Accounting has many rules and standards. It is no surprise, then, that there are rules about purchases of long-lasting items, such as equipment, real estate, and furniture. These rules call for allocating purchase expenses to more than one period. The rules and allocations are part of depreciation accounting.
When purchasing a long-lasting item, its full cost less any salvage value should be allocated over its estimated useful life. If a computer server is purchased for $15,000 US Dollars (USD), for example, and the server has a five year life, then the expense — called depreciation — should be allocated to five years, not just the year it was purchased. In this example, a depreciation expense of $3,000 USD per year would apply. If the computer server had a life of only one year, then expensing it all in the year it was purchased would make sense, because its value to the business is only one year.
Many businesses have policies and procedures about when to capitalized an item and then depreciate it. To capitalize an item is to book it as an asset and then to depreciate it over time. Usually, it is not worth to capitalize items under a certain amount, say something purchased at $100 USD to be used for five years. The $20 USD depreciation expense to be taken every year is too small and may not be worth the trouble.
Dealing with capitalization and depreciation requires common sense and adherence to set policies. If policy indicates that computers are to be depreciated over three years, then all computers are depreciated over three years. If policy indicates that all items purchased over $5,000 USD are to be capitalized, then all items over this amount are capitalized and anything under are expensed.
There are certain types of items that are typically capitalized and then depreciated over time. These include real estate, equipment, furniture, leasehold improvements, and automobiles. It is important to note that land is not depreciated, only buildings and other non-permanent items.
The concept of depreciation accounting involves an asset with a long useful life. Part of this is the basis of the asset, which is the cost of the asset less any salvage value, which is the value the asset may have at disposal. Also important is the estimated useful life of the asset, the estimated time the asset will be kept on service.
There are several depreciation accounting methods. In the straight-line method, the depreciation amount is computed by dividing the base of asset by the years or months of life. Depreciation expense is the same number on most periods. For the declining balance method, the depreciation expense is higher in first years, and declines as time progresses.
Another method, called sum-of-the-years digits, is calculated on a fraction with the denominator as the sum of years. Depreciation expense is higher in first years, declining as time progresses. The activity method is calculated based on asset usage, such as hours used or some other rational basis reflecting activity of asset.
Usually, businesses account for depreciation expense in two separate accounts in the general ledger. One account is called depreciation expense, and is reported in the income statement; a second one is called accumulated depreciation, and is reported in the balance sheet and accumulating depreciation expense. The accumulated depreciation account is a contra-asset account and has a credit balance.
Note that, in the US, the Internal Revenue Service (IRS) has its own way to report assets and depreciation. Financial depreciation accounting and tax depreciation accounting are different. The IRS allows for the 100% deduction of long-lived assets up to a certain limit, while Generally Accepted Accounting Principles (GAAP), the standard financial accounting framework, does not allow that.