Understanding Depreciation: A Guide for Students and Professionals

Depreciation is a core accounting concept that helps match the cost of long-term assets with the revenue they generate. Instead of expensing the full cost of equipment or buildings all at once, depreciation systematically allocates that cost over the asset’s useful life. This ensures financial statements remain accurate and aligned with the matching principle.

Depreciation, Amortization, and Depletion

• Depreciation applies to tangible assets (machinery, equipment, buildings).

• Amortization applies to intangible assets (patents, copyrights, software).

• Depletion applies to natural resources (oil, minerals, timber).

Types of Depreciation

• Physical depreciation: the natural wear and tear from use.

• Functional depreciation: when assets become outdated or inadequate (obsolescence).

Key Concepts

• Salvage value: the estimated value of an asset at the end of its useful life.

• Useful life: the expected period the asset will contribute to operations.

• Depreciation base: historical cost – salvage value.

Both salvage value and useful life must be disclosed in financial statement footnotes under GAAP. For tax purposes, salvage value is not required.

If the useful life estimate changes, it is treated as a change in estimate and applied prospectively (going forward).

Component vs. Composite Depreciation

• Component depreciation: Each part of an asset is depreciated separately. Optional under GAAP, required under IFRS.

• Composite depreciation: Groups similar assets and depreciates them over a single average life.

When using composite depreciation, the sale of an individual item does not result in a gain or loss:

DR Cash

DR Accumulated Depreciation

    CR Historical Cost

Methods of Depreciation

1. Straight-Line Method

• Used when an asset provides equal benefit over time.

• Formula:

Depreciation = Cost – Salvage Value

Useful Life ​

2. Sum-of-the-Years’-Digits (SYD)

• Accelerated method, higher expense in early years.

• Formula:

  
  

Depreciation = (Cost – Salvage) × Remaining Life​

                                                             SYD

• To calculate SYD:

S = n (n+1)

             2

Example: If useful life = 3 years → SYD = 6.

3. Units-of-Production Method

• Based on actual usage or output.

• Step 1:

Rate per unit = Depreciable Base

                          Estimated Units

• Step 2:

Depreciation Expense = Rate per Unit × Units Produced

4. Declining Balance Method (e.g., Double Declining Balance – DDB)

• Accelerated method, useful when assets lose value quickly.

• Formula:

Rate = 2 

N (for double-declining)

Depreciation expense = Rate × (Cost – Accumulated Depreciation).

• Salvage value is ignored in calculations but the asset is never depreciated below it.

Depreciation Timing

• Placed-in-service method: Expense only for the portion of the year used.

• Half-year convention: Six months’ expense in year of purchase and six months in year of sale.

• Full-year convention: Either no depreciation in the first year and full in disposal year, or vice versa.

PPE Impairment

If it becomes clear that an asset’s value has permanently dropped, an impairment must be recorded immediately (rule of conservatism).

Under U.S. GAAP, the first step in determining if a long-lived asset is impaired is to compare the carrying amount of the asset to the undiscounted expected future cash flows from the asset.

The impairment loss is calculated by taking the difference between the carrying amount of the asset and the fair value.

Final Thoughts

Depreciation isn’t just an accounting rule — it’s a way of accurately reflecting how assets lose value over time, ensuring that financial reports stay aligned with reality. Whether you’re a student learning the basics or a professional refreshing the details, understanding depreciation is key to interpreting and preparing financial statements.