Annual depreciation is an accounting figure that nets against the assets recorded on a company’s accounting ledger. It represents the usage a company receives from buildings and equipment throughout the calendar year. Several methods exist for calculating depreciation; this figure is simply an accounting number and does not actually represent a cash expense relating to the purchase or acquisition of an item.
When purchasing a long-term asset, accounting standards allow companies to avoid expenses the item at one time against net income. The purpose behind this theory is that companies will receive more benefits from the asset than a single accounting period, unlike one-time consumption items like office supplies or utilities. Therefore, the building or equipment is recorded as an asset and annual depreciation calculated according to the useful life of the item.
The most common calculations for annual depreciation are straight line, double declining balance, and units produced, which is only used for depreciating machines. Straight line depreciation is most common and makes for a simple demonstration. For example, assume a company purchases a piece of equipment for $200,000 US Dollars (USD) with a useful life of 20 years and no salvage value. Annual depreciation is $10,000 USD (200,000 / 20). This figure is then divided by 12 months and recorded into the accounting ledger as the company uses the machine in its operations. If the machine has a salvage value of $20,000 USD, the annual depreciation is $9,000 USD (200,000 – 20,000 / 20).
The double declining balance depreciation method is a bit more complicated and results in higher depreciation booked in the early years of an asset’s life. This allows the company to report lower net income and a lower tax liability, a significant advantage for expensive assets.
When recording depreciation on a monthly basis, accountants will debit depreciation expense and credit accumulated depreciation. The accumulated depreciation account will naturally carry a credit balance and act as a contra account to an asset account. The purpose of this method allows companies to report assets on the balance sheet at historical cost, reduced to actual cost by deducting accumulated depreciation. End users or business stakeholders can then review the balance sheet and have a clear understanding of the asset’s book value.
Government agencies may dictate the depreciation methods a company can use based on current tax law. This ensures all companies use a standardized depreciation method for tax purposes. A basic asset reconciliation will match the tax depreciation method to the internal accounting method, creating a balanced accounting ledger.