How to calculate depreciation and depreciation on an income statement

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Depreciation and depreciation are non-cash expenses in a company’s income statement. Depreciation represents the cost of on-balance sheet fixed assets used over time, and depreciation is the similar cost of using intangible assets like goodwill over time.

Calculating the appropriate amount of expense for depreciation and impairment on an income statement varies from specific situation to specific situation, but we can use a simple example to understand the basics.

The process begins on the balance sheet and ends on the income statement
Accounting for amortization and depreciation is essentially the same, so for our example, we can simplify the process and just consider a simple equipment purchase. Remember that an intangible asset would depreciate in a very similar way over time, whether it is intellectual property, goodwill, or some other account.

When a company purchases a fixed asset such as a piece of equipment, it reports that asset on its balance sheet at its purchase price. Let’s say our company buys equipment for $ 15,000. This means that our equipment asset account increases by $ 15,000 on the balance sheet. Nothing has yet been transferred to the income statement.

Over the next year, however, the company will begin recording depreciation expense for the equipment, representing its progressive obsolescence, loss of value in use and advanced age. This expense, which appears in the income statement, does not correspond to the total purchase price of the equipment, but rather to an incremental amount calculated from accounting formulas.

The first step in this calculation is to determine which depreciation method will be used to determine the appropriate amount of expense. The simplest method is the straight-line method, where the amortization load is constant over time as the equipment is used. Other methods allow the business to recognize more depreciation expense earlier in the life of the asset. The key is for the company to have a coherent policy and well-defined procedures justifying the method.

For simplicity, we’ll use the straight line method in this example. The business must first determine the value of the asset at the end of its useful life. This salvage value, or residual value, is subtracted from the purchase price and then divided by the number of years of the asset’s useful life. In the case of our equipment, the company expects a useful life of seven years, by which time the equipment will be worth $ 4,500, its residual value.

Completing the calculation, the purchase price subtracting the residual value is $ 10,500 divided by seven years of useful life gives us an annual depreciation expense of $ 1,500. This will be the depreciation expense that the company will record for the equipment each year for the next seven years.

How this calculation appears on the financial statements over time
Each of the next seven years, the company will record an annual depreciation expense of $ 1,500 in the income statement. At the same time, the book value of the equipment will decrease on the balance sheet by that same $ 1,500 per year. The book value reduction is posted through an account called accumulated depreciation. The table below summarizes the seven year accounting life of this equipment.

Year

Depreciation expense

Original carrying amount

Accumulated depreciation

Net book value

Year 0: Purchase

$ 1,500

$ 15,000

$ 0

$ 15,000

Year 1

$ 1,500

$ 15,000

$ 1,500

$ 13,500

Year 2

$ 1,500

$ 15,000

$ 3,000

$ 12,000

Year 3

$ 1,500

$ 15,000

$ 4,500

$ 10,500

Year 4

$ 1,500

$ 15,000

$ 6,000

$ 9,000

Year 5

$ 1,500

$ 15,000

$ 7,500

$ 7,500

Year 6

$ 1,500

$ 15,000

$ 9,000

$ 6,000

Year 7

$ 1,500

$ 15,000

$ 10,500

$ 4,500

Each year, the income statement is depreciated by $ 1,500. This charge is offset on the balance sheet by the increase in accumulated depreciation, which reduces the net book value of the equipment. As the name of the “straight line” method suggests, this process is repeated in the same amounts each year.

A final consideration on depreciation and amortization expenses
In strict terms, amortization and depreciation are non-monetary expenses. In the example above, the business does not write a check each year for $ 1,500. Instead, depreciation and depreciation are used to represent the economic cost of obsolescence, wear and tear, and the natural decline in an asset’s value over time.

But just because there might not be actual cash expenses for depreciation and depreciation each year, these are actual expenses that an analyst should pay attention to. For example, if the equipment purchased above is critical to the business, it may need to be replaced in order for the business to function. This purchase is a real monetary event, even if it only happens once every seven or ten years.

In many cases, it may be appropriate to treat amortization or impairment as a non-cash event. However, the best analysts will first understand what is depreciated or depreciated, how these assets fit into the company’s operations, and then make a conscious decision on how to handle these expenses that is best suited to that specific situation. .

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