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FINANCIAL ACCOUNTING

Topic 11: Define and Calculate Depreciation and Amortization

Reference: Kimmel, Paul. D., Weygandt, Jerry. J. & Kieso, Donald. E. (2006). Financial Accounting: Tools for Business Decision Making (4th ed.). Hoboken, NJ: John Wiley & Sons. Used with permission from the publisher.

Introduction

Depreciation is the process of allocating to expense the cost of a plant asset over its useful (service) life in a rational and systematic manner. Such cost allocation is designed to properly match expenses with revenues.

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Depreciation affects the balance sheet through accumulated depreciation, which companies report as a deduction from plant assets. It affects the income statement through depreciation expense.

It is important to understand that depreciation is a cost allocation process, not an asset valuation process. No attempt is made to measure the change in an asset's market value during ownership. Thus, the book value—cost less accumulated depreciation—of a plant asset may differ significantly from its market value. In fact, if an asset is fully depreciated, it can have zero book value but still have a significant market value.

Depreciation applies to three classes of plant assets: land improvements, buildings, and equipment. Each of these classes is considered to be a depreciable asset because the usefulness to the company and the revenue-producing ability of each class decline over the asset's useful life. Depreciation does not apply to land because its usefulness and revenue-producing ability generally remain intact as long as the land is owned. In fact, in many cases, the usefulness of land increases over time because of the scarcity of good sites. Thus, land is not a depreciable asset.

During a depreciable asset's useful life its revenue-producing