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In business accounting, accumulated depreciation is the process of spreading the cost of an asset over the duration of its expected lifespan. It is primarily used by companies that make significant one-time investments into assets that are necessary for their operations, like buildings, production equipment or vehicles. Rather than treating the full cost of the asset as a business expense in the year it was purchased, accountants can use this process to divide the cost up over multiple years.
Calculating Asset Depreciation
Accounts must use several key values to accurately calculate accumulated depreciation for a specific piece of property or equipment: cost of purchase, salvage value and life expectancy. To make the calculation, the salvage value is subtracted from the cost of initial purchase, then the remainder is divided over the number of years of expected use. The result represents the expense of the asset for each year it is in use.
Using the standard straight-line depreciation model, an asset accumulates the same amount of depreciation value for each year of its life expectancy. This calculation can also be used to evaluate depreciation on a monthly or quarterly basis. Some businesses use an alternate accounting method called accelerated depreciation, which spreads the cost unevenly with more weight towards the first few years after purchase.
Why Use Depreciation in Accounting?
Since calculating the accumulation of asset depreciation adds extra steps to the accounting process, it can seem like an unnecessary burden that further complicates the process. However, there are several potential advantages for business that spread the cost in this way. This method of accounting allows the company to report higher income during the year of purchase, which could be critical for maintaining investor or shareholder confidence. It also allows executives to analyze overall state of the company’s finances, as well as property and equipment accounting specifically, with greater ease and accuracy.
Including Depreciation in the Books
Businesses typically establish two accounts to keep track of the value of their long-term assets: Depreciation Expense and Accumulated Depreciation. The Depreciation Expense account is debited at the beginning of each year, with the value credited to the other account. This allows for easier reading of financial statements, as well as evaluation of all assets and other key values.
There are some limitations that should be considered when using this accounting method. Assets can not have a total depreciation value that is greater than their initial cost, although it can be equal to the initial cost if there is no salvage or resale value following its life expectancy. It’s also important to note that life expectancy is not a guarantee, so it’s a good idea to under-estimate this value to avoid unexpected loss on the balance sheets.
Ultimately, the purpose of accounting for depreciation is to provide a clear and useful picture of the company’s fiscal state. Many businesses can do just as well to use standard methods and expense investments in the year of purchase. Businesses that decide to use accumulated depreciation methodology must conduct their accounts and tax reporting according to the standards set by the IRS each year.