Depreciation is the gradual reduction of the price of a fixed asset, such as furniture, building, machinery etc. The only element that does not fit here is land. This is because it increases in value over time, until the asset’s worth becomes nil. Using the method of depreciation enables businesses to see the direct relation to revenues they generate by the asset over its useful life. Depreciation goes into recording with a credit to accumulated depreciation and a debit to depreciation expense on the balance sheet. This is just a small part of the depreciation formula.
There are various formulas to calculate deprecation, each with their own benefits. So, which depreciation formula you select usually depends on whether you want to reduce the asset’s cost starting from time or use.
Depreciation by Time
1. Straight Line Method
The most common method of depreciation is the straight-line method. Of course, this is because it is the easiest to use.
Depreciation expense = Total Acquisition Cost -Salvage Value/Useful life.
- Under this depreciation formula, you can calculate depreciation by taking the price you paid for an asset.
- Then, you deduct the cost at which you can sell the asset at the end of its useful life. This is also known as the salvage value.
- Divide it by the total time the asset should be in service.
The overall benefit of the straight-line method of depreciation is that it enables businesses to deduct a continuous depreciation expense over the life of the asset. Then, at the end of the asset’s useful life, you record the asset at its salvage value.
2. Accelerated-Depreciation Method
The accelerated method of depreciation enables businesses to deduct larger depreciation expenses in the first few years and then deduct a lesser amount in the later years. Therefore, it is most commonly used for deducting assets that you might replace when they become outdated. This method works as opposed to when they reach the end of their useful life.
The main benefit of the accelerated-depreciation method is the tax shelter it provides. For instance, businesses with a sizable tax obligation might use accelerated depreciation to write off smaller earnings in the earlier years to appear more valuable in the latter years and receive a higher assessment.
There are two main methods of accelerated depreciation: the double-declining-balance method and the sum-of-year method.
2.1. Double-Declining-Balance Method (DDB)
The double-declining-balance depreciation formula deducts twice the sum of the straight-line-depreciation that is written off in year 1. Then, that same percentage goes to the non-depreciated sum in the following years
Double Declining Balance year i= (2/n)*(Total acquisition cost – Accumulated depreciation, n = Number of years).
For instance, let’s say your business bought equipment for $1 million. At the time, it had an approximate useful life of 3 years. Additionally, you estimate that at the conclusion of these 3 years you will be able to sell the equipment for $100,000 for parts.
The double-declining-balance method enables you to depreciate the equipment using a very aggressive timetable. However, you cannot write off the equipment after its salvage value.
2.2. Sum-of-Year Method (SYD)
The sum-of-year depreciation formula enables businesses to create a variable depreciation expense.
Depreciation in year i + ((n – i+1/n!* (Total acquisition cost – Salvage cost).
For instance, let’s say your business purchased equipment for $1 million. With the aid of estimation, its useful life is of 3 years. Furthermore, at the end of 3 years you estimate that you can sell it for $100,000 for parts.
Under the sum-of-year method, businesses can write off variable costs during the first few years. At the conclusion of the asset’s useful life, the depreciation it accumulated is the same as the depreciation resulting from the straight-line method.
Depreciation by Use
1. Units of Production Depreciation
The main benefit of units of production depreciation, also known as units of activity depreciation, is that depreciation expenses deduct in direct percentage to the amount of asset usage. In other words, it enables businesses to write off more depreciation during times where there is higher asset usage and vice versa. Therefore, specialists consider it the most realistic method of depreciation. This is because it closely relates to the actual decline of an asset.
However, you need to be able to approximate total production spanning the life of an asset. This is in order to arrive at the depreciation sum to benefit in each accounting term. Also, it requires that you track asset usage. So, it generally limites to more expensive assets.
2. Units of Activity Depreciation
For this depreciation formula, first estimate the usage time of the asset, in total hours. You can also use the total number of units that your company will produce over its useful life.
Depreciation expense = (Cost – Salvage value) x Actual activity it performs during the period/Total estimated lifetime activity of the asset).
- Next, to get the depreciation cost per unit of production or hour of usage, simply deduct the salvage value you estimate from the asset cost.
- Then, divide the total units of production for usage hours from the estimation from this total depreciation sum.
- Lastly, to arrive at the total depreciation expense for the accounting term, multiply the number of units or the number of hours of actual production by the depreciation sum for each unit produced or hour of usage.
- As the estimated number of units of production or hours of usage fluctuate, only if there are significant fluctuations in usage or production units from term to term, simply incorporate these changes into the calculation of the depreciation sum for each unit of production or hour of usage. These changes will alter the depreciation cost for each time being. However, it will have no bearing on the depreciation that has already been credited.
The calculation of units of production depreciation is the method of depreciation that goes the most into details. Yet, it may not be beneficial unless it observers of your business’s financial records use it.
Depreciation is not a way to determine the potential market value of an asset. However, it does enable businesses to pay asset expenses over time. This comes in opposition to simply paying one huge expense upfront. This action can cause a huge burden. Furthermore, the depreciation formula you select provides even more benefits by enabling you to select a depreciation schedule applicable to your specific needs.
To calculate depreciation, simply invest in reputable business accounting software. These will enable you to accurately record depreciation. You can also employ the services a professional accountant. Just make sure you pick one with experience and who is knowledgeable in depreciation.