Companies purchase fixed assets to use in the operation of their businesses. Examples of fixed assets include production equipment, factory buildings and vehicles. These assets benefit the company for many years and cannot be expensed in the company’s accounting records. The company capitalizes these assets and depreciates the balance over the useful life of the asset.
Accountants use estimates to calculate the amount of fixed-asset cost to depreciate each year. Accountants need to know the number of years the asset will be useful and the value of the asset at the end of its useful life. The accountant considers the type of asset, the potential technological advances for similar assets and the current condition of the asset to determine how long the company can use the asset. To estimate the value of the asset at the end of its life, the accountant considers whether another company could use the asset and potential scrap value of the equipment.
Several options exist for calculating depreciation. Companies use straight-line depreciation because it is simple to calculate. This method takes the total cost of the asset and subtracts the salvage value. This amount is divided by the number of years in the asset’s useful life. Accelerated methods of depreciation, such as declining-balance or sum of the years digits, create a larger depreciation amount in the earlier years. Businesses use accelerated depreciation methods to reduce their taxable incomes in the early years.
When the annual depreciation amount is determined, the company recognizes depreciation expense. The accountant debits Depreciation Expense and credits Accumulated Depreciation for the depreciation amount. Depreciation Expense is an operating expense and is reported on the company’s income statement. The income statement subtracts operating expenses from net sales to arrive at net income.
Accumulated Depreciation is a contra-asset account. A contra-asset behaves in an opposite manner from an asset account. Where an asset maintains a normal debit balance, a contra-asset maintains a normal credit balance. The asset value minus accumulated depreciation determines the net asset value. The accountant reports accumulated depreciation on the balance sheet following property, plant and equipment.