Depreciation is both a business concept and an accounting practice. In business, depreciation refers to the wear and tear of the fixed assets used in operations, while in accounting, depreciation is the expense charge representing the loss in the value of an asset. In the U.S., GAAP, or generally accepted accounting principles, governs asset depreciation in accounting. Accounting depreciation is calculated based on different asset elements and the depreciation methods prescribed by GAAP rules.
Depreciation as an accounting practice is a cost allocation process by which the value of an asset is charged to periodic depreciation expense over the asset's economic useful life. Accounting rules under GAAP require that companies capitalize a fixed-asset purchase and then recover the asset's cost through periodic depreciation charge, rather than expensing the total purchase in the immediate period. The cost allocation approach matches expenses of using an asset with the revenues that the asset helps generate in different periods over the life of the asset.
Depreciation elements for an asset include the original purchase cost of the asset, the estimated salvage value of the asset after depreciation, and the intended economic life of the asset in service. Given a depreciation method, an asset's depreciation elements are the factors that affect the depreciation outcome. To calculate depreciation, companies must first determine the depreciable base of an asset — the difference between an asset's cost and its salvage value. A asset's salvage value, or scrap value, is the dollar amount recovered from the sale of the asset at the end of its economic life. Thus, the salvage value cannot be depreciated and must be subtracted from an asset's total cost.
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Accounting rules per the U.S. GAAP allow a number of depreciation methods that companies may choose based on asset types and management decisions about capital investment and replacement. Three commonly used depreciation methods are the activity-based method, the straight-line method and the accelerated depreciation method. Different depreciation methods try to match depreciation charges with the actual decline in asset value. Depreciation by the activity-based method is a function of asset usage and production, while depreciation by the straight-line method is a function of time of an asset in service. The accelerated depreciation method charges more depreciation in early periods for assets that require higher repair costs in later periods because of greater loss in asset value earlier.
Per U.S. GAAP rules, depreciation charge is reported in both the income statement and the balance sheet. Companies record depreciation charge in each accounting period as a noncash expense against total revenue to arrive at net income. In the meantime, companies also record depreciation charge in the account of accumulated depreciation, the journal entry account opposite to the account of depreciation expense. The account of accumulated depreciation is a negative account to the related asset account on the balance sheet and represents the total loss of value for the asset as a result of depreciation taken from current and all prior periods.