determine the costs associated with each department, product, or service, which are used to allocate resources more efficiently. By allocating resources based on accurate cost

## How Does Cost Allocation Impact Pricing Decisions?

Cost allocation helps companies understand the costs associated with each product or service used to make informed pricing decisions. By accurately determining the cost of goods or services, companies can ensure that their pricing is based on a solid understanding of the costs involved.

## The Comprehensive Guide to Cost Allocation in Accounting – Conclusion

Allocation of costs is a critical component of any business. By allocating costs, you can ensure that your company makes the best use of its resources and operates efficiently.

The ability to allocate costs allows you to make strategic decisions about your business’s operations and management and take appropriate actions regarding financial reporting.

## The Comprehensive Guide to Cost Allocation in Accounting – Recommended Reading

Corporate Accountant: What Are the Responsibilities, Duties, & Salary of a Corporate Accountant?

How Can Business Intelligence Help with Budget Planning (in 2023)

Standard Costing- Common Problems (And How to Solve Them)

Updated: 5/19/2023

Related posts.

## The Price of Happiness: Examining Trade-Offs Between Wealth and Well-Being

In today’s society, the pursuit of wealth often leads to trade-offs in well-being. True contentment encompasses mental, emotional, and physical health, purpose, and relationships. Wealth does not guarantee happiness and can impact mental health, relationships, and sustainable living. Balancing wealth with well-being results in a more fulfilling life.

## How Can Diversity of Thought Lead to Good Ethical Decisions?

Diversity of thought, or cognitive diversity, encompasses varied perspectives and beliefs. Embracing this diversity leads to better ethical decision-making by broadening perspectives, enhancing critical thinking, mitigating groupthink, fostering cultural competence, strengthening stakeholder engagement, promoting ethical leadership, improving risk management, and fostering employee engagement.

## The 26 Most Influential Leadership Quotes from Silicon Valley Icons

Silicon Valley, a hotbed of innovation and entrepreneurship, is driven by a unique culture of risk-taking, an abundant talent pool, access to capital, and a strong sense of community. The region’s success is propelled by visionary leadership, resilience, innovation, risk-taking, and customer-centric approaches.

Social media.

## Other Pages

Contact indo.

Discover more from accounting professor.org.

• Credit cards
• View all credit cards
• Banking guide
• Loans guide
• Insurance guide
• Personal finance
• View all personal finance
• View all taxes

## You’re our first priority. Every time.

We believe everyone should be able to make financial decisions with confidence. And while our site doesn’t feature every company or financial product available on the market, we’re proud that the guidance we offer, the information we provide and the tools we create are objective, independent, straightforward — and free.

So how do we make money? Our partners compensate us. This may influence which products we review and write about (and where those products appear on the site), but it in no way affects our recommendations or advice, which are grounded in thousands of hours of research. Our partners cannot pay us to guarantee favorable reviews of their products or services. Here is a list of our partners .

## What Is Depreciation? Definition, Types, How to Calculate

Many or all of the products featured here are from our partners who compensate us. This influences which products we write about and where and how the product appears on a page. However, this does not influence our evaluations. Our opinions are our own. Here is a list of our partners and here's how we make money .

Depreciation gives you a way to correlate the cost of an asset with its usefulness, or ability to produce revenue, year over year.

Distributing an asset’s cost over its lifespan, instead of recognizing the entire cost at once, gives you a more accurate view of the asset’s value and your business’s profit at the end of the year. It can also have tax benefits.

There are four main depreciation methods: straight-line, units of production, double declining balance and sum of the years’ digits.

If you’re not sure which depreciation method to use for each of your assets, your accountant can be a great resource.

Depreciation is an accounting method that spreads the cost of an asset over its expected useful life to give you a more accurate view of its value and your business’s profitability. As opposed to recording the entire cost of an asset as soon as it’s bought, businesses record depreciation as a periodic expense on the income statement. How much value an asset loses year-over-year depends on which depreciation method your business uses: straight-line, units of production, double declining balance or sum of the years' digits.

Businesses have some control over how they depreciate their assets over time. Good small-business accounting software lets you record depreciation, but the process will probably still require manual calculations. You'll need to understand the ins and outs to choose the right depreciation method for your business.

» MORE: 9 accounting basics for small-business owners

QuickBooks Online

## Types of depreciation

Here are four common methods of calculating annual depreciation expenses, along with when it's best to use them.

## 1. Straight-line depreciation

This is the most common and simplest depreciation method.

Formula: (Cost of asset – Scrap value of asset) / Useful life of asset = Depreciation expense

Most often used for: Equipment that loses value steadily over time.

Pros: It spreads the expense evenly over each accounting period. It’s also easy to automate the adjusting entry for straight-line depreciation in most accounting software.

Cons: Determining the useful life of the asset requires guesswork. A miscalculation could result in the asset being overvalued for several years.

## 2. Units of production depreciation

Units of production depreciation is based on how many items a piece of equipment can produce.

Formula: (Number of units produced / Life of asset in units) x (Cost of asset – Scrap value of asset) = Depreciation expense

Most often used for: Manufacturing for equipment that is expected to produce a certain number of items before it's no longer useful.

Pros: Easy to calculate. Because it’s tied to the number of items a piece of equipment produces, it creates a more accurate depreciation calculation.

Cons: You have to keep an accurate record of how many items the equipment has produced. Because production will likely vary from month to month, you’ll need to manually enter this depreciation expense into your accounting software every month. The entry can’t be automated, as it can with straight-line depreciation.

» MORE: Best accounting software for small manufacturing businesses

## 3. Double declining balance depreciation

Double declining balance depreciation is an accelerated depreciation method. Businesses use accelerated methods when dealing with assets that are more productive in their early years. The double declining balance method is often used for equipment when the units of production method is not used.

Formula: 2 x (1/Life of asset) x Book value = Depreciation expense

Most often used for: Vehicles and other assets that lose value quickly. It writes off an asset’s value the quickest.

Pros: Represents the accelerated loss of certain assets’ value more accurately than straight-line depreciation. You’ll get larger tax write-offs at the beginning of the asset’s life, when it’s most productive. Depreciation expenses continually decline as time goes on and the asset is less productive and/or requires greater maintenance (another write-off).

Cons: The calculations are more complex than the other methods. Usually, business owners using accelerated methods will set up a depreciation schedule — a table that shows the depreciation expense for each year of the asset’s life — so they only have to do the calculations once.

## 4. Sum of the years’ digits depreciation

Sum of the years’ digits depreciation is another accelerated depreciation method. It doesn’t depreciate an asset quite as quickly as double declining balance depreciation, but it does it quicker than straight-line depreciation.

Formula: (Remaining life of the asset / Sum of the years' digits) x (Cost of asset – Scrap value of asset) = Depreciation expense

Most often used for: Assets that could become obsolete quickly.

Pros: Lets you choose how many years you want to depreciate an asset, based on its useful life. This gives you control over the depreciation expense you record each month. Like other accelerated depreciation methods, it also lets you write off more of the asset’s cost earlier on.

Cons: The most difficult depreciation method to calculate. If you use it with the wrong type of asset, you can easily overstate or understate your net income in a given accounting period.

## Depreciation examples

Let’s say you purchase a piece of equipment for \$260,000. You anticipate using the equipment for eight years, and you anticipate the scrap value will be \$20,000. The annual and monthly depreciation expenses for the vehicle using the straight-line depreciation method would be:

(\$260,000 – \$20,000) / 8 = \$30,000

\$30,000 / 12 months = \$2,500 per month

Find out what your annual and monthly depreciation expenses should be using the simplest straight-line method, as well as the three other methods, in the calculator below.

## Understanding depreciation in business and accounting

Depreciation is an expense, which means that it appears as a line item on your income statement and reduces net income. Many small-business owners find depreciation confusing because the depreciation expense on the income statement doesn't match cash flow . Remembering the following points can help simplify the concept.

Depreciation is not a cash expense. That is, a business does not write a check to "depreciation." Instead, the business records or recognizes the cost of the asset over time on the income statement.

Accordingly, depreciation usually doesn’t coincide with when the business buys the asset, even if the purchase is made over time with installment payments.

Depreciation matches expenses to a given time period, but it isn’t strictly an accrual-basis concept. This calculation will appear on both cash-basis and accrual-basis financial statements.

## Using depreciation to plan for future business expenses

One often-overlooked benefit of properly recognizing depreciation in your financial statements is that the calculation can help you plan for and manage your business’s cash requirements. This is especially helpful if you want to pay cash for future assets rather than take out a business loan to acquire them.

Because you've taken the time to determine the useful life of your equipment for depreciation purposes, you can make an educated assumption about when the business will need to purchase new equipment. The earlier you can start planning for that purchase — perhaps by setting aside cash each month in a business savings account — the easier it will be to replace the equipment when the time comes.

» MORE: Best business budgeting software

## Depreciation and taxes

The four methods described above are for managerial and business valuation purposes. Tax depreciation is different from depreciation for managerial purposes.

Tax depreciation follows a system called MACRS, which stands for modified accelerated cost recovery system. MACRS is a form of accelerated depreciation, and the IRS publishes tables for each type of property. Work with your accountant to be sure you’re recording the correct depreciation for your tax return.

» MORE: Best accounting and bookkeeping apps for small businesses

Instead of recording an asset’s entire expense when it’s first bought, depreciation distributes the expense over multiple years. Depreciation quantifies the declining value of a business asset, based on its useful life, and balances out the revenue it’s helped to produce.

How you calculate depreciation depends on which method you use. Each has its own formula that takes into account some combination of the following figures:

The asset’s useful life in years.

The asset’s cost or book value.

The scrap value of the asset.

How many units the asset will produce over its lifespan.

Assets that don’t lose their value, such as land, do not get depreciated. Alternatively, you wouldn’t depreciate inexpensive items that are only useful in the short term.

On a similar note...

## Workflow Solutions

FloQast Close

FloQast Reconciliation Management

FloQast Variance Analysis

FloQast Analyze

FloQast Compliance Management

FloQast Ops

FloQast ReMind

## Finance and Accounting Operations Platform

Platform Overview

Scalability

Trust & Security

Integrations

FloVerse Community

FloQast Studios

FloQast Blog

Controller Manifesto

## Charting the Future of Accounting eBook

Your next step: navigating the future amidst changes and challenges

Chief Accounting Officer

Accounting Manager

Compliance Manager

Internal Audit Manager

## By Workflow

Financial Close

Account Reconciliations

Audit Findings

Controls and Risk Management

SOX Compliance

Oracle NetSuite

Sage Intacct

FloQast Connect API

## The IPO Playbook for Finance & Accounting Teams

An at-a-glance guide to going public

Success Stories

Video Testimonials

## PulteGroup Constructs Faster Close and Team Productivity with FloQast

Learn how FloQast helped PulteGroup reduce paper consumption, speed up its monthly Close, and streamline compliance reporting.

## Closing Collaboration in a Multinational Accounting Team: How Emma Improved Team Collaboration and Internal Controls Together with FloQast

Emma's 70-person geographically distributed accounting team improved internal controls and streamlined the audit thanks to FloQast.

## Qualys Modernizes SOX Compliance and Improves the Annual Audit with FloQast

Read how in just a matter of weeks, Qualys leveraged FloQast to standardize the close process and organize controls and documentation for a more simplified SOX compliance.

Partner Program

Become a Partner

FloQast’s suite of easy-to-use and quick-to-deploy solutions enhance the way accounting teams already work. Learn how a FloQast partnership will further enhance the value you provide to your clients.

All Resources

Checklists & Templates

Customer Video Testimonials

Whitepapers

Customer Success Stories

## SOX RCM Template

Leverage best practices to build a SOX RCM that focuses on what’s most important for SOX compliance.

Customer Success

Request Support

## Earn Free CPE with FloQademy

FloQademy, FloQast’s learning portal, provides over 100+ hours of free CPE, on-demand, 24/7, and is open to everyone.

## Initiatives

Diversity, Inclusion, & Community

Get In Touch

## FloQast raises \$100M at a \$1.6B valuation

The Series E round was led by ICONIQ Growth to supercharge FloQast's global expansion and Innovation with Artificial Intelligence.

## What is Cost Allocation? Definition & Process

Jul 16, 2020 Michael Whitmire

Working with the former accountants now working at FloQast, we decided to take a look at some of the pillars of the accounting professions.

The key to running a profitable enterprise of any kind is making sure that your prices are high enough to cover all your costs — and leave at least a bit for profit. For a really simple business — like the proverbial lemonade stand that almost every kid ran — that’s pretty simple. Your costs are what you (or your parents) paid for lemons and sugar. But what if it’s a more complex business? Then you might need to brush up on cost accounting, and learn about allocation accounting . Let’s walk through this using the hypothetical company, Lisa’s Luscious Lemonade.

## What is cost allocation ?

The cost allocation definition is best described as the process of assigning costs to the things that benefit from those costs or to cost centers . For Lisa’s Luscious Lemonade, a cost center can be as granular as each jug of lemonade that’s produced, or as broad as the manufacturing plant in Houston.

Let’s assume that the owner, Lisa, needs to know the cost of a jug of lemonade. The total cost to create that jug of lemonade isn’t just the costs of the water, lemons, sugar and the jug itself, but also includes all the allocated costs to make it.

Let’s start by defining some terms…

Direct costs are costs that can be traced directly to the product or service itself. For manufacturers, these consist of direct materials and direct labor. They appear in the financial statements as part of the cost of goods sold .

Direct materials are those that become an integral part of the finished product. This will be the costs of the water, sugar, lemons, the plastic jug, and the label.

Direct labor includes the labor costs that can be easily traced to the production of those finished products. Direct labor for that jug will be the payroll for the workers on the production line.

Indirect costs are the costs that can’t be easily traced to a product or service but are clearly required for making whatever an enterprise sells. This includes materials that are used in such insignificant quantities that it’s not worth tracing them to finished products, and labor for employees who work in the factory, but not on the production line.

Overhead costs encompass all the costs that support the enterprise that can’t be directly linked to making the items that are sold. This includes indirect costs , as well as selling, marketing, administration, and facility costs.

Manufacturing overhead includes the overhead costs that are directly related to making the products for sale. This includes the electricity, rent, and utilities for the factory and salaries of supervisors on the factory floor.

Product costs are all the costs in making or acquiring the product for sale. These are also known as manufacturing costs or total costs . This includes direct labor, direct materials, and allocated manufacturing overhead.

## What is the process?

The first step in any cost allocation system is to identify the cost objects to which costs need to be allocated. Here, our cost objec t is a jug of lemonade. For a more complex organization, the cost object could be a product line, a department, or a branch.

Direct costs are the simplest to allocate. Last month, Lisa’s Luscious Lemonades produced 50,000 gallons of lemonade and had the following direct costs:

Total costs     Cost per gallon Direct materials        \$142,500               \$2.85 Direct labor                   \$37,500                   \$.75

## How are costs allocated?

Allocating overhead costs is a bit more complex. First, the overhead costs are split between manufacturing costs and non-manufacturing costs. Some of this is pretty straightforward: the factory floor supervisor’s salary is clearly a manufacturing cost, and the sales manager’s salary is a non-manufacturing cost. But what about the cost of human resources or other service departments that serve all parts of the organization? Or facilities costs, which might include the rent for the building, insurance, utilities, janitorial services, and general building maintenance?

Human resources and other services costs might be logically split based on the headcount of the manufacturing versus non-manufacturing parts of the business. Facilities costs might be split based on the square footage of the manufacturing space versus the administrative offices. Electricity usage might be allocated on the basis of square footage or machine hours , depending on the situation.

Let’s say that for Lisa’s Luscious Lemonades, after we split the overhead between manufacturing and non-manufacturing costs, we have the following annual manufacturing overhead costs :

Supervisor salary                                  \$84,000 Indirect costs                                         \$95,000 Facility costs                                           \$150,000 Human resources                                  \$54,000 Depreciation                                          \$65,000 Electricity                                                \$74,000 Total manufacturing overhead             \$522,000

In a perfect world, it would be possible to keep an accurate running total of all overhead costs so that management would have detailed and accurate cost information. However, in practice, a predetermined overhead rate is used to allocate overhead using an allocation base .

This overhead rate is determined by dividing the total estimated manufacturing overhead by the estimated total units in the allocation base . At the end of the year or quarter, the allocated costs are reconciled to actual costs.

Ideally, the allocation base should be a cost driver that causes those overhead costs . For manufacturers, direct labor hours or machine-hours are commonly used. Since Lisa only makes one product — gallon jugs of lemonade — the simplest cost driver is the number of jugs produced in a year.

If we estimate that 600,000 gallons of lemonade are produced in a year, then the overhead rate will be \$522,000 / 600,000 = \$.87 per gallon.

Our final cost to produce a gallon of Lisa’s Luscious Lemonade is as follows:

Direct materials                             \$2.85 Direct labor                                     \$0.75 Manufacturing overhead               \$0.87 Total cost                                         \$4.47

## What is cost allocation used for?

Cost allocation is used for both external reporting and internally for decision making. Under generally accepted accounting principles (GAAP), the matching principle requires that expenses be reported in the financial statements in the same period that the related revenue is earned.

This means that manufacturing overhead costs cannot be expensed in the period incurred, but must be allocated to inventory items, where those costs remain until the inventory is sold, when overhead is finally expensed as part of the cost of goods sold. For Lisa’s Luscious Lemonade, that means that every time a jug of lemonade is produced, another \$4.47 goes into inventory. When a jug is sold, \$4.47 goes to the cost of goods sold.

However, for internal decision-making, the cost allocation systems used for GAAP financials aren’t always helpful. Cost accountants often use activity-based costing , or ABC, in parallel with the cost allocation system used for external financial reporting .

In ABC, products are assigned all of the overhead costs that they can reasonably be assumed to have caused. This may include some — but not all — of the manufacturing overhead costs , as well as operating expenses that aren’t typically assigned to products under the costing systems used for GAAP.

## AutoRec to keep you sane

Whatever cost accounting method you use, it’s going to require spreadsheets that you have to reconcile to the GL. Combine that with the other reconciliations you have to do to close out the books, and like Lisa’s controller, you might be ready to jump into a vat of lemonade to drown your sorrows.

Enter FloQast AutoRec. Rather than spend hours every month reconciling accounts, AutoRec leverages AI to match one-to-one, one-to-many, or many-to-many transactions in minutes. Simple set up means you can start using it in minutes because you don’t need to create or maintain rules. Try it out, and see how much time you can save this month.

## Michael Whitmire

As CEO and Co-Founder, Mike leads FloQast’s corporate vision, strategy and execution. Prior to founding FloQast, he managed the accounting team at Cornerstone OnDemand, a SaaS company in Los Angeles. He began his career at Ernst & Young in Los Angeles where he performed public company audits, opening balance sheet audits, cash to GAAP restatements, compilation reviews, international reporting, merger and acquisition audits and SOX compliance testing. He holds a Bachelor’s degree in Accounting from Syracuse University.

## Allocation of Depreciation

• Finances & Taxes

## Depreciation

• ')" data-event="social share" data-info="Pinterest" aria-label="Share on Pinterest">
• ')" data-event="social share" data-info="Reddit" aria-label="Share on Reddit">
• ')" data-event="social share" data-info="Flipboard" aria-label="Share on Flipboard">

## What Is an Amortization Expense?

Accounting for an asset purchase, how to calculate ebita.

• How to Create a Depreciation Schedule

A company allocates depreciation expense on an annual basis, using one of the three methods. A business may choose to depreciate its assets using the straight-line, double-declining balance or sum-of-the-year's-digits methods of depreciation. An aggressive depreciation schedule reduces net income. In contrast, a less conservative approach spreads depreciation expense over a longer period, resulting in higher reported net income.

Although depreciation shows up as an expense on a company's income statement, reducing net income, it is a noncash expense. Depreciation is an accounting convention used to recognize the useful life of an asset after purchase until the asset reaches salvage value. Because depreciation is a noncash expense, financial analysts add the expense back to net income to derive a company's cash flow from operating activities.

## Accumulated Depreciation

Typically, a company records depreciation on an annual basis and deducts the expense from its net income as part of its operations on the income statement. On the balance sheet, the company creates a general ledger account for the asset. It also records a contra asset account, usually labeled "Accumulated Depreciation," to recognize the growing depreciating value of the asset as the equipment ages. For example, if the company bought a printing lathe for \$10,000 and expects it to depreciate by \$1,000 each year, after year three, the accumulated depreciation is \$3,000. This brings the asset value down to \$7,000.

## Depreciation Methods

How quickly a company depreciates its assets is up to the management's discretion. Accounting rules allow for three types of depreciation methods. Straight-line depreciation allocates the same level of depreciation each year. Accelerated methods, such as DDB or SOYD, recognize a larger depreciation expense in the early life of the asset and smaller depreciation amounts toward the end of an asset's useful life.

Under straight-line depreciation, a \$10,000 asset purchase with a 10 year life depreciates \$1,000 each year, or \$10,000 divided by 10 years. In contrast, the depreciation rate under DDB is twice that of straight-line rate of 10 percent per year. In year one under DDB, the company records depreciation expense of \$2,000, calculated by multiplying 20 percent by \$10,000. The SOYD method adds years 1 through 10 to reach a sum of 55. In year one, depreciation under SOYD is 10 divided by 55 times \$10,000, for a depreciation expense of \$1,818.18. In the second year, the depreciation expense is \$1,636.36, or nine divided by 55 times \$10,000.

• Accounting For Management: Double Declining Balance Method of Depreciation
• Accounting For Management: Sum of the Year's Digits Method of Depreciation
• AccountingStudy.com: Depreciation Methods
• AccountingCoach.com: Depreciation

## Related Articles

Gaap depreciation methods, units-of-production depreciation method, gaap declining balance method, accounting guidelines on depreciation, why is depreciation estimated, what does a negative depreciation mean, do companies still use the straight line method for tax depreciation, how to connect iweb to the ipad, tax depreciation vs. book depreciation & an intangible asset valuation, most popular.

• 1 GAAP Depreciation Methods
• 2 Units-of-Production Depreciation Method
• 3 GAAP Declining Balance Method
• 4 Accounting Guidelines on Depreciation

principlesofaccounting.com

## Service Life And Cost Allocation

• Goals Achievement
• Fill in the Blanks
• Multiple Choice

Determining the service life of an asset is an essential first step in calculating the amount of depreciation attributable to a specific period. Several factors must be considered:

Physical deterioration — “Wear and tear” will eventually cause most assets to simply wear out and become useless. Thus, physical deterioration serves to establish an outer limit on the service life of an asset. Obsolescence — The shortening of service life due to technological advances that cause an asset to become out of date and less desirable. Inadequacy — An economic determinant of service life which is relevant when an asset is no longer fast enough or large enough to fill the competitive and productive needs of a company.

Factors such as these must be considered in determining the service life of a particular asset. In some cases, all three factors come into play. In other cases, one factor alone may control the determination of service life. Importantly, service life can be completely different from physical life. For example, computers are often replaced even though still physically functional.

Recognize that some assets have an indefinite (or permanent) life. One prominent example is land. Accordingly, it is not considered to be a depreciable asset.

## 3.9 Depreciation: Allocation of Long-term Asset Cost

Fundamentals of depreciation.

As you have learned, when accounting for a long-term fixed asset, we cannot simply record an expense for the cost of the asset and record the entire outflow of cash in one accounting period. Like all other assets, when purchasing or acquiring a long-term asset, it must be recorded at the historical (initial) cost, which includes all costs to acquire the asset and put it into use. The initial recording of an asset has two steps:

• Record the initial purchase on the date of purchase, which places the asset on the balance sheet (as property, plant, and equipment) at cost, and record the amount as notes payable, accounts payable, or an outflow of cash.
• At the end of the period, make an adjusting entry to recognize the depreciation expense. Companies may record depreciation expense incurred annually, quarterly, or monthly.

Following GAAP and the expense recognition principle, the depreciation expense is recognized over the asset’s estimated useful life.

## CONCEPTS IN PRACTICE

Estimating useful life and salvage value.

Useful life and salvage value are estimates made at the time an asset is placed in service. It is common and expected that the estimates are inaccurate with the uncertainty involved in estimating the future. Sometimes, however, a company may attempt to take advantage of estimating salvage value and useful life to improve earnings. A larger salvage value and longer useful life decrease annual depreciation expense and increase annual net income. An example of this behavior is  Waste Management , which was disciplined by the Securities and Exchange Commission for fraudulently altering its estimates to reduce depreciation expense and overstate net income by \$1.7 billion. 6

## Components Used in Calculating Depreciation

The expense recognition principle that requires that the cost of the asset be allocated over the asset’s useful life is the process of depreciation. For example, if we buy a delivery truck to use for the next five years, we would allocate the cost and record depreciation expense across the entire five-year period. The calculation of the depreciation expense for a period is not based on anticipated changes in the fair market value of the asset; instead, the depreciation is based on the allocation of the cost of owning the asset over the period of its useful life.

The following items are important in determining and recording depreciation:

• Book value : the asset’s original cost less accumulated depreciation.
• Useful life : the length of time the asset will be productively used within operations.
• Salvage (residual) value : the price the asset will sell for or be worth as a trade-in when its useful life expires. The determination of salvage value can be an inexact science, since it requires anticipating what will occur in the future. Often, the salvage value is estimated based on past experiences with similar assets.
• Depreciable base (cost) : the depreciation expense over the asset’s useful life. For example, if we paid \$50,000 for an asset and anticipate a salvage value of \$10,000, the depreciable base is \$40,000. We expect \$40,000 in depreciation over the time period in which the asset was used, and then it would be sold for \$10,000.

Depreciation records an expense for the value of an asset consumed and removes that portion of the asset from the balance sheet. The journal entry to record depreciation is shown here.

Depreciation expense is a common operating expense that appears on an income statement.  Accumulated depreciation  is a  contra account , meaning it is attached to another account and is used to offset the main account balance that records the total depreciation expense for a fixed asset over its life. In this case, the asset account stays recorded at the historical value but is offset on the balance sheet by accumulated depreciation. Accumulated depreciation is subtracted from the historical cost of the asset on the balance sheet to show the asset at book value. Book value is the amount of the asset that has not been allocated to expense through depreciation.

In this case, the asset’s book value is \$20,000: the historical cost of \$25,000 less the accumulated depreciation of \$5,000.

It is important to note, however, that not all long-term assets are depreciated. For example, land is not depreciated because depreciation is the allocating of the expense of an asset over its useful life. How can one determine a useful life for land? It is assumed that land has an unlimited useful life; therefore, it is not depreciated, and it remains on the books at historical cost.

Once it is determined that depreciation should be accounted for, there are three methods that are most commonly used to calculate the allocation of depreciation expense: the  straight-line method , the  units-of-production method , and the  double-declining-balance method . A fourth method, the  sum-of-the-years-digits  method, is another  accelerated  option that has been losing popularity and can be learned in intermediate accounting courses. Let’s use the following scenario involving Kenzie Company to work through these three methods.

Assume that on January 1, 2019, Kenzie Company bought a printing press for \$54,000. Kenzie pays shipping costs of \$1,500 and setup costs of \$2,500, assumes a useful life of five years or 960,000 pages. Based on experience, Kenzie Company anticipates a salvage value of \$10,000.

Recall that determination of the costs to be depreciated requires including all costs that prepare the asset for use by the company. The Kenzie example would include shipping and setup costs. Any costs for maintaining or repairing the equipment would be treated as regular expenses, so the total cost would be \$58,000, and, after allowing for an anticipated salvage value of \$10,000 in five years, the business could take \$48,000 in depreciation over the machine’s economic life.

## Fixed Assets

You work for  Georgia-Pacific  as an accountant in charge of the fixed assets subsidiary ledger at a production and warehouse facility in Pennsylvania. The facility is in the process of updating and replacing several asset categories, including warehouse storage units, fork trucks, and equipment on the production line. It is your job to keep the information in the fixed assets subsidiary ledger up to date and accurate. You need information on original historical cost, estimated useful life, salvage value, depreciation methods, and additional capital expenditures. You are excited about the new purchases and upgrades to the facility and how they will help the company serve its customers better. However, you have been in your current position for only a few years and have never overseen extensive updates, and you realize that you will have to gather a lot of information at once to keep the accounting records accurate. You feel overwhelmed and take a minute to catch your breath and think through what you need. After a few minutes, you realize that you have many people and many resources to work with to tackle this project. Whom will you work with and how will you go about gathering what you need?

## Straight-Line Depreciation

Straight-line depreciation  is a method of depreciation that evenly splits the depreciable amount across the useful life of the asset. Therefore, we must determine the yearly depreciation expense by dividing the depreciable base of \$48,000 by the economic life of five years, giving an annual depreciation expense of \$9,600. The journal entries to record the first two years of expenses are shown, along with the balance sheet information. Here are the journal entry and information for year one:

After the journal entry in year one, the press would have a book value of \$48,400. This is the original cost of \$58,000 less the accumulated depreciation of \$9,600. Here are the journal entry and information for year two:

Kenzie records an annual depreciation expense of \$9,600. Each year, the accumulated depreciation balance increases by \$9,600, and the press’s book value decreases by the same \$9,600. At the end of five years, the asset will have a book value of \$10,000, which is calculated by subtracting the accumulated depreciation of \$48,000 (5 × \$9,600) from the cost of \$58,000.

## Units-of-Production Depreciation

Straight-line depreciation is efficient, accounting for assets used consistently over their lifetime, but what about assets that are used with less regularity? The  units-of-production depreciation method  bases depreciation on the actual usage of the asset, which is more appropriate when an asset’s life is a function of usage instead of time. For example, this method could account for depreciation of a printing press for which the depreciable base is \$48,000 (as in the straight-line method), but now the number of pages the press prints is important.

In our example, the press will have total depreciation of \$48,000 over its useful life of 960,000 pages. Therefore, we would divide \$48,000 by 960,000 pages to get a cost per page of \$0.05. If Kenzie printed 180,000 pages in the first year, the depreciation expense would be 180,000 pages × \$0.05 per page, or \$9,000. The journal entry to record this expense would be the same as with straight-line depreciation: only the dollar amount would have changed. The presentation of accumulated depreciation and the calculation of the book value would also be the same. Kenzie would continue to depreciate the asset until a total of \$48,000 in depreciation was taken after printing 960,000 total pages.

## Double-Declining-Balance Depreciation

The  double-declining-balance depreciation method  is the most complex of the three methods because it accounts for both time and usage and takes more expense in the first few years of the asset’s life. Double-declining considers time by determining the percentage of depreciation expense that would exist under straight-line depreciation. To calculate this, divide 100% by the estimated life in years. For example, a five-year asset would be 100 ÷ 5, or 20% a year. A four-year asset would be 100 ÷ 4, or 25% a year. Next, because assets are typically more efficient and “used” more heavily early in their life span, the double-declining method takes usage into account by doubling the straight-line percentage. For a four-year asset, multiply 25% (100% ÷ 4-year life) × 2, or 50%. For a five-year asset, multiply 20% (100% ÷ 5-year life) × 2, or 40%.

One unique feature of the double-declining-balance method is that in the first year, the estimated salvage value is not subtracted from the total asset cost before calculating the first year’s depreciation expense. Instead the total cost is multiplied by the calculated percentage. However, depreciation expense is not permitted to take the book value below the estimated salvage value, as demonstrated in the following text.

Notice that in year four, the remaining book value of \$12,528 was not multiplied by 40%. This is because the expense would have been \$5,011.20, and since we cannot depreciate the asset below the estimated salvage value of \$10,000, the expense cannot exceed \$2,528, which is the amount left to depreciate (difference between the book value of \$12,528 and the salvage value of \$10,000). Since the asset has been depreciated to its salvage value at the end of year four, no depreciation can be taken in year five.

In our example, the first year’s double-declining-balance depreciation expense would be \$58,000 × 40%, or \$23,200. For the remaining years, the double-declining percentage is multiplied by the remaining book value of the asset. Kenzie would continue to depreciate the asset until the book value and the estimated salvage value are the same (in this case \$10,000).

The net effect of the differences in straight-line depreciation versus double-declining-balance depreciation is that under the double-declining-balance method, the allowable depreciation expenses are greater in the earlier years than those allowed for straight-line depreciation. However, over the depreciable life of the asset, the total depreciation expense taken will be the same, no matter which method the entity chooses. For example, in the current example both straight-line and double-declining-balance depreciation will provide a total depreciation expense of \$48,000 over its five-year depreciable life.

## Summary of Depreciation

Table 3.3 compares the three methods discussed. Note that although each time-based (straight-line and double-declining balance) annual depreciation expense is different, after five years the total amount depreciated (accumulated depreciation) is the same. This occurs because at the end of the asset’s useful life, it was expected to be worth \$10,000: thus, both methods depreciated the asset’s value by \$48,000 over that time period.

The units of production method is different from the two above methods in that while those methods are based on time factors, the units of production is based on usage. However, the total amount of depreciation taken over an asset’s economic life will still be the same. In our example, the total depreciation will be \$48,000, even though the sum-of-the-years-digits method could take only two or three years or possibly six or seven years to be allocated.

## Partial-Year Depreciation

A company will usually only own depreciable assets for a portion of a year in the year of purchase or disposal. Companies must be consistent in how they record depreciation for assets owned for a partial year. A common method is to allocate depreciation expense based on the number of months the asset is owned in a year. For example, a company purchases an asset with a total cost of \$58,000, a five-year useful life, and a salvage value of \$10,000. The annual depreciation is \$9,600 ([\$58,000 – 10,000] ÷ 5). However, the asset is purchased at the beginning of the fourth month of the fiscal year. The company will own the asset for nine months of the first year. The depreciation expense of the first year is \$7,200 (\$9,600 × 9/12). The company will depreciate the asset \$9,600 for the next four years, but only \$2,400 in the sixth year so that the total depreciation of the asset over its useful life is the depreciable amount of \$48,000 (\$7,200 + 9,600 + 9,600 + 9,600 + 9,600 + 2,400).

## Calculating Depreciation Costs

Liam buys his silk screen machine for \$10,000. He estimates that he can use this machine for five years or 100,000 presses, and that the machine will only be worth \$1,000 at the end of its life. He also estimates that he will make 20,000 clothing items in year one and 30,000 clothing items in year two. Determine Liam’s depreciation costs for his first two years of business under straight-line, units-of-production, and double-declining-balance methods. Also, record the journal entries.

Straight-line method : (\$10,000 – \$1,000) ÷ 5 = \$1,800 per year for both years.

Units-of-production method : (\$10,000 – \$1,000) ÷ 100,000= \$0.09 per press

Year 1 expense: \$0.09 × 20,000 = \$1,800

Year 2 expense: \$0.09 × 30,000 = \$2,700

Double-declining-balance method :

Year 1 expense: [(\$10,000 – 0) ÷ 5] × 2 = \$4,000

Year 2 expense: [(\$10,000 – \$4,000) ÷ 5] × 2 = \$2,400

## Special Issues in Depreciation

While you’ve now learned thebasic foundationof the major available depreciation methods, there are a few special issues. Until now, we have assumed a definite physical or economically functional useful life for the depreciable assets. However, in some situations, depreciable assets can be used beyond their useful life. If so desired, the company could continue to use the asset beyond the original estimated economic life. In this case, a new remaining depreciation expense would be calculated based on the remaining depreciable base and estimated remaining economic life.

Assume in the earlier Kenzie example that after five years and \$48,000 in accumulated depreciation, the company estimated that it could use the asset for two more years, at which point the salvage value would be \$0. The company would be able to take an additional \$10,000 in depreciation over the extended two-year period, or \$5,000 a year, using the straight-line method.

As with the straight-line example, the asset could be used for more than five years, with depreciation recalculated at the end of year five using the double-declining balance method. While the process of calculating the additional depreciation for the double-declining-balance method would differ from that of the straight-line method, it would also allow the company to take an additional \$10,000 after year five, as with the other methods, so long as the cost of \$58,000 is not exceeded.

As a side note, there often is a difference in useful lives for assets when following GAAP versus the guidelines for depreciation under federal tax law, as enforced by the Internal Revenue Service (IRS). This difference is not unexpected when you consider that tax law is typically determined by the United States Congress, and there often is an economic reason for tax policy.

For example, if we want to increase investment in real estate, shortening the economic lives of real estate for taxation calculations can have a positive increasing effect on new construction. If we want to slow down new production, extending the economic life can have the desired slowing effect. In this course, we concentrate on financial accounting depreciation principles rather than tax depreciation.

## Fundamentals of Depletion of Natural Resources

Another type of fixed asset is  natural resources , assets a company owns that are consumed when used. Examples include lumber, mineral deposits, and oil/gas fields. These assets are considered natural resources while they are still part of the land; as they are extracted from the land and converted into products, they are then accounted for as inventory (raw materials). Natural resources are recorded on the company’s books like a fixed asset, at cost, with total costs including all expenses to acquire and prepare the resource for its intended use.

As the resource is consumed (converted to a product), the cost of the asset must be expensed: this process is called  depletion . As with depreciation of nonnatural resource assets, a contra account called  accumulated depletion , which records the total depletion expense for a natural resource over its life, offsets the natural resource asset account. Depletion expense is typically calculated based on the number of units extracted from cutting, mining, or pumping the resource from the land, similar to the units-of-production method. For example, assume a company has an oil well with an estimated 10,000 gallons of crude oil. The company purchased this well for \$1,000,000, and the well is expected to have no salvage value once it is pumped dry. The depletion cost per gallon will be \$1,000,000 ÷ 10,000 = \$100. If the company extracts 4,000 gallons of oil in a given year, the depletion expense will be \$400,000.

## Fundamentals of Amortization of an Intangible

Recall that intangible assets are recorded as long-term assets at their cost. As with tangible assets, many intangible assets have a finite (limited) life span so their costs must be allocated over their useful lives: this process is  amortization . Depreciation and amortization are similar in nature but have some important differences. First, amortization is typically only done using the straight-line method. Second, there is usually no salvage value for intangible assets because they are completely used up over their life span. Finally, an accumulated amortization account is not required to record yearly expenses (as is needed with depreciation); instead, the intangible asset account is written down each period.

For example, a company called Patents-R-Us purchased a product patent for \$10,000, granting the company exclusive use of that product for the next twenty years. Therefore, unless the company does not think the product will be useful for all twenty years (at that point the company would use the shorter useful life of the product), the company will record amortization expense of \$500 a year or (\$10,000 ÷ 20 years). Assuming that it was placed into service on October 1, 2019, the journal entry would be as follows:

## Long Descriptions

Columns labeled left to right: Year, Depreciation Expense, Accumulated Depreciation, Book Value. Line 1: \$58,000 in the Book Value column. Line 2: 1: \$58,000 times 40 percent equals \$23,200, \$23,200, 34,800. Line 3: 2: \$34,800 times 40 percent equals \$13,920, 37,120, 20,880. Line 4: 3: \$20,880 times 40 percent equals 8,352, 45,472, 12,528. Line 5: 4: \$12,528 minus \$10,000 equals 2,528, 48,000, 10,000. Line 6: 5, 0, 48,000, 10.000. Line 7: Total, \$48,000, \$48,000, \$10,000. Return

Columns labeled left to right: Period, Straight-Line Depreciation Method, Units of Production Method, Double-Declining Balance Method. Year 1, \$9,600, (180,000 units) \$9,000, \$23,200. Year 2, 9,600, (200,000 units) 10,000, 13,920. Year 3, 9,600, (210,000 units) 10,500, 8,352. Year 4, 9,600, (190,000 units) 9,500, 2,528. Year 5, 9,600, (180,000 units) 9,000, 0. Total, \$48,000, \$48,000, \$48,000.” Return

• 6   U.S. Securities and Exchange Commission. “Judge Enters Final Judgment against Former CFO of Waste Management, Inc. Following Jury Verdict in SEC’s Favor.” January 3, 2008. https://www.sec.gov/news/press/2008/2008-2.htm

## Depreciation is Not a Matter of Valuation But a Means of Cost Allocation:

• school Campus Bookshelves
• perm_media Learning Objects
• how_to_reg Request Instructor Account
• hub Instructor Commons
• Periodic Table
• Physics Constants
• Scientific Calculator
• Reference & Cite
• Tools expand_more

This action is not available.

## 4.3: Alternative Patterns for Calculating Depreciation

• Last updated
• Save as PDF
• Page ID 51340

## Learning Objectives

At the end of this section, students should be able to meet the following objectives:

• Explain the justification for accelerated methods of depreciation.
• Compute depreciation expense using the double-declining balance method.
• Realize that the overall impact on net income is not affected by a particular cost allocation pattern.

Question: Straight-line depreciation certainly qualifies as systematic and rational. The same amount of cost is assigned to expense during each period of use . Because no specific method is required by U.S. GAAP, do companies ever use alternative approaches to create other allocation patterns for depreciation?   If so, how are these additional methods justified?

Answer: The most common alternative to the straight-line method is accelerated depreciation , which records a larger expense in the initial years of an asset’s service. The primary rationale for this pattern is that property and equipment often produce higher revenues earlier in their lives because they are newer. The matching principle would suggest that recognizing more depreciation in these periods is appropriate to better align the expense with the revenues earned.

A second justification for accelerated depreciation is that some types of property and equipment lose value more quickly in their first few years than they do in later years. Automobiles and other vehicles are a typical example of this pattern. Recording a greater expense initially is said to better reflect reality.

Over the decades, a number of equations have been invented to mathematically create an accelerated depreciation pattern, high expense at first with subsequent cost allocations falling throughout the life of the property. The most common is the double-declining balance method (DDB) . When using DDB, annual depreciation is determined by multiplying the book value of the asset times two divided by the expected years of life. As book value drops, annual expense drops. This formula has no internal logic except that it creates the desired pattern, an expense that is higher in the first years of operation and less after that. Although residual value is not utilized in this computation, the final amount of depreciation recognized must be manipulated to arrive at this proper ending balance.

Depreciation for the building bought above for \$600,000 with an expected five-year life and a residual value of \$30,000 is calculated as follows if DDB is applied.

(cost – accumulated depreciation) × 2/expected life = depreciation expense for period

(\$600,000 – \$0) = \$600,000 × 2/5 = \$240,000 depreciation expense

(\$600,000 – \$240,000) = \$360,000 × 2/5 = \$144,000 depreciation expense   note using the depreciation from year 1 as accumulated depreciation

Year Three:

(\$600,000 – \$384,000) = \$216,000 × 2/5 = \$86,400 depreciation expense   note using the depreciation from year 1 and 2 as accumulated depreciation

(\$600,000 – \$470,400) = \$129,600 × 2/5 = \$51,840 depreciation expense

(\$600,000 – \$522,240) = \$77,760,

so depreciation for Year Five must be set at \$47,760 to arrive at the expected residual value of \$30,000. This final expense is always the amount needed to arrive at the expected residual value.

Note that the desired expense pattern has resulted. The expense starts at \$240,000 and becomes smaller (declines) in each subsequent period.

## So while both straight line and double declining balance methods end up with the same total depreciation over 5 years – the amount of depreciation recorded each year is different.  Double declining balance records more depreciation and thus will have lower net income in the early years while straight line will have lower net income in the later years.

Check yourself.

If Downtown Company purchases a machine for \$120,000 with a useful life of 7 years and an estimated residual value of \$10,000, how much depreciation would be recorded in  the  second year    of its useful life using Double Declining Balance ?

A.  \$24,490

B.  \$31,428

C.  \$34,286

D.  \$28,571

The correct answer is A.  For year one the calculation would be 120,000 x 2 / 7 = 34,286.  Subtract that accumulated depreciation from 120,000.  So (120,000 – 34,286) x 2 / 7 = 24,490.

Question: The two methods demonstrated here for establishing a depreciation pattern are based on time, five years to be precise. In most cases, though, it is the physical use of the asset rather than the passage of time that is actually relevant to this process. Use is the action that generates revenues . How is the depreciation of a long-lived tangible asset determined if usage can be measured?   For example, assume that a limousine company buys a new vehicle for \$90,000 to serve as an addition to its fleet. Company officials expect this limousine to be driven for three hundred thousand miles and then have no residual value. How is depreciation expense determined each period?

Answer: Depreciation does not have to be based on time; it only has to be computed in a systematic and rational manner. Thus, the units-of-production method (UOP) is another alternative that is occasionally encountered. UOP is justified because the periodic expense is matched with the work actually performed. In this illustration, the limousine’s depreciation can be computed using the number of miles driven in a year, an easy figure to determine.

(\$90,000 less \$0)/300,000 miles = \$0.30 per mile

Depreciation is recorded at a rate of \$0.30 per mile. The depreciable cost basis is allocated evenly over the miles that the vehicle is expected to be driven. UOP is a straight-line method but one that is based on usage (miles driven, in this example) rather than years. Because of the direct connection between the expense allocation and the work performed, UOP is a very appealing approach. It truly mirrors the matching principle. Unfortunately, measuring the physical use of most assets is rarely as easy as with a limousine.

For example, if this vehicle is driven 80,000 miles in Year One, 120,000 miles in Year Two, and 100,000 miles in Year Three, depreciation will be \$24,000, \$36,000, and \$30,000 when the \$0.30 per mile rate is applied.

Figure 4.4  Depreciation—Units-of-Production Method

Estimations rarely prove to be precise reflections of reality. This vehicle will not likely be driven exactly three hundred thousand miles. If used for less and then retired, both the cost and accumulated depreciation are removed. A loss is recorded equal to the remaining book value unless some cash or other asset is received. If driven more than the anticipated number of miles, depreciation stops at three hundred thousand miles. At that point, the cost of the asset will have been depreciated completely.

Which of the following is true with regard to units of production calculation of depreciation?

A.  Residual value is ignored in the calculation just like double declining balance.

B.  It requires two steps – cost per unit calculation and multiply by units to get depreciation expense.

C.  Over the life of an asset the units of production method results in higher total depreciation than double declining balance.

D.  Units of production is probably the worst method for matching revenues with expenses.

The answer is B.  Residual value is subtracted when calculating the cost per unit and all methods of depreciation must have the same total depreciation amount.  Calculating depreciation requires two steps – cost per unit and then multiplying that cost by the number of units for the time period to get the depreciation expense for that time period.

## Key Takeaway

Cost allocation patterns for determining depreciation exist beyond just the straight-line method. Accelerated depreciation records more expense in the earlier years of use than in later periods. This pattern is sometimes considered a better matching of expenses with revenues and a closer image of reality. The double-declining balance method is the most common version of accelerated depreciation. Its formula was derived to create the appropriate allocation pattern. The units-of-production method is often used for property and equipment where the quantity of work performed can be easily monitored.

## Our Recommendations

• Best Small Business Loans for 2024
• Biz2Credit Review
• SBG Funding Review
• Rapid Finance Review
• 26 Great Business Ideas for Entrepreneurs
• Startup Costs: How Much Cash Will You Need?
• Articles of Incorporation: What New Business Owners Should Know

• Startup Basics
• Startup Funding
• Franchising
• Success Stories
• Entrepreneurs
• The Best Credit Card Processors of 2024
• Clover Credit Card Processing Review
• Merchant One Review
• Stax Review
• Local Marketing Strategies for Success
• Tips for Hiring a Marketing Company
• Benefits of CRM Systems
• 10 Employee Recruitment Strategies for Success
• Sales & Marketing
• Social Media
• Best Business Phone Systems of 2024
• The Best PEOs of 2024
• RingCentral Review
• Nextiva Review
• Ooma Review
• Guide to Developing a Training Program for New Employees
• How Does 401(k) Matching Work for Employers?
• Why You Need to Create a Fantastic Workplace Culture
• 16 Cool Job Perks That Keep Employees Happy
• 7 Project Management Styles
• Personal Growth
• Best Accounting Software and Invoice Generators of 2024
• Best Payroll Services for 2024
• Best POS Systems for 2024
• Best CRM Software of 2024
• Best Call Centers and Answering Services for Busineses for 2024
• Rippling vs Gusto: An In-Depth Comparison
• RingCentral vs. Ooma Comparison
• Equipment Leasing: A Guide for Business Owners
• HR Solutions
• Financial Solutions
• Marketing Solutions
• Security Solutions
• Retail Solutions
• SMB Solutions

## What Is Depreciation in Business?

• Depreciation is the process of deducting the cost of a business asset over a long period of time, rather than over the course of one year.
• There are four main methods of depreciation: straight line, double declining, sum of the years’ digits and units of production.
• Each method is used for different types of businesses and types of assets.

Depreciation is often misunderstood as a term for something simply losing value, or as a calculation performed for tax purposes. Depreciation is an important part of your business’s tax returns, but it is a complex concept. Keep reading to learn what depreciation is, how it is calculated and how your depreciation calculation can affect your business.

## What is depreciation?

Depreciation has two main aspects. The first aspect is the decrease in the value of an asset over time. The second aspect is allocating the price you originally paid for an expensive asset over the period of time you use that asset.

The number of years over which an asset is depreciated is determined by the asset’s estimated useful life, or how long the asset can be used. For example, the estimate useful life of a laptop computer is about five years.

There are multiple classes of assets, including commodities and property. When doing your yearly budget or balance sheet , asset depreciation is considered a fixed cost, unless you are using a method where the depreciable amount changes every year (such as the unit of production method), in which case it would be a variable cost.

[ Related: Business Liabilities And How to Manage Them ]

## What assets can be depreciated?

The IRS has specific guidelines about what types of assets can be depreciated for accounting purposes. According to the IRS, to be depreciable, an asset must

• Be owned by you
• Have a determinable useful life
• Be expected to last for more than one year

Some examples of the most common types of depreciable assets include vehicles; buildings; office equipment or furniture; computers and other electronics; machinery and equipment; and certain intangible items, such as patents, copyrights, and computer software.

## What assets cannot be depreciated?

You cannot depreciate an asset that does not meet the IRS’ requirements, so nothing that does not wear out, become obsolete or get used up. You also cannot depreciate

• Collectibles (e.g., art, coins, memorabilia, etc.)
• Investments (e.g., stocks and bonds)
• Personal property
• Any asset used for less than one year

## Types of depreciation

There are multiple methods of depreciation used in accounting. The four main types of depreciation are as follows.

## 1. Straight-line depreciation

This is the simplest and most straightforward method of depreciation. It splits an asset’s value equally over multiple years, meaning you pay the same amount for every year of the asset’s useful life.

Straight-line depreciation is a good option for small businesses with simple accounting systems or businesses where the business owner prepares and files the tax return.

The advantages of straight-line depreciation are that it is easy to use, it renders relatively few errors, and business owners can expense the same amount every accounting period.

However, its simplicity can also be a drawback, because the useful life calculation is largely based on guesswork or estimation. It also does not factor in the accelerated loss of an asset’s value in the short term or the likelihood that maintenance costs will go up as the asset gets older.

• Depreciation formula: Divide the cost of the asset (minus its salvage value) by the estimated number of years of its useful life. The “salvage value” is the estimated amount of money the item will be worth at the end of its useful life. Here’s what the formula looks like: (Cost of asset – Salvage value of asset) / Useful life of asset = Depreciation expense

[ Related Content: What Is EBITDA And How Is It Used? ]

## 2. Double-declining depreciation

This method, also called declining balance depreciation, allows you to write off more of an asset’s value right after you purchase it and less as time goes by. This is a good option for businesses that want to recover more of the asset’s value upfront rather than waiting a certain number of years, such as small businesses with a lot of initial costs and requiring extra cash.

The double-declining balance method is advantageous because it can help offset increased maintenance costs as an asset ages; it can also maximize tax deductions by allowing higher depreciation expenses in the early years.

• Depreciation formula: 2 x (Single-line depreciation rate) x (Book value at beginning of the year). The “book value” is the asset’s cost minus the amount of depreciation you have already taken.

## 3. Sum of the years’ digits depreciation

Sum of the years’ digits (SYD) depreciation is similar to the double-declining method in that it is also an accelerated depreciation calculation. Instead of decreasing the book value, SYD calculates a weighted percentage based on the asset’s remaining useful life.

SYD suits businesses that want to recover more value upfront, but with more even distribution than they would otherwise get using the double-declining method. The SYD method’s main advantage is that the accelerated depreciation reduces taxable income and taxes owed during the early years of the asset’s life. The main drawback of SYD is that it is markedly more complex to calculate than the other methods.

• Depreciation formula: (Remaining lifespan / SYD) x (Asset cost – Salvage value). You must first calculate the SYD by adding together the digits for each depreciation year. For example, the SYD calculation for five years is 5+4+3+2+1=15. You then divide each year by this sum to calculate that year’s depreciation percentage. To find the percentage for the first year’s depreciation, you would divide the digit of the first year (5) by the SYD total (15), which comes out to 33% (5 / 15 = 33%).

[ See: Helpful Accounting Formulas and Ratios ]

## 4. Units of production depreciation

This is a simple way to depreciate the value of an asset based on how frequently the asset is used. “Units of production” can refer to something the equipment makes — like the number of pizzas that can be made in a pizza oven, or the number of hours that it’s in use. This method is good for businesses that want to write off equipment with a quantifiable and widely accepted (i.e., based on the manufacturer’s specifications) output during its useful life. Make sure you have a method in place for tracking your use of equipment, and expect to write off a different amount every year.

The main advantage of the units of production depreciation method is that it gives you a highly accurate picture of your depreciation cost based on actual numbers, depending on your tracking method. Its main disadvantage is that it is difficult to apply to many real-life situations, as it is not always easy to estimate how many units an asset can produce before it reaches the end of its useful life.

• Depreciation formula: (Asset cost – Salvage value) / Units produced in useful life

## How does deprecation affect tax liability?

Depreciation reduces the taxes your business must pay via deductions by tracking the decrease in the value of your assets. Your business’s depreciation expense reduces the earnings on which your taxes are based, reducing the taxes your business owes the IRS.  The larger the depreciation expense, the lower your taxable income.

## Long-Term Assets

Read these sections to continue our discussion on assets. Assets are classified as current (can be liquidated in one year or less) and long-term (will take longer than one year to liquidate). Pay attention to the balance sheet treatment of long-term assets, and also the process for depreciating those assets.

## 1. Long-Term Assets

1.3. explain and apply depreciation methods to allocate capitalized costs.

In this section, we concentrate on the major characteristics of determining capitalized costs and some of the options for allocating these costs on an annual basis using the depreciation process. In the determination of capitalized costs, we do not consider just the initial cost of the asset; instead, we determine all of the costs necessary to place the asset into service. For example, if our company purchased a drill press for \$22,000, and spent \$2,500 on sales taxes and \$800 for delivery and setup, the depreciation calculation would be based on a cost of \$22,000 plus \$2,500 plus \$800, for a total cost of \$25,300.

We also address some of the terminology used in depreciation determination that you want to familiarize yourself with. Finally, in terms of allocating the costs, there are alternatives that are available to the company. We consider three of the most popular options, the straight-line method, the units-of-production method, and the double-declining-balance method.

## Calculating Depreciation Costs

Liam buys his silk screen machine for \$10,000. He estimates that he can use this machine for five years or 100,000 presses, and that the machine will only be worth \$1,000 at the end of its life. He also estimates that he will make 20,000 clothing items in year one and 30,000 clothing items in year two. Determine Liam's depreciation costs for his first two years of business under straight-line, units-of-production, and double-declining-balance methods. Also, record the journal entries.

Straight-line method: (\$10,000 – \$1,000)/5 = \$1,800 per year for both years.

Units-of-production method: (\$10,000 – \$1,000)/100,000= \$0.09 per press

Year 1 expense: \$0.09 × 20,000 = \$1,800

Year 2 expense: \$0.09 × 30,000 = \$2,700

Double-declining-balance method:

Year 1 expense: [(\$10,000 – 0)/5] × 2 = \$4,000

Year 2 expense: [(\$10,000 – \$4,000)/5] × 2 = \$2,400

## Fundamentals of Depreciation

As you have learned, when accounting for a long-term fixed asset, we cannot simply record an expense for the cost of the asset and record the entire outflow of cash in one accounting period. Like all other assets, when purchasing or acquiring a long-term asset, it must be recorded at the historical (initial) cost, which includes all costs to acquire the asset and put it into use. The initial recording of an asset has two steps:

• Record the initial purchase on the date of purchase, which places the asset on the balance sheet (as property, plant, and equipment) at cost, and record the amount as notes payable, accounts payable, or an outflow of cash.
• At the end of the period, make an adjusting entry to recognize the depreciation expense. Companies may record depreciation expense incurred annually, quarterly, or monthly.

Following GAAP and the expense recognition principle, the depreciation expense is recognized over the asset's estimated useful life.

## Recording the Initial Purchase of an Asset

Assets are recorded on the balance sheet at cost, meaning that all costs to purchase the asset and to prepare the asset for operation should be included. Costs outside of the purchase price may include shipping, taxes, installation, and modifications to the asset.

The journal entry to record the purchase of a fixed asset (assuming that a note payable is used for financing and not a short-term account payable) is shown here.

Applying this to Liam's silk-screening business, we learn that he purchased his silk-screening machine for \$5,000 by paying \$1,000 cash and the remainder in a note payable over five years. The journal entry to record the purchase is shown here.

## Concepts In Practice

Estimating useful life and salvage value.

Useful life and salvage value are estimates made at the time an asset is placed in service. It is common and expected that the estimates are inaccurate with the uncertainty involved in estimating the future. Sometimes, however, a company may attempt to take advantage of estimating salvage value and useful life to improve earnings. A larger salvage value and longer useful life decrease annual depreciation expense and increase annual net income. An example of this behavior is Waste Management, which was disciplined by the Securities and Exchange Commission for fraudulently altering its estimates to reduce depreciation expense and overstate net income by \$1.7 billion.

## Components Used in Calculating Depreciation

The expense recognition principle that requires that the cost of the asset be allocated over the asset's useful life is the process of depreciation. For example, if we buy a delivery truck to use for the next five years, we would allocate the cost and record depreciation expense across the entire five-year period. The calculation of the depreciation expense for a period is not based on anticipated changes in the fair market value of the asset; instead, the depreciation is based on the allocation of the cost of owning the asset over the period of its useful life.

The following items are important in determining and recording depreciation:

• Book value: the asset's original cost less accumulated depreciation.
• Useful life: the length of time the asset will be productively used within operations.
• Salvage (residual) value: the price the asset will sell for or be worth as a trade-in when its useful life expires. The determination of salvage value can be an inexact science, since it requires anticipating what will occur in the future. Often, the salvage value is estimated based on past experiences with similar assets.
• Depreciable base (cost): the depreciation expense over the asset's useful life. For example, if we paid \$50,000 for an asset and anticipate a salvage value of \$10,000, the depreciable base is \$40,000. We expect \$40,000 in depreciation over the time period in which the asset was used, and then it would be sold for \$10,000.

Depreciation records an expense for the value of an asset consumed and removes that portion of the asset from the balance sheet. The journal entry to record depreciation is shown here.

Depreciation expense is a common operating expense that appears on an income statement. Accumulated depreciation is a contra account , meaning it is attached to another account and is used to offset the main account balance that records the total depreciation expense for a fixed asset over its life. In this case, the asset account stays recorded at the historical value but is offset on the balance sheet by accumulated depreciation. Accumulated depreciation is subtracted from the historical cost of the asset on the balance sheet to show the asset at book value. Book value is the amount of the asset that has not been allocated to expense through depreciation.

In this case, the asset's book value is \$20,000: the historical cost of \$25,000 less the accumulated depreciation of \$5,000.

It is important to note, however, that not all long-term assets are depreciated. For example, land is not depreciated because depreciation is the allocating of the expense of an asset over its useful life. How can one determine a useful life for land? It is assumed that land has an unlimited useful life; therefore, it is not depreciated, and it remains on the books at historical cost.

Once it is determined that depreciation should be accounted for, there are three methods that are most commonly used to calculate the allocation of depreciation expense: the straight-line method, the units-of-production method, and the double-declining-balance method. A fourth method, the sum-of-the-years-digits method, is another accelerated option that has been losing popularity and can be learned in intermediate accounting courses. Let's use the following scenario involving Kenzie Company to work through these three methods.

Assume that on January 1, 2019, Kenzie Company bought a printing press for \$54,000. Kenzie pays shipping costs of \$1,500 and setup costs of \$2,500, assumes a useful life of five years or 960,000 pages. Based on experience, Kenzie Company anticipates a salvage value of \$10,000.

Recall that determination of the costs to be depreciated requires including all costs that prepare the asset for use by the company. The Kenzie example would include shipping and setup costs. Any costs for maintaining or repairing the equipment would be treated as regular expenses, so the total cost would be \$58,000, and, after allowing for an anticipated salvage value of \$10,000 in five years, the business could take \$48,000 in depreciation over the machine's economic life.

## Fixed Assets

You work for Georgia-Pacific as an accountant in charge of the fixed assets subsidiary ledger at a production and warehouse facility in Pennsylvania. The facility is in the process of updating and replacing several asset categories, including warehouse storage units, fork trucks, and equipment on the production line. It is your job to keep the information in the fixed assets subsidiary ledger up to date and accurate. You need information on original historical cost, estimated useful life, salvage value, depreciation methods, and additional capital expenditures. You are excited about the new purchases and upgrades to the facility and how they will help the company serve its customers better. However, you have been in your current position for only a few years and have never overseen extensive updates, and you realize that you will have to gather a lot of information at once to keep the accounting records accurate. You feel overwhelmed and take a minute to catch your breath and think through what you need. After a few minutes, you realize that you have many people and many resources to work with to tackle this project. Whom will you work with and how will you go about gathering what you need?

## Straight-Line Depreciation

Straight-line depreciation is a method of depreciation that evenly splits the depreciable amount across the useful life of the asset. Therefore, we must determine the yearly depreciation expense by dividing the depreciable base of \$48,000 by the economic life of five years, giving an annual depreciation expense of \$9,600. The journal entries to record the first two years of expenses are shown, along with the balance sheet information. Here are the journal entry and information for year one:

After the journal entry in year one, the press would have a book value of \$48,400. This is the original cost of \$58,000 less the accumulated depreciation of \$9,600. Here are the journal entry and information for year two:

Kenzie records an annual depreciation expense of \$9,600. Each year, the accumulated depreciation balance increases by \$9,600, and the press's book value decreases by the same \$9,600. At the end of five years, the asset will have a book value of \$10,000, which is calculated by subtracting the accumulated depreciation of \$48,000 (5 × \$9,600) from the cost of \$58,000.

## Units-of-Production Depreciation

Straight-line depreciation is efficient, accounting for assets used consistently over their lifetime, but what about assets that are used with less regularity? The units-of-production depreciation method bases depreciation on the actual usage of the asset, which is more appropriate when an asset's life is a function of usage instead of time. For example, this method could account for depreciation of a printing press for which the depreciable base is \$48,000 (as in the straight-line method), but now the number of pages the press prints is important.

In our example, the press will have a total depreciation of \$48,000 over its useful life of 960,000 pages. Therefore, we would divide \$48,000 by 960,000 pages to get a cost per page of \$0.05. If Kenzie printed 180,000 pages in the first year, the depreciation expense would be 180,000 pages × \$0.05 per page, or \$9,000. The journal entry to record this expense would be the same as with straight-line depreciation: only the dollar amount would have changed. The presentation of accumulated depreciation and the calculation of the book value would also be the same. Kenzie would continue to depreciate the asset until a total of \$48,000 in depreciation was taken after printing 960,000 total pages.

## Think It Through

Deciding on a depreciation method.

Liam is struggling to determine which depreciation method he should use for his new silk-screening machine. He expects sales to increase over the next five years. He also expects (hopes) that in two years he will need to buy a second silk-screening machine to keep up with the demand for products of his growing company. Which depreciation method makes more sense for Liam: higher expenses in the first few years, or keeping expenses consistent over time? Or would it be better for him to not think in terms of time, but rather in the usage of the machine?

## Double-Declining-Balance Depreciation

The double-declining-balance depreciation method is the most complex of the three methods because it accounts for both time and usage and takes more expense in the first few years of the asset's life. Double-declining considers time by determining the percentage of depreciation expense that would exist under straight-line depreciation. To calculate this, divide 100% by the estimated life in years. For example, a five-year asset would be 100/5, or 20% a year. A four-year asset would be 100/4, or 25% a year. Next, because assets are typically more efficient and "used" more heavily early in their life span, the double-declining method takes usage into account by doubling the straight-line percentage. For a four-year asset, multiply 25% (100%/4-year life) × 2, or 50%. For a five-year asset, multiply 20% (100%/5-year life) × 2, or 40%.

One unique feature of the double-declining-balance method is that in the first year, the estimated salvage value is not subtracted from the total asset cost before calculating the first year's depreciation expense. Instead the total cost is multiplied by the calculated percentage. However, depreciation expense is not permitted to take the book value below the estimated salvage value, as demonstrated in the following text.

Notice that in year four, the remaining book value of \$12,528 was not multiplied by 40%. This is because the expense would have been \$5,011.20, and since we cannot depreciate the asset below the estimated salvage value of \$10,000, the expense cannot exceed \$2,528, which is the amount left to depreciate (difference between the book value of \$12,528 and the salvage value of \$10,000). Since the asset has been depreciated to its salvage value at the end of year four, no depreciation can be taken in year five.

In our example, the first year's double-declining-balance depreciation expense would be \$58,000 × 40%, or \$23,200. For the remaining years, the double-declining percentage is multiplied by the remaining book value of the asset. Kenzie would continue to depreciate the asset until the book value and the estimated salvage value are the same (in this case \$10,000).

The net effect of the differences in straight-line depreciation versus double-declining-balance depreciation is that under the double-declining-balance method, the allowable depreciation expenses are greater in the earlier years than those allowed for straight-line depreciation. However, over the depreciable life of the asset, the total depreciation expense taken will be the same, no matter which method the entity chooses. For example, in the current example both straight-line and double-declining-balance depreciation will provide a total depreciation expense of \$48,000 over its five-year depreciable life.

## IFRS Connection

Accounting for depreciation.

Both US GAAP and International Financial Reporting Standards (IFRS) account for long-term assets (tangible and intangible) by recording the asset at the cost necessary to make the asset ready for its intended use. Additionally, both sets of standards require that the cost of the asset be recognized over the economic, useful, or legal life of the asset through an allocation process such as depreciation. However, there are some significant differences in how the allocation process is used as well as how the assets are carried on the balance sheet.

IFRS and US GAAP allow companies to choose between different methods of depreciation, such as even allocation (straight-line method), depreciation based on usage (production methods), or an accelerated method (double-declining balance). The mechanics of applying these methods do not differ between the two standards. However, IFRS requires companies to use "component depreciation" if it is feasible. Component depreciation would apply to assets with components that have differing lives. Consider the following example using a plane owned by Southwest Airlines. Let's divide this plane into three components: the interior, the engines, and the fuselage. Suppose the average life of the interior of a plane is ten years, the average life of the engines is fifteen years, and the average life of the fuselage is twenty-five years. Given this, what should be the depreciable life of the asset? In that case, under IFRS, the costs associated with the interior would be depreciated over ten years, the costs associated with the engines would be depreciated over fifteen years, and the costs associated with the fuselage would be depreciated over twenty-five years. Under US GAAP, the total cost of the airplane would likely be depreciated over twenty years. Obviously, component depreciation involves more record keeping and differing amounts of depreciation per year for the life of the asset. But the same amount of total depreciation, the cost of the asset less residual value, would be taken over the life of the asset under both US GAAP and IFRS.

Probably one of the most significant differences between IFRS and US GAAP affects long-lived assets. This is the ability, under IFRS, to adjust the value of those assets to their fair value as of the balance sheet date. The adjustment to fair value is to be done by "class" of asset, such as real estate, for example. A company can adjust some classes of assets to fair value but not others. Under US GAAP, almost all long-lived assets are carried on the balance sheet at their depreciated historical cost, regardless of how the actual fair value of the asset changes. Consider the following example. Suppose your company owns a single building that you bought for \$1,000,000. That building currently has \$200,000 in accumulated depreciation. This building now has a book value of \$800,000. Under US GAAP, this is how this building would appear in the balance sheet. Even if the fair value of the building is \$875,000, the building would still appear on the balance sheet at its depreciated historical cost of \$800,000 under US GAAP. Alternatively, if the company used IFRS and elected to carry real estate on the balance sheet at fair value, the building would appear on the company's balance sheet at its new fair value of \$875,000.

It is difficult to determine an accurate fair value for long-lived assets. This is one reason US GAAP has not permitted the fair valuing of long-lived assets. Different appraisals can result in different determinations of "fair value." Thus, the Financial Accounting Standards Board (FASB) elected to continue with the current method of carrying assets at their depreciated historical cost. The thought process behind the adjustments to fair value under IFRS is that fair value more accurately represents true value. Even if the fair value reported is not known with certainty, reporting the class of assets at a reasonable representation of fair value enhances decision-making by users of the financial statements.

## Summary of Depreciation

Table 11.2 compares the three methods discussed. Note that although each time-based (straight-line and double-declining balance) annual depreciation expense is different, after five years the total amount depreciated (accumulated depreciation) is the same. This occurs because at the end of the asset's useful life, it was expected to be worth \$10,000: thus, both methods depreciated the asset's value by \$48,000 over that time period.

The units of production method is different from the two above methods in that while those methods are based on time factors, the units of production is based on usage. However, the total amount of depreciation taken over an asset's economic life will still be the same. In our example, the total depreciation will be \$48,000, even though the sum-of-the-years-digits method could take only two or three years or possibly six or seven years to be allocated.

Calculation of Depreciation Expense

## Ethical Considerations

Depreciation analysis requires careful evaluation.

When analyzing depreciation, accountants are required to make a supportable estimate of an asset's useful life and its salvage value. However, "management teams typically fail to invest either time or attention into making or periodically revisiting and revising reasonably supportable estimates of asset lives or salvage values, or the selection of depreciation methods, as prescribed by GAAP". This failure is not an ethical approach to properly accounting for the use of assets.

Accountants need to analyze depreciation of an asset over the entire useful life of the asset. As an asset supports the cash flow of the organization, expensing its cost needs to be allocated, not just recorded as an arbitrary calculation. An asset's depreciation may change over its life according to its use. If asset depreciation is arbitrarily determined, the recorded "gains or losses on the disposition of depreciable property assets seen in financial statements" are not true best estimates. Due to operational changes, the depreciation expense needs to be periodically reevaluated and adjusted.

Any mischaracterization of asset usage is not proper GAAP and is not proper accrual accounting. Therefore, "financial statement preparers, as well as their accountants and auditors, should pay more attention to the quality of depreciation-related estimates and their possible mischaracterization and losses of credits and charges to operations as disposal gains."  An accountant should always follow GAAP guidelines and allocate the expense of an asset according to its usage.

## Partial-Year Depreciation

A company will usually only own depreciable assets for a portion of a year in the year of purchase or disposal. Companies must be consistent in how they record depreciation for assets owned for a partial year. A common method is to allocate depreciation expense based on the number of months the asset is owned in a year. For example, a company purchases an asset with a total cost of \$58,000, a five-year useful life, and a salvage value of \$10,000. The annual depreciation is \$9,600 ([\$58,000 – 10,000]/5). However, the asset is purchased at the beginning of the fourth month of the fiscal year. The company will own the asset for nine months of the first year. The depreciation expense of the first year is \$7,200 (\$9,600 × 9/12). The company will depreciate the asset \$9,600 for the next four years, but only \$2,400 in the sixth year so that the total depreciation of the asset over its useful life is the depreciable amount of \$48,000 (\$7,200 + 9,600 + 9,600 + 9,600 + 9,600 + 2,400).

## Choosing Appropriate Depreciation Methods

You are part of a team reviewing the financial statements of a new computer company. Looking over the fixed assets accounts, one long-term tangible asset sticks out. It is labeled "USB" and valued at \$10,000. You ask the company's accountant for more detail, and he explains that the asset is a USB drive that holds the original coding for a game the company developed during the year. The company expects the game to be fairly popular for the next few years, and then sales are expected to trail off. Because of this, they are planning on depreciating this asset over the next five years using the double-declining method. Does this recording seem appropriate, or is there a better way to categorize the asset? How should this asset be expensed over time?

## Special Issues in Depreciation

While you've now learned the basic foundation of the major available depreciation methods, there are a few special issues. Until now, we have assumed a definite physical or economically functional useful life for the depreciable assets. However, in some situations, depreciable assets can be used beyond their useful life. If so desired, the company could continue to use the asset beyond the original estimated economic life. In this case, a new remaining depreciation expense would be calculated based on the remaining depreciable base and estimated remaining economic life.

Assume in the earlier Kenzie example that after five years and \$48,000 in accumulated depreciation, the company estimated that it could use the asset for two more years, at which point the salvage value would be \$0. The company would be able to take an additional \$10,000 in depreciation over the extended two-year period, or \$5,000 a year, using the straight-line method.

As with the straight-line example, the asset could be used for more than five years, with depreciation recalculated at the end of year five using the double-declining balance method. While the process of calculating the additional depreciation for the double-declining-balance method would differ from that of the straight-line method, it would also allow the company to take an additional \$10,000 after year five, as with the other methods, so long as the cost of \$58,000 is not exceeded.

As a side note, there often is a difference in useful lives for assets when following GAAP versus the guidelines for depreciation under federal tax law, as enforced by the Internal Revenue Service (IRS). This difference is not unexpected when you consider that tax law is typically determined by the United States Congress, and there often is an economic reason for tax policy.

For example, if we want to increase investment in real estate, shortening the economic lives of real estate for taxation calculations can have a positive increasing effect on new construction. If we want to slow down new production, extending the economic life can have the desired slowing effect. In this course, we concentrate on financial accounting depreciation principles rather than tax depreciation.

## Fundamentals of Depletion of Natural Resources

Another type of fixed asset is natural resources, assets a company owns that are consumed when used. Examples include lumber, mineral deposits, and oil/gas fields. These assets are considered natural resources while they are still part of the land; as they are extracted from the land and converted into products, they are then accounted for as inventory (raw materials). Natural resources are recorded on the company's books like a fixed asset, at cost, with total costs including all expenses to acquire and prepare the resource for its intended use.

As the resource is consumed (converted to a product), the cost of the asset must be expensed: this process is called depletion . As with depreciation of nonnatural resource assets, a contra account called accumulated depletion , which records the total depletion expense for a natural resource over its life, offsets the natural resource asset account. Depletion expense is typically calculated based on the number of units extracted from cutting, mining, or pumping the resource from the land, similar to the units-of-production method. For example, assume a company has an oil well with an estimated 10,000 gallons of crude oil. The company purchased this well for \$1,000,000, and the well is expected to have no salvage value once it is pumped dry. The depletion cost per gallon will be \$1,000,000/10,000 = \$100. If the company extracts 4,000 gallons of oil in a given year, the depletion expense will be \$400,000.

## Fundamentals of Amortization of an Intangible

Recall that intangible assets are recorded as long-term assets at their cost. As with tangible assets, many intangible assets have a finite (limited) life span so their costs must be allocated over their useful lives: this process is amortization . Depreciation and amortization are similar in nature but have some important differences. First, amortization is typically only done using the straight-line method. Second, there is usually no salvage value for intangible assets because they are completely used up over their life span. Finally, an accumulated amortization account is not required to record yearly expenses (as is needed with depreciation); instead, the intangible asset account is written down each period.

For example, a company called Patents-R-Us purchased a product patent for \$10,000, granting the company exclusive use of that product for the next twenty years. Therefore, unless the company does not think the product will be useful for all twenty years (at that point the company would use the shorter useful life of the product), the company will record amortization expense of \$500 a year (\$10,000/20 years). Assuming that it was placed into service on October 1, 2019, the journal entry would be as follows:

See Form 10-K that was filed with the SEC to determine which depreciation method McDonald's Corporation used for its long-term assets in 2017.

## Cost Segregation Applied

A taxpayer can substantially increase cash flow by segregating property costs..

CPAs play a central role in the cost segregation process. They are the most likely people to recommend use of the technique to their clients or employers. CPAs also will review and implement the findings in the required engineering report. This article will guide CPAs through the process by discussing how cost segregation operates, providing a comprehensive example of the technique in a real estate acquisition and outlining its advantages and disadvantages.

A BRIEF HISTORY Under prior law taxpayers would separate a building’s parts into its various components—doors, walls and floors. Once these components were isolated, taxpayers would depreciate them using a short cost-recovery period. CPAs referred to this practice as component depreciation.

The introduction of the accelerated cost recovery system (ACRS) and the modified accelerated cost recovery system (MACRS) eliminated the use of component depreciation, but not the use of cost segregation. Hospital Corporation of America [HCA] v. Commissioner, 109 TC 21 (1997), is the seminal cost segregation case. In it the Tax Court permitted HCA to use cost segregation with respect to a multitude of improvements (see exhibit 1 ). Critical to the Tax Court’s analysis was that in formulating accelerated depreciation methods, Congress intended to distinguish between components that constitute IRC section 1250 class property (real property) and property items that constitute section 1245 class property (tangible personal property). This distinction opened the doors to cost segregation.

Armed with this victory, taxpayers have increasingly begun to use cost segregation to their advantage. The IRS reluctantly agreed that cost segregation does not constitute component depreciation (action on decision (AOD) 1999-008). Moreover, cost segregation recently was featured in temporary regulations issued by the Treasury Department (regulations section 1.446-1T). In a chief counsel advisory (CCA), however, the IRS warned taxpayers that an “accurate cost segregation study may not be based on noncontemporaneous records, reconstructed data or taxpayers’ estimates or assumptions that have no supporting records” (CCA 199921045).

HOW THE TECHNIQUE WORKS The process of cost segregation begins at the time of purchase. Accounting professionals should advise clients or employers buying real estate to use an engineering report to segregate assets into four categories:

This allows a purchaser to achieve faster depreciation deductions as well as possible and easier subsequent write-offs, so its cash flow will be increased. Assets allocated into the first two categories enjoy relatively short useful lives and, thus, accelerated depreciation methods. Furthermore, if the components of a building have been separately valued and a component subsequently becomes worthless, the taxpayer can write it off more easily.

Personal property. Taxpayers normally can depreciate this property using a five- or seven-year recovery period and the double-declining method. Within permissible bounds, there is a huge tax-savings premium for valuing this property as high as possible. This category includes items such as furniture, carpeting, certain fixtures and window treatments.

Land improvements. Like the first category, these have a relatively short useful life—15 years—and are subject to an accelerated depreciation method, namely the 150% declining-balance method. Again, within permissible bounds, purchasers should maximize the values they attribute to this category, which ordinarily includes items such as sidewalks, fences and docks.

The building. As in the first and second categories, buyers should attempt to maximize a building’s value; any residual value will be allocated to nondepreciable land. Although a building’s separate components (such as its roof) all are considered part of the building itself, there is merit to valuing and depreciating each component separately (albeit, on the same depreciation schedule). This way, if one of the building’s components subsequently becomes worthless, the taxpayer can write it off immediately.

Land. Whatever amount of the purchase price is not accounted for in the three prior categories is allocated to land. Land valued in this residuary fashion may have a relatively low or insignificant value, but proper documentation normally will protect a taxpayer from an IRS challenge.

THE HARD PART One of the trickier aspects of cost segregation is the actual categorization of property. Distinguishing between tangible personal property and a building made up of its structural components is an area of great controversy. IRC section 1245(a)(3) and Treasury regulations section 1.1245-3(b)(1) say the distinction between tangible personal property and structural components should be based on the criteria once used to determine whether property qualified for the now repealed investment tax credit under IRC section 38.

The Treasury regulations found under IRC section 48 delineate this distinction. Treasury regulations section 1.48-1(c) defines tangible personal property as all property “except land and improvements thereto, such as buildings or other inherently permanent structures (including items which are structural components of such buildings or structures).” That section further defines tangible personal property as “all property (other than structural components) which is contained in or attached to a building.” Examples of such property, it says, consist of printing presses, transportation and office equipment, refrigerators and display racks.

Treasury regulations section 1.48-1(e)(2) classifies as structural components any property that “relates to the operation or maintenance of a building,” and includes, by way of example, parts of a building (walls, floors and ceilings), as well as any permanent coverings (paneling, windows and doors), components of a central air conditioning or heating system (motors, pipes and ducts), plumbing and fixtures (sinks and bathtubs), electrical wiring and lighting fixtures, stairs and elevators and sprinkler systems.

CPAs may want to read Senate report 1881, which accompanied the Revenue Act of 1962, and Senate report 95-1263, which accompanied the Revenue Act of 1978, which both amplify and elucidate the distinction between tangible personal property and structural components.

In distinguishing between a building’s tangible personal property and structural components, CPAs will find the courts to be a final source of guidance. In Whiteco Industries, Inc. v. Commissioner (65 TC 664 (1975)), for example, the Tax Court set forth the following six questions CPAs can use to determine whether property is inherently permanent and thus a structural component excluded from the definition of tangible personal property:

Even with ample regulatory, legislative and judicial guidance, making the distinction between tangible personal property and a building’s structural components remains a challenge for CPAs. No bright-line test exists. What is fortunate, however, is that many of the factual issues involving properties of different sorts have been litigated, and their outcomes illuminate the direction a court confronted with similar facts is likely to take. Examples of how the courts viewed various categories of property are provided in “ Categorizing Property: Court Rulings ,” below.

COST SEGREGATION EXAMPLE A thorough analysis of the facts of each situation helps CPAs quantify the present-value tax savings associated with using cost segregation.

Consider the following example based on an actual cost segregation engineering report. Suppose a taxpayer purchases a nonresidential building for \$12,135,000 (assume the land is owned by an independent third party). If the taxpayer does not use cost segregation, it must use straight-line depreciation over 39 years.

In contrast, suppose the accounting professional advises his or her client or employer to retain an engineering consultant to prepare a cost segregation study. The engineer’s report shows that of the total purchase price, \$11,285,000 should be allocated to the building, \$50,000 to 15-year property and \$800,000 to 5-year property. Allocating part of the purchase price to these two additional property categories results in tremendous tax savings. Assuming a 35% tax rate and a 5% discount rate, the cost segregation study produces \$133,563 of tax savings. Exhibit 2 illustrates the yearly savings.

WHEN TO APPLY THE TECHNIQUE CPAs should keep three additional things in mind. First, the 2001 and 2003 tax acts made cost segregation more valuable. If real property is reclassified as 5-, 7- and 15-year personal property, it may qualify for 30% and 50% bonus depreciation. This bonus depreciation applies to new property in the first year it is placed in service. The magnitude of this additional allowance in the first year can be enormous. For example, a shift of \$1 million from 39-year property to 5-year property can augment first-year depreciation deductions by a whopping \$575,000 (\$25,000 vs. \$600,000). The resulting cash flow can provide the capital for numerous other projects. (Practitioners should be aware, however, that the application of alternative minimum tax—which in certain instances mandates slower depreciation methodologies—may reduce some of the tax savings associated with cost segregation.)

Second, cost segregation is applicable not only when taxpayers acquire new or existing structures but also when they previously had acquired or improved a structure and have the proper engineering report to justify cost segregation. (If, however, the real property in question was put into service too many years ago—commonly 10—there may be insufficient adjusted basis remaining to justify using cost segregation.)

Third, regulations issued in March 2004 sanction the use of cost segregation years after a real estate acquisition. Treasury regulations section 1.446-1T(e)(5)(iii), example 9, posits a situation where a cost segregation study was conducted four years after an initial building acquisition; the study showed the taxpayer had missed opportunities to take enhanced depreciation deductions. Under these circumstances the taxpayer was permitted to make an IRC section 481 adjustment all in the year it changed its method of depreciation. These changes in methodology, however, require that the taxpayer in a timely manner file form 3115 for permission to change its depreciation accounting method, which is granted automatically under current revenue procedures.

Today virtually all real-property purchases entail the simultaneous acquisition of tangible personal property. For that reason CPAs should routinely recommend the use of cost segregation studies whenever the expenditures for an acquisition, including leasehold improvements, equal or exceed \$750,000.

ADVANTAGES AND DISADVANTAGES The benefits of cost segregation overwhelmingly outweigh the drawbacks. When it comes to real estate acquisitions, the jewel of cost segregation is that it yields enhanced depreciation deductions. As evidenced by the above example, there can be astounding differences in outcomes between using and not using it. The major advantage of cost segregation is not necessarily that it will produce more depreciation deductions (except, of course, to the extent depreciable basis has been allocated away from the land element of the purchase). Instead, due to the time value of money, the advantage of these front-loaded deductions will be quantifiably greater than had the deductions been spread over longer periods of time using slower depreciation methods.

Another advantage of using cost segregation is that if a building component subsequently needs replacement, taxpayers can write off its remaining tax basis. To illustrate, suppose a cost segregation study showed the initial value of a roof to be \$500,000. Two years later, when the roof has an adjusted tax basis of \$480,000, it needs to be replaced. The taxpayer could deduct a \$480,000 loss. Had the taxpayer not done the cost segregation study, the outcome would have been vastly different; no loss could be taken because the roof’s tax basis and the basis of the building would remain intertwined.

Cost segregation also may result in lower local realty-transfer taxes. Localities often impose these taxes based on a building’s fair market value. When a cost segregation study reduces a building’s value, this produces a corresponding reduction in the amount of the transfer tax due (and a potential reduction of annual real estate taxes as well).

The process of cost segregation has shortcomings, however. First, and most easily quantifiable, is the actual cost of the engineering study. While the fees vary widely, a well-done study is not inexpensive: A typical cost segregation study and written report will cost between \$10,000 and \$25,000. Cost factors are the property’s location, whether the building is new or existing, the nature of the property (residential vs. nonresidential) and time pressures for completion of construction. As in any investment, the taxpayer must conduct a cost-benefit analysis. From the time of its initial commission, a cost segregation study should take about four to six weeks to complete. A business entity can deduct the cost of the study as a business expense under IRC section 162.

A second disadvantage is that the subsequent disposition of the real estate acquisition likely will trigger the tax code’s recapture provisions. For tangible personal property, IRC section 1245 will apply, so the taxpayer must recognize ordinary income, potentially subject to the top marginal tax rate (in 2004, 35%). Installment sale treatment also will not be available with respect to the recapture. With real property, IRC section 1250 will apply, so the taxpayer must recognize unrecaptured section 1250 gain, taxed at 25%. (In practice the contract for sale usually can be adjusted to allocate less of the purchase price to recapture items.)

Another disadvantage is that taxpayers who use cost segregation too aggressively, or who receive misinformation in their engineering report, may be subject to penalties. There is a 20% penalty on the portion of any tax underpayment from a “substantial valuation overstatement” (IRC section 6662(a)). A valuation overstatement occurs if the valuation is 200% or more than the amount determined to be the correct amount (IRC section 6662(e)(1)). This penalty will not apply, however, if the overvaluation does not result in a substantial misstatement of taxes—that is, exceeding \$5,000 (IRC section 6662(e)(1))—or the taxpayer can show reasonable cause and that it acted in good faith (IRC section 6664(c)(1)).

Some taxpayers are reluctant to use cost segregation, equating it with a high-risk tax shelter. In truth, this reluctance is misplaced. If the cost of the components in the engineering report is well-documented, the cost segregation technique is no more aggressive than using a permissible depreciation method under the Internal Revenue Code. Patrick Malayter, CPA, a partner with BKD LLP, who heads up one of the nation’s largest cost segregation practices, agrees. “In a well-prepared engineering-based report,” he says, “tangible property and land improvement segments of real estate may be traced to applicable construction documents, and the property unit costs are clearly determined. You will normally have great success in an IRS examination sustaining claimed tax benefits. In contrast, an accountant’s ad hoc cost segregation calculation or reliance on a contractor (who typically is familiar neither with a subcontractor’s cost for specific property items nor the tax law) is a recipe for disaster on examination.”

OVERLOOKED OPPORTUNITY Accounting professionals must be able to suggest and help implement cost segregation for their clients or employers so they can achieve maximum tax savings. In the past when taxpayers purchased real estate, they traditionally allocated 20% of the purchase price to land and 80% to buildings. While the IRS rarely questioned this simplistic approach, purchasers did themselves a financial disservice: They forfeited opportunities to achieve a better tax result.

## Where to find May’s flipbook issue

The Journal of Accountancy is now completely digital.

## Manage the talent, hand off the HR headaches

Recruiting. Onboarding. Payroll administration. Compliance. Benefits management. These are just a few of the HR functions accounting firms must provide to stay competitive in the talent game.

FEATURED ARTICLE

## 2023 tax software survey

CPAs assess how their return preparation products performed.

• Accounting /
• Principles of Accounting /
• Plant Assets, Natural Resources, and Intangible Assets /

## Problem-13: Plant Assets, Natural Resources and intangible Assets

Tom Parkey has prepared the following list of statements about depreciation.

• Depreciation is a process of asset valuation, not cost allocation.
• Depreciation provides for the proper matching of expenses with revenues.
• The book value of a plant asset should approximate its fair value.
• Depreciation applies to three classes of plant assets: land, buildings, and equipment.
• Depreciation does not apply to a building because its usefulness and revenue-producing ability generally remain intact over time.
• The revenue-producing ability of a depreciable asset will decline due to wear and tear and to obsolescence.
• Recognizing depreciation on an asset results in an accumulation of cash for replacement of the asset.
• The balance in accumulated depreciation represents the total cost that has been charged to expense.
• Depreciation expense and accumulated depreciation are reported on the income statement.
• Four factors affect the computation of depreciation: cost, useful life, salvage value, and residual value.

## Instructions

• False. The correct answer: Depreciation is a process of cost allocation, not a process of asset valuation.
• False: The correct Answer: The book value of a plant asset may be quite different from its fair value.
• False: The correct Answer: Depreciation applies to three classes of plant assets: land improvements, buildings, and equipment.
• False: The correct Answer: Depreciation does not apply to a land because its usefulness and revenue-producing ability generally remain intact over time.
• False: The correct Answer: Recognizing depreciation on an asset does not results in an accumulation of cash for replacement of the asset.
• False: The correct Answer: Depreciation expense is reported on the income statement.
• False: The correct Answer: Three factors affect the computation of depreciation: cost, useful life, and salvage value

## Latest Articles

Without using log tables, find x if ½log₁₀ (11+4√7) = log₁₀ (2+x), why should banks be concerned about their level of profitability and exposure to risk, why may a trial balance not contain up-to-date and complete financial information, why do accrual basis financial statements provide more usual information than cash-basis statements, who are internal users of accounting data how does accounting provide relevant data to these users, who are external users of accounting data how does accounting provide relevant data to these users, which accounts are most important and which are least important on the asset side of a bank's balance sheet, what uses of financial accounting information are made by investors and creditors, what sum should be paid for an annuity of \$2,400 for 20 years at 4½% compound interest p.a., what is the purpose of a trial balance, what is the present value of rs. 10,000 due in 2 years at 8% p.a., c.i. according as the interest is paid (a) yearly or (b) half-yearly, what is the present value of \$1000 due in 2 years at 5% p.a. compound interest, according as the interest is paid (a) yearly or (b) half yearly, what is the monetary unit assumption, what is the economic entity assumption, what is the basic accounting equation, what is the accounting cycle, what is business risk, what is accounting what are the basic activities of accounting, what is account, what is a trial balance, what is a ledger, what do you mean by accrual vs. cash basis accounting, what are the steps in the recording process, what are the principal accounts that appear on a bank's balance sheet (report of condition), what are the limitations of a trial balance, what are off-balance-sheet items and why are they important to some financial firms, what accounts are most important on the liability side of a bank's balance sheet, the vertices of a triange abc are a(2, 3), b(5, 7) and c(-3, 4). d, e, f are respectively the midpoints of bc, ca and ab. prove that, the total cost y, for x units of a certain product consists of fixed cost and the variable cost(proportional to the number of unit produced). it is know that th..., the total cost y, for x units of a certain product consists of fixed cost and the variable cost. it is know that the total cost is rs. 6000 for 500 units and rs..., the sum of three numbers in g.p. is 35 and their product is 1000. find the numbers., the sum of the pay of two lectures is rs. 1600 per month. if the pay of one lecture be decreased by 9% and the pay of the second be increased by 17% their pays..., the sum of n terms of an a.p. is 2n². find the 5th term., the speed of a boat in still water is 10 km per hour. if it can travel 24 km downstream and 14 km in the upstream in equal time, indicate the speed of the flow..., the points (3, 4), and (-2, 3) from with another point (x, y) an equilateral triangle. find x and y., the demand and supply equations are 2p²+ q²=11 and p+2q=7. find the equilibrium price and quantity, where p stands for price and q stands for quantity., the cost of a machine is \$100,000 and its effective life is 12 years. if the scrap realizes only \$5,000, what amount should be retained out of profits at the en..., the annual subscription for the membership of a club is \$25 and a person may become a life member by paying \$1000 in a lump sum. find the rate of interest charg..., the 4th term of an a.p. is 64 and the 54th term is -61, show the 23rd term is 16½, suppose that a bank holds cash in its vault of \$1.4 million, short-term government securities of \$12.4 million, privately issued money market instruments of \$5...., simplify ½log₁₀ 25 - 2log₁₀ 3 + log₁₀ 18, show that the triangle whose vertices are (1, 10), (2, 1) and (-7, 0) are an isosceles triangle. find the altitude of this triangle, show that the points a(1, -1), b(-1, 1) and c(-√3, -√3) are the verticies of equilateral triangle, show that the points (6,6), (2,3) and (4,7) are the vertices of a right-angled triangle., show that log2+16log(16/15)+12log(25/24)+7log(81/80) = 1, seven persons sit in a row. find the total number of searing arrangements, if, prove that the triangle with vertices at the points (0, 3), (-2, 1) and (-1, 4) are right angled., prove that the triangel formed by the points a(8, -10), b(7, -3) and c(0, -4) is a right angled triangle., prove that the quadrilateral with vertices (2, -1), (3,4), (-2, 3) and (-3, -2) is a rhombus., prove that the points (4,3), (7,-1) and (9,3) are the vertices of an isoscales triangle..

• Search Search Please fill out this field.
• An Overview

## Amortization

Depreciation, key differences, special considerations, the bottom line.

• Fundamental Analysis

## Amortization vs. Depreciation: What's the Difference?

Gordon Scott has been an active investor and technical analyst or 20+ years. He is a Chartered Market Technician (CMT).

## Amortization vs. Depreciation: An Overview

An asset acquired by a company may have a long useful life. Whether it is a company vehicle, goodwill, corporate headquarters, or a patent, that asset may provide benefit to the company over time as opposed to just in the period it is acquired. To accurately reflect the use of these assets, the cost of business assets can be expensed each year over the life of the asset. The expense amounts are then used as a tax deduction, reducing the tax liability of the business.

Amortization and depreciation are the two main methods of calculating the value of these assets, with the key difference between the two methods involving the type of asset being expensed. There are also differences in the methods allowed, components of the calculations, and how they are presented on financial statements.

## Key Takeaways

• Amortization and depreciation are two methods of calculating the value for business assets over time.
• Amortization is the practice of spreading an intangible asset's cost over that asset's useful life.
• Depreciation is the expensing a fixed asset as it is used to reflect its anticipated deterioration.
• Amortization and depreciation differ in that there are many different depreciation methods, while the straight-line method is often the only amortization method used.
• The two accounting approaches also differ in how salvage value is used, whether accelerated expensing is done, or how each are shown on the financial statements.

Amortization  is the accounting practice of spreading the cost of an intangible asset over its useful life. Intangible assets are not physical but they are still assets of value. Examples of intangible assets that are expensed through amortization include patents, trademarks , franchise agreements, copyrights , costs of issuing bonds to raise capital, and organizational costs.

Amortization is typically expensed on a straight-line basis . That means that the same amount is expensed in each period over the asset's useful life. Assets that are expensed using the amortization method typically don't have any resale or salvage value.

The term amortization is used in another, unrelated context. An amortization schedule  is often used to calculate a series of loan payments consisting of both principal and interest in each payment, as in the case of a mortgage. Though different, the concept is somewhat similar. As a loan is an intangible item, amortization is the reduction in the carrying value of the balance.

The term amortization is used in both accounting and in lending with completely different definitions and uses.

Depreciation is the expensing of a fixed asset over its useful life. Fixed assets are tangible objects acquired by a business. Some examples of fixed or tangible assets that are commonly depreciated include buildings, equipment, office furniture, vehicles, and machinery.

Unlike intangible assets, tangible assets may have some value when the business no longer has a use for them. For this reason, depreciation is calculated by subtracting the asset's salvage value  or resale value from its original cost. The difference is depreciated evenly over the years of the expected life of the asset. In other words, the depreciated amount expensed in each year is a tax deduction for the company until the useful life of the asset has expired.

For example, a business may buy or build an office building, and use it for many years. The business then relocates to a newer, bigger building elsewhere. The original office building may be a bit rundown but it still has value. The cost of the building, minus its resale value, is spread out over the predicted life of the building, with a portion of the cost being expensed in each accounting year.

Depreciation of some fixed assets can be done on an accelerated basis , meaning that a larger portion of the asset's value is expensed in the early years of the asset's life. Vehicles are typically depreciated on an accelerated basis.

The definition of depreciate is to diminish in value over a period of time.

## Depreciation Methods

Companies often have several options when choosing their depreciation method. The most common depreciation methods include:

• Straight-Line Method: A company depreciates the asset equally over the term of its useful life. The depreciable base is determined by taking the asset's cost and reducing the salvage value. The same amount of depreciation is recorded each year.
• Declining Balance : A company depreciates an accelerated amount of depreciation earlier in the asset's useful life. This is done by multiplying the current book value of the asset by a fixed depreciation rate that does not change over the life of the asset.
• Double Declining Balance Method : A company depreciates an accelerated amount of depreciation earlier in the asset's useful life by doubling the rate under the straight-line method. This rate is then applied to the current book value.
• Sum-of-the-Years' Digits Method : The digits of the asset's useful life are summed (i.e. an asset with a useful life would add up to 5+4+3+2+1 = 15 years). Then, a company depreciates a proportion of costs based on the corresponding digit (i.e. 5/15 for Year 1, 4/15 for Year 2).
• Units of Production : A company assesses a baseline of anticipated usage. For example, a company buys a company vehicle and intends to drive it 100,000 miles. Each year, it assesses its actual use (i.e. 17,000 miles driven in year one) to determine what proportion to depreciation (i.e. 17% of the depreciable base in year one).

Now that we've highlighted some of the most obvious differences between amortization and depreciation above, let's take a look at some of the more specific factors that make these two concepts so distinct.

## Applicability

By definition, depreciation is only applicable to physical, tangible assets subject to having their costs allocated over their useful lives. Alternatively, amortization is only applicable to intangible assets.

## General Philosophy

The term depreciate means to diminish in value over time, while the term amortize means to gradually write off a cost over a period. Depreciation is recorded to reflect that an asset is no longer worth the previous carrying cost reflected on the financial statements.

Amortization, on the other hand, is recorded to allocate costs over a specific period. Both methods appear very similar but are philosophically different.

## Options of Methods

Almost all intangible assets are amortized over their useful life using the straight-line method. This means the same amount of amortization expense is recognized each year. On the other hand, there are several depreciation methods a company can choose from.

These options differentiate the amount of depreciation expense a company may recognize in a given year, yielding different net income calculations based on the option chosen.

## Timing (Acceleration)

Of the different options mentioned above, a company often has the option of accelerating depreciation. This means more depreciation expense is recognized earlier in an asset's useful life as that asset may be used heavier when it is newest.

Tangible assets can often use the modified accelerated cost recovery system (MACRS) . Meanwhile, amortization often does not use this practice, and the same amount of expense is recognized whether the intangible asset is older or newer.

## Use of Salvage Value

The formulas for depreciation and amortization are different because of the use of salvage value . The depreciable base of a tangible asset is reduced by the salvage value. The amortization base of an intangible asset is not reduced by the salvage value.

This is often because intangible assets do not have a salvage, while physical goods (i.e. old cars can be sold for scrap, outdated buildings can still be occupied) may have residual value.

## Use of Contra Account

Depending on the asset and materiality, the credit side of the amortization entry may go directly to to the intangible asset account. On the other hand, depreciation entries always post to accumulated depreciation, a contra account that reduces the carrying value of capital assets.

Depletion is another way that the cost of business assets can be established in certain cases. It is relevant only to the valuation of natural resources . For example, an oil well has a finite life before all of the oil is pumped out. Therefore, the oil well's setup costs can be spread out over the predicted life of the well.

The two basic forms of depletion allowance are percentage depletion and cost depletion . The percentage depletion method allows a business to assign a fixed percentage of depletion to the gross income received from extracting natural resources. The cost depletion method takes into account the basis of the property, the total recoverable reserves, and the number of units sold.

One of the primary similarities between depreciation and amortization (and depletion) is the recognition of an expense without the associated cash flow. For this reason, depreciation and amortization are both very misleading expenses that may be omitted from certain reports to better clarify operating needs.

For example, a company often must often treat depreciation and amortization as non-cash transactions when preparing their statement of cash flow . Without this level of consideration, a company may find it more difficult to plan for capital expenditures that may require upfront capital.

## Example of Amortization vs. Depreciation

As part of its 2021 annual report, Amazon ( AMZN ) included full-year comparative financial statements accompanied by financial statement notes. As shown on the company's statement of cash flow, Amazon aggregated depreciation and amortization, reporting \$34,296 of combined activity.

As is standard in financial statement disclosures, Amazon explained how it approaches depreciation and amortization. For both, the company uses the straight-line method. However, it uses a wide range of useful lives depending on the underlying asset.

At the end of 2021, Amazon reported \$238.8 billion of gross property and equipment. Of this, only \$78.5 billion of total accumulated depreciation and amortization was recognized. This means that roughly one-third of the company's fixed assets were depreciated. In addition, you'll note that land was included in this section, which is non-depreciable. At the end of the year, Amazon reported \$160.3 billion of net property and equipment.

Amazon provided additional details regarding its intangible assets. It classified its intangible assets as either finite-lived or in-process used in research and development (R&D) . Most of the company's intangible assets were finite-lived, with most of them being either marketing-related or contract-based. At the end of 2021, the company had almost \$7 billion of intangible assets, though the company had accumulated amortization of over \$1.8 billion.

Correction — Jan. 20, 2022: An earlier version of this article erroneously listed land as an asset that could be depreciated. Land can never be depreciated, according to the IRS.

## What Is an Example of Amortization?

A company may amortize the cost of a patent over its useful life. Say the company owns the exclusive rights over a patent for 10 years, and the patent is not to renew at the end of the period. The company may amortize the cost of the patent for the decade, recognizing 10% of the expenses each year. Through amortization, the carrying value of the trademark decreases.

## What Is an Example of Depreciation?

The sum-of-the-years digits method is an example of depreciation in which a tangible asset like a vehicle undergoes an accelerated method of depreciation. Under the sum-of-the-years digits method, a company recognizes a heavier portion of depreciation expense during the earlier years of an asset's life. In theory, more expense should be expensed during this time because newer assets are more efficient and more in use than older assets.

## Why Do We Amortize a Loan Instead of Depreciate a Loan?

Loans are amortized because they are intangible. A loan doesn't deteriorate in value or become worn down over use like physical assets do. Loans are also amortized because the original asset value holds little value in consideration for a financial statement. Though the notes may contain the payment history, a company only needs to record its currently level of debt as opposed to the historical value less a contra asset.

## How Do I Know Whether to Amortize or Depreciate an Asset?

Generally speaking, there is accounting guidance via GAAP on how to treat different types of assets. Accounting rules stipulate that physical, tangible assets (with exceptions for non-depreciable assets) are to be depreciated, while intangible assets are amortized.

## Is It Better to Amortize or Depreciate an Asset?

It is neither better to amortize or depreciate an asset. Instead, there is accounting guidance that determines whether it is correct to amortize or depreciate an asset. Both terminologies spread the cost of an asset over its useful life, and a company doesn't gain any financial advantage through one as opposed to the other.

Two common techniques are used to reflect the benefit of an asset and its associated costs over a period of time. Both depreciation and amortization reduce the carrying value of assets and recognize expenses as assets are used over time. However, depreciation is used for physical assets, while amortization is used for intangible assets. In addition, there are differences in the methods available, acceleration options, how salvage value is used, and how contra accounts are used.

Internal Revenue Service. " Publication 535, Business Expenses ." Pages 29-32.

Internal Revenue Service. " Publication 550, Investment Income and Expenses ." Pages 32-33.

Internal Revenue Service. " Publication 946, How To Depreciate Property ." Page 9.

Internal Revenue Service. " Publication 946, How To Depreciate Property ." Pages 3-4.

Internal Revenue Service. " Publication 946, How To Depreciate Property ." Pages 7-9.

Internal Revenue Service. " Topic No. 510, Business Use of Car ."

Internal Revenue Service. " Publication 946, How To Depreciate Property ." Pages 26-30.

Internal Revenue Service. " Publication 535, Business Expenses ." Pages 37-38.

Amazon Investor Relations. " Annual Report 2021 ." Page 36.

Amazon Investor Relations. " Annual Report 2021 ." Pages 46-47.

Amazon Investor Relations. " Annual Report 2021 ." Page 52.

Amazon Investor Relations. " Annual Report 2021 ." Page 55.

Internal Revenue Service. " Publication 946, How To Depreciate Property ." Page 6.

• Editorial Policy

1. 11.3 Explain and Apply Depreciation Methods to Allocate Capitalized Costs

The calculation of the depreciation expense for a period is not based on anticipated changes in the fair market value of the asset; instead, the depreciation is based on the allocation of the cost of owning the asset over the period of its useful life. The following items are important in determining and recording depreciation:

2. Depreciation

Depreciation Is a Process of Cost Allocation. Depreciation is allocated over the useful life of an asset based on the book value of the asset originally entered in the books of accounts. The market value of the asset may increase or decrease during the useful life of the asset. However, the allocation of depreciation in each accounting period ...

3. The Comprehensive Guide to Cost Allocation in Accounting

Step 1: Identify the Costs That Need to Be Allocated. The first step in cost allocation is identifying the costs that need to be allocated. This includes both direct and indirect costs. Direct costs can be easily traced to specific products or services, while indirect costs, such as rent and utilities, cannot.

4. Depreciation: Definition and Types, With Calculation Examples

Depreciation is an accounting method of allocating the cost of a tangible asset over its useful life. Businesses depreciate long-term assets for both tax and accounting purposes. For tax purposes ...

5. Depreciated Cost: Definition, Calculation Formula, Example

Depreciated cost is the value of a fixed asset net of all accumulated depreciation that has been recorded against it. It follows the formula of: Depreciated Cost = Purchase Price (or cost basis ...

6. What Is Depreciation and How Do You Calculate It?

The formula for calculating straight-line depreciation is: (Asset cost - salvage value) ÷ useful life = annual depreciation. For the above transaction, the calculation is: (\$20,000 - \$1,000) ÷ ...

7. What Is Depreciation? Definition, Types, How to Calculate

The annual and monthly depreciation expenses for the vehicle using the straight-line depreciation method would be: (\$260,000 - \$20,000) / 8 = \$30,000 \$30,000 / 12 months = \$2,500 per month

8. Cost Allocation in Accounting: An In-Depth Look

Depreciation \$65,000 Electricity \$74,000 Total manufacturing overhead \$522,000. In a perfect world, it would be possible to keep an accurate running total of ... Cost allocation is used for both external reporting and internally for decision making.

9. Allocation of Depreciation

The SOYD method adds years 1 through 10 to reach a sum of 55. In year one, depreciation under SOYD is 10 divided by 55 times \$10,000, for a depreciation expense of \$1,818.18. In the second year ...

10. Accumulated Depreciation and Depreciation Expense

Depreciation expense is the cost of an asset that has been depreciated for a single period, and shows how much of the asset's value has been used up in that year. ... Expense allocation is ended ...

11. Depreciation Expense

3. Units of Production Method. The units of production method recognizes depreciation based on the perceived usage ("wear and tear") of the fixed asset (PP&E). Depreciation Expense = [ (Cost Basis of Fixed Asset - Salvage Value) ÷ Estimated Capacity of Total Units Produced] × Actual Number of Units Produced.

12. Service Life And Cost Allocation

Service Life And Cost Allocation. People will casually speak of depreciation as a decline in value or "using-up" of an asset. However, in accounting jargon, the term is meant to refer to the allocation of an asset's cost to the accounting periods benefited. It is not an attempt to value the asset.

13. 3.9 Depreciation: Allocation of Long-term Asset Cost

A common method is to allocate depreciation expense based on the number of months the asset is owned in a year. For example, a company purchases an asset with a total cost of \$58,000, a five-year useful life, and a salvage value of \$10,000. The annual depreciation is \$9,600 ( [\$58,000 - 10,000] ÷ 5).

14. Depreciation is Not a Matter of Valuation But a Means of Cost Allocation:

The cost allocation approach is used because a matching of costs with revenues occurs and because fluctuations in fair value are tenuous and difficult to measure. When long-lived assets are written off, the depreciation is most often used to indicate that tangible plant assets have declined in value.

15. 4.3: Alternative Patterns for Calculating Depreciation

Depreciation for the building bought above for \$600,000 with an expected five-year life and a residual value of \$30,000 is calculated as follows if DDB is applied. (cost - accumulated depreciation) × 2/expected life = depreciation expense for period. Year One: (\$600,000 - \$0) = \$600,000 × 2/5 = \$240,000 depreciation expense. Year Two:

16. What Is Depreciation in Business?

Table of Contents. Depreciation is the process of deducting the cost of a business asset over a long period of time, rather than over the course of one year. There are four main methods of ...

17. Depreciated Cost

The most common depreciation method is the straight-line method, which is used in the example above. The cost available for depreciation is equally allocated over the asset's life span. As the depreciation expense is constant for each period, the depreciated cost decreases at a constant rate under the straight-line depreciation method. 2.

18. Cost Allocation

Cost Allocation or cost assignment is the process of identifying and assigning costs to the various cost objects. These cost objects could be those for which th ... One can allocate depreciation costs to the department on the basis square ft area of each department. This cost will then be further assigned to the products on which the department ...

19. Long-Term Assets: Explain and Apply Depreciation Methods to Allocate

The calculation of the depreciation expense for a period is not based on anticipated changes in the fair market value of the asset; instead, the depreciation is based on the allocation of the cost of owning the asset over the period of its useful life. The following items are important in determining and recording depreciation:

20. Cost Segregation Applied

The process of cost segregation has shortcomings, however. First, and most easily quantifiable, is the actual cost of the engineering study. While the fees vary widely, a well-done study is not inexpensive: A typical cost segregation study and written report will cost between \$10,000 and \$25,000.

21. Tom Parkey has prepared the following list of statements about

Problem-13: Plant Assets, Natural Resources and intangible Assets. Tom Parkey has prepared the following list of statements about depreciation. Depreciation is a process of asset valuation, not cost allocation. Depreciation provides for the proper matching of expenses with revenues. The book value of a plant asset should approximate its fair value.

22. Amortization vs. Depreciation: What's the Difference?

Amortization and depreciation are two methods of calculating the value for business assets over time. Amortization is the practice of spreading an intangible asset's cost over that asset's useful ...