[Mr.SugarSkulls]

Originally Posted by tony20009

Note: This is longish, and I'm sorry for that. It's long because I'm writing this in simplified layman's terms rather than referring you to an accounting text on the WWW. It'd be far longer there.

That isn't depreciation at all. It's a decline in inventory value that resulted either from obsolescence or other market forces. Depreciation doesn't apply to inventory. One can book an inventory write-down, but one cannot record depreciation in connection with the drop in value.

Depreciation applies only to fixed assets. Amortization applies to long term intangible assets. Depletion applies to mines, aquifers and fossil fuel deposits, but not the things extracted from the mines/deposits; those "things" are inventory.

Depreciation (and the related concepts of asset amortization/depletion) is something that is 100% internal to the entity that holds title to the asset being depreciated. In order to determine what depreciation is, one must define the "useful life" of the item in question. Next one chooses a depreciation method. (There are several, but "straight line" is the most often chose one because it "gets the job done," and is easily calculated. Units of production is the method most often used for depletable assets.) Having made those two elections, one determines whether the item will have a salvage value.

At this point one can calculate the annual, monthly or daily depreciation expense as follows (straight line is what I'll use because it is simple):

Historic cost - salvage value = depreciable asset cost (DAC)
DAC/useful life = annual depreciation amount (ADA)
ADA/12 = monthly depreciation expense.

When one buys a depreciable asset, it's always recorded in the books at historic cost. Let's say that in month 2 of one's fiscal year one buys a $14,000 asset that has a useful life of 10 years and a $2K salvage value. It's annual depreciation is $1200 and the monthly depreciation is $100. Depreciation begins when the item is placed in service. We'll assume the asset goes into service in the same period in which it's purchased.

• Start of Month 1:
  Looking in one's balance sheet t the start of month one sees only the following:
  Asset Cost: $14,000
  Net Book Value: $14,000
• End of Month 1:
  At the end of month one, one records depreciation expense and one's balance sheet shows the following:
  Asset Cost: $14,000
  Accumulated Depreciation: $100
  Net Book Value: $13,900
  
  There is also an income statement impact and it appears as:
  Depreciation Expense: $100
• Month 2: Balance Sheet
  Asset Cost: $14,000
  Accumulated Depreciation: $200
  Net Book Value: $13,800
  
  Month 2: Income Statement
  Depreciation Expense: $200

The sequence continues like that for ten years and at the end of the tenth year, one sees the following

• Balance Sheet
  Asset Cost: $14,000
  Accumulated Depreciation: $12,000
  Net Book Value: $2,000

• Income Statement
  Depreciation Expense: $100
  Why just $100?
  • The asset was placed in service and depreciated in month two of its purchase fiscal year, which means that in the first year if it's life we took 11 months of depreciation expense against it. Thus in its final fiscal year of useful life, we'll take only one month.
  • Because at the end of each fiscal year, the totality of the income statement (Net profit or loss --> Income Summary) is closed to the balance sheet; thereby resulting in an income statement that begins at zero for all accounts at the start of every fiscal year. The entry that does that is what transfers a given year's net profit (or loss) to a business' equity account. The depreciation expense recorded in the prior years has already been transferred to the equity account and is this reflected in its balance.

Now, with that out of the way, we are in a position to see why the decline in market value has nothing to do with depreciation.

Let's say that after depreciating the asset for one year, the owner of our asset were to sell it. The correct calculation to determine whether there is a gain or loss on the sale is as follows:

NBV - selling price = gain/loss on sale of asset or
$13,000 - selling price = gain/loss on sale of asset

If the seller sells it for $13,500, s/he has a gain. If it's sold for $12,000, s/he has a loss. The selling price, strictly called "fair market value," determines whether there is a gain or loss. The depreciation that's been recorded in association with the asset is the same $1,000 no matter what the selling price is. ("Fair market value" is whatever sum is mutually agreed upon in an "arms length" transaction between a buyer and a seller.)

What CSU87 has been attempting to assert is in substance the following:

Purchase price (PP) - selling price (SP) = depreciation (expense).

Well, that's just not what depreciation is and it's not how it's calculated. What PP - SP equals is an increase or decrease in fair market value, not depreciation. Moreover, many things can cause that increase or decrease, but depreciation is not one of them. Also worth noting is that the net book value of an asset is its value in the owner's book of record. It has absolutely nothing to do with how much that item is worth on the open market.

Having now discussed how depreciation is calculated, let's consider what it is. In short it's the application of what is called the "matching principle." Depreciation is the means by which the use of an entity's long term property is matched over time to the revenues it helps generate. (See PDF page 36, sections 144ff here: http://www.fasb.org/cs/BlobServer?bl...lication%2Fpdf) In effect the cost of the asset is divided up with some of the cost being reported on each of the income statements issued during the life of the asset. By assigning a portion of the asset's cost to various income statements, the accountant is matching a portion of the asset's cost with each period in which the asset is used. Hopefully this also means that the asset's cost is being matched with the revenues earned by using the asset.


Red:
Well, actually CSU87, it's I who is willing to deem it "okay that you don't understand" accounting, even the most basic elements of it that one learns within the first four weeks or so of Principles of Accounting I. It's a discipline that seems to have straightforward enough principles and practice, but in fact it actually requires a bit of training for one to understand how to interpret and apply its principles. I hardly expect most folks to read FASB statements and bulletins in order to fully grasp them.

Blue:
The only "sense" for which the term depreciation has any meaning is the accounting sense. I bid you find any authoritative writer who describes what depreciation is and how to calculate it and you'll find that what they are writing about is the accounting application of the term. The definition of deprecation you provided isn't wrong by any means.

It's your interpretation and application of it that's mistaken. As I noted just above, I don't expect that non-accountants should have a full enough understanding of what depreciation is to interpret it differently. I do, however, expect that intelligent people realize when their knowledge is insufficient to speak/write authoritatively about it.

There's no question in my mind that as the bookkeeper for your company you are quite capable of applying straight line depreciation to your construction equipment. You may even be able to apply accelerated or units of production depreciation to those items. The thing is that doing so, even doing so well and accurately, isn't the same as knowing how to apply accounting principles and interpret the FASB's statements.

What I understand about depreciation, in fact accounting -- tax, audit, forensic accounting, accounting systems, cost accounting and managerial accounting -- as a business discipline, is both the theory and the practice in the private, non-profit and public sectors.

All the best.

That....was pretty long indeed.