Financial accounting is cumbersome. Interpreting the reports, keeping good records, crunching numbers – it’s all a part of the day-to-day routine of an accountant. As a business owner, it’s important to understand accounting basics to ensure you are doing the best you can do for your company.
An operating business will have assets, and these assets can be current or fixed. Current assets include cash, inventory and accounts receivable. Fixed assets include the equipment you use to run the business. The items and materials that make up the fixed assets category often incur something called value depreciation. Calculating the company expense of an asset’s lost value is the concept we’ll discuss in the scope of this article.
Before getting started, try the course financial accounting basics to get familiar with financial terms and concepts.
Fixed Assets
So, you know that fixed assets consist of the tangible items a company owns that assist in creating income for the business. Sometimes fixed assets is referred to as tangible assets or PP&E for property, plant and equipment. Let’s say you run a dry cleaning business. Likely, your biggest fixed assets are the washing and drying machines, and maybe a truck to run deliveries. These items are essential to the health of your business because without them you couldn’t operate. These are income generating materials yet they are not sold directly to the consumers. Inventory, for example, is a current asset because it’s an item that can be turned into cash within a 12-month period. Inventory is also sold directly to the customer. Now, why is this important? Because depreciation expenses occur with fixed assets and not typically with current assets. Learn how to interpret financial statements in this course and where the fixed and current assets are recorded on your reports.
What’s Depreciation?
They say that the minute you drive a brand new car off the lot it depreciates in value by thousands of dollars. Depreciate only means to lose value. If you buy something used, you’re typically paying a lot less and with that price reduction comes associated risks. You get what you pay for. This is an important concept in business accounting because a lot of those fixed assets I mentioned above will one day need to be replaced or upgraded which means you’ll have to sell a used item. In the course an Introduction to Financial Accounting the topic of depreciation is discussed in detail.
Depreciation Expense
Depreciation expense is an accounting method used to systematically allocate the Depreciable cost of a tangible fixed asset over its useful life. This helps in understanding the reduction in value of the asset over time due to wear and tear, obsolescence, or other factors.
Accountants and business owners use the depreciation expense to account for the value of an asset during its useful life. When you buy that washing machine and continue to use it for ten years – ten years is the useful life of the asset (washing machine). When recording depreciation expenses they are deducted from the overall income of the company in the incomestatement, however, they are not deducted from cash flow since its a non cash item.
There are two principle methods of determining depreciation expense: cost principle and matching principle. Cost principle says that the cost you paid to obtain the asset is the cost recorded in the books – regardless of inflation or reduction of the asset’s market price. The matching principle requires the asset cost to be divided up over the estimated useful life of the item. The accountant would match the percentage of the cost to the percentage of time over which the asset lasts.
Calculate Depreciation Expense
Like the two principles, there are also two main methods that are broadly used to choose from when calculating this expense, straight-line depreciation and Reducing-balance (accelerated) depreciation. Straight-line depreciation calculates the assets loss in value every year until the end of its useful life. If the washing machine was $10,000 in 2000 and its useful life ends in 2010 the formula would look like this:
$10,000 purchase cost – (scrap value)/ (10 years) = depreciation expense
$10,000 purchase cost / 10 years = $1000 depreciation expense each year
For the reducing-balance / accelerated depreciation method of accounting, it’s assumed that the Asset loses most of its value within the first few years of purchase (remember brand new car off the lot).
- Formula: Depreciation Expense=Book Value at Beginning of Year×Depreciation Rate
- Depreciation Expense=Book Value at Beginning of Year×Depreciation Rate
- Example: If the book value of an asset is $10,000 and the depreciation rate is 20%, the depreciation expense for the first year would be: 10,000×0.20=$2,000
So to calculate the loss a couple of strategies are used including double declining balance and sum of years digits. Read more about a double declining balance in this article. More often than not, the company will track the value loss over the first few years and then deduct the total loss from the original purchase cost. The book value is the product of this calculation. Accelerated depreciation helps a business see the overall loss and gains of an asset more accurately. If an asset is sold for more than its calculated book value – the company makes a profit. Likewise, the contrary is true.
Learn more about asset depreciation in this introduction to financial accounting online course.