Depreciation definition
/What is Depreciation?
Depreciation is a planned, gradual reduction in the recorded value of an asset over its useful life by charging it to expense. Depreciation is applied to fixed assets, which generally experience a loss in their utility over multiple years. The use of depreciation is intended to spread expense recognition over the period of time when a business expects to earn revenue from the use of an asset.
Example of Deprecation
For example, an organization buys a truck for $50,000 and expects to use it for the next five years. Accordingly, the firm charges $10,000 to depreciation expense in each of those five years. This charging to expense in a consistent, even amount over time is called the straight-line method. If the firm had instead elected to recognize a larger expense earlier in the life of the truck, it would use an accelerated depreciation method, which reduces the amount of reported income early in the life of an asset. Yet another variation is to depreciate based on the actual usage of an asset, which is addressed by the units of production method.
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Capitalization Limit
It is time-consuming to accounting for depreciation, so accountants reduce the work load by only capitalizing assets if the amount paid exceeds a certain threshold level, such as $5,000. Below that amount, all expenditures are automatically charged to expense. The threshold level is not stated within Generally Accepted Accounting Principles; it is only an internal accounting policy issue. Smaller businesses tend to set lower capitalization limits, while larger companies set higher limits.
Accounting for Depreciation
The typical depreciation entry is a debit to depreciation expense and a credit to accumulated depreciation. Accumulated depreciation is a contra asset account; it is paired with and offsets the fixed assets line item in the balance sheet. When a fixed asset is eventually disposed of, the associated asset and accumulated depreciation amounts are credited and debited, respectively, in order to clear them off the books.
The Impact of Depreciation on Cash Flows
The recognition of depreciation expense is unrelated to cash flows, so it is considered a noncash expense. Instead, the only cash flows related to a fixed asset are when it is acquired and when it is eventually sold.