Depreciation: Follow the Asset, Not the Cash
Depreciation can feel like a collection of unrelated rules: equipment, depreciation expense, accumulated depreciation, net book value, useful life, residual value.
They are really all parts of one story about one asset.
The Big Idea
A company buys an asset because it expects that asset to help the business for more than one accounting period.
Depreciation spreads the depreciable cost of that asset across the periods that benefit from using it.
It is not another cash payment. It is not a yearly estimate of what the asset could be sold for.
Meet the Delivery Van
July 1, Year 1
$50,000
$5,000
5 years
July 1, Year 1: Buy the Van
The company pays $50,000 cash for the delivery van.
Notice what did not happen: the company did not record a $50,000 expense.
Why? The company still owns a resource that is expected to help generate revenue for several years.
How Much Cost Will Be Depreciated?
Start with the amount of the asset's cost that the company expects to use up.
That $45,000 is spread over the van's five-year useful life.
That is also:
December 31, Year 1: Stop and Count the Months
The van was purchased on July 1.
During Year 1, the company used it for:
That is 6 months, not a full year.
Now Look at the Three Numbers
The equipment account is still $50,000.
We did not credit equipment when recording depreciation.
Instead, accumulated depreciation keeps track of how much of the asset's depreciable cost has been allocated to expense so far.
Follow the Same Van Through Time
Watch what changes and what stays the same.
| Date | Depreciation Expense for Period | Equipment | Accumulated Depreciation | Net Book Value |
|---|---|---|---|---|
| July 1, Year 1 | $0 | $50,000 | $0 | $50,000 |
| Dec. 31, Year 1 | $4,500 | $50,000 | $4,500 | $45,500 |
| Dec. 31, Year 2 | $9,000 | $50,000 | $13,500 | $36,500 |
| Dec. 31, Year 3 | $9,000 | $50,000 | $22,500 | $27,500 |
| Dec. 31, Year 4 | $9,000 | $50,000 | $31,500 | $18,500 |
| Dec. 31, Year 5 | $9,000 | $50,000 | $40,500 | $9,500 |
| June 30, Year 6 | $4,500 | $50,000 | $45,000 | $5,000 |
At the end of the five-year useful life, net book value reaches the expected $5,000 residual value.
Follow the $50,000
No additional cash leaves the company when depreciation is recorded.
What Depreciation Is NOT
Depreciation means the company pays cash every year. Tap to check
The $50,000 cash payment occurred when the van was purchased. Recording depreciation does not require another cash payment.
The equipment account gets smaller each year. Tap to check
Equipment generally remains recorded at its original cost. Accumulated depreciation is recorded separately as a contra-asset.
Accumulated depreciation is an expense. Tap to check
Depreciation expense is an expense. Accumulated depreciation is a contra-asset account that accumulates depreciation over the asset's life.
Net book value tells us exactly what the van is worth today. Tap to check
Net book value is an accounting amount:
asset cost - accumulated depreciation
It is not necessarily the asset's current market value.
One More Connection
Income Statement
Depreciation expense reduces net income for the current period.
The expense account begins again at zero in the next accounting period.
Balance Sheet
Accumulated depreciation reduces the carrying amount of the related asset.
Its balance carries forward and continues to accumulate.
Can You Follow the Asset?
A company buys equipment on October 1, Year 1 for $36,000. The equipment has a $6,000 residual value and a five-year useful life. The company uses straight-line depreciation.
Before revealing the answer, calculate:
Reveal the completed solution
Step 1: Depreciable cost
$36,000 - $6,000 = $30,000
Step 2: Annual depreciation
$30,000 ÷ 5 years = $6,000 per year
Step 3: Monthly depreciation
$6,000 ÷ 12 = $500 per month
The equipment was used for October, November, and December in Year 1.
$500 × 3 months = $1,500 Year 1 depreciation
| End of Year | Equipment | Accumulated Depreciation | Net Book Value |
|---|---|---|---|
| Year 1 | $36,000 | $1,500 | $34,500 |
| Year 2 | $36,000 | $7,500 | $28,500 |
If You Remember Only Four Things...
The cash payment happens when the asset is purchased.
Depreciation allocates depreciable cost across periods of use.
Equipment stays at cost while accumulated depreciation grows.
Net book value = cost - accumulated depreciation.