Depreciation in Accounting

In the world of accounting, there are a few methodologies to recognize long-lasting assets. The accrual method is the one recognized in the U.S. by the "Generally Accepted Accounting Principles," also known as "GAAP." Under this method, items that are used within a year are considered to be expenses. Examples are publications, office supplies and small equipment. However, when items purchased are expensive and will last more than a year, they may be capitalized -- they are NOT expensed. Examples of often capitalized items are furniture, real estate and large equipment.Many companies have policies and procedures regarding capitalization and depreciation processes to maintain the consistency and reliability of financial reports. For instance, a firm may have a policy of capitalizing all business equipment that cost $5,000 or more. This means that the income statement will NOT show equipment expenses of $5,000 or more. Without a set policy, accountants may capitalize items at random, creating confusion and making financial statements not comparable over periods of time. The journal entry to capitalize an asset is Debit an asset account and Credit "Cash" or "Accounts Payable"Once a purchase is capitalized, it is expensed in small amounts for the life of the item. 

For example, an equipment cost $10,000 and has an expected life of 10 years. Using a simple methodology called straight-line, the equipment will be expensed about $1,000 a year. After 10 years, the equipment will be fully depreciated. The journal entry to recognize depreciation isDebit "Depreciation Expense," and Credit "Allowance for Depreciation," a contra-asset account reporting in the balance sheet. In order to calculate depreciation, 3 issues must be considered: costs, salvage value and methodology.1- Costs -- The cost of capitalized assets include shipping, setup costs and any sales taxes. If you purchase furniture that needs setup and installation, these costs are capitalized as part of the costs of the asset.2- Salvage Value -- Salvage value is the left- over when the asset reaches the end of its useful life. This amount is usually small if any. For instance, an equipment may have a scrap value that may be estimated and accounted for as salvage.3- Methodology -- Methods of depreciation can make a big difference on how expenses are recognized. The simplest method is the "straight line," where the same amount is depreciated each period, often every month. Other methods of depreciation are:

Declining Balance -- Straight line depreciation rate x 200% or 150%

Sum-of-the-Years -- (Cost - Salvage Value) x Fraction where the denominator is the sum of the years and the numerator varies. If an asset has 5 years of life, the fraction for the first year will be 5/(1+2+3+4+5)= 5/15.

It's important to notice that companies can have one method for calculating depreciation on its books and another one for income tax purposes. It's complicated, but when using computerized systems to run this process, it's a doable task.