# Depreciation of Fixed Assets Explained

Depreciation of fixed assets is an accounting process used to allocate the cost of a tangible fixed asset (such as machinery, buildings, vehicles, and equipment) over its estimated useful life. Fixed assets, also known as property, plant, and equipment (PP&E), gradually lose their value or usefulness over time due to factors like wear and tear, obsolescence, and aging. Depreciation allows organizations to accurately reflect the reduction in the value of these assets on their financial statements.

Here’s how the process of depreciation works:

1. Cost of the Asset: When a fixed asset is acquired or constructed, its initial cost includes all expenditures directly related to acquiring, preparing, and placing the asset into service. This cost forms the basis for calculating depreciation.
2. Useful Life: Each fixed asset has an estimated useful life, which is the period of time over which the asset is expected to provide economic benefits to the organization. Useful life can vary widely depending on the type of asset. For example, a computer might have a useful life of 3 to 5 years, while a building could have a useful life of 30 years or more.
3. Residual Value: Residual value, also known as salvage value or scrap value, is the estimated value of the asset at the end of its useful life. This value represents what the organization expects to receive when the asset is eventually sold or disposed of.
4. Depreciation Methods:
• Straight-Line Depreciation: This is the most common method. It evenly allocates the asset’s cost over its useful life. The formula is: Depreciation Expense = (Cost – Residual Value) / Useful Life.
• Declining Balance Depreciation: This method allocates a larger portion of the asset’s cost in the early years of its life and decreases the allocation in subsequent years. The formula is: Depreciation Expense = Book Value at Beginning of Year x Depreciation Rate.
• Units-of-Production Depreciation: This method allocates the cost based on the asset’s usage or production. The formula is: Depreciation Expense = (Actual Usage/Production) x (Cost – Residual Value).
5. Depreciation Expense: The calculated depreciation amount is recorded as an expense on the income statement. This expense reduces the organization’s reported net income.
6. Accumulated Depreciation: The cumulative depreciation expense is recorded in a separate account on the balance sheet called “Accumulated Depreciation.” This account offsets the original cost of the fixed asset, providing a clear indication of the asset’s remaining value on the balance sheet. The asset’s carrying amount (Cost – Accumulated Depreciation) reflects its net book value.

Depreciation serves several purposes:

• It accurately reflects the consumption of an asset’s value over time.
• It matches expenses with revenues on the income statement, improving financial reporting accuracy.
• It helps organizations plan for asset replacements and upgrades.
• It aids in calculating taxes and complying with accounting standards.

It’s important for organizations to select an appropriate depreciation method and consistently apply it across all fixed assets. Depreciation calculations should follow generally accepted accounting principles (GAAP) or other relevant accounting standards applicable in their region.

Caroline Grimm

Caroline Grimm is an accounting educator and a small business enthusiast. She holds Masters and Bachelor degrees in Business Administration. She is the author of 13 books and the creator of Accounting How To YouTube channel and blog. For more information visit: https://accountinghowto.com/about/