Property, plant and equipment, also referred to as fixed assets, have finite useful lives. These assets depreciate in value over time, and depreciation is calculated using a method that shifts the asset's cost from the balance sheet to the income statement as the asset depreciates in value.
When a fixed asset is initially purchased, its cost basis is recorded on the balance sheet. A contra account called accumulated depreciation is assigned to the fixed asset, and as depreciation expense is recorded every month, it is credited to accumulated depreciation, resulting in a decrease in the asset's book value. Its book value is equal to its historical cost less total accumulated depreciation.
Generally accepted accounting principles, or GAAP, require that companies use a double-entry accounting system, and the debit that offsets the credit to accumulated depreciation is a depreciation expense on the income statement. Depreciation does not reflect any actual cash outflows, but it is treated as an operating expense for accounting purposes.
The methods for calculating depreciation include the straight-line method, the units of output method and accelerated depreciation methods.
Items you will need
- the asset's cost.
- the asset's estimated useful life
- the asset's residual value
The asset's cost can be determined using its original cost and should include costs incurred to transport and prepare the asset. The asset's useful life is based on the number of years it is expected to be in service. Residual value is calculated based on management's most reasonable estimate of the amount that can be collected from liquidating the asset at the end of its useful life.
Depreciation expense is calculated using this formula: (cost basis minus residual value) divided by the number of years of the asset's expected useful life. For example, if a car's cost basis is $1,000, its residual value is $100 and its useful life is seven years, depreciation expense equals ($1,000 - $100)/ 7, or $900/ 7, which equals $128.57. Divide this figure by 12 months to arrive at a monthly depreciation expense of $10.71.
Units of Output Method
The units of output method estimates depreciation based on actual production generated by the depreciable asset. Depreciation expense rises and falls based on production, and if production is zero because of the fixed asset sitting idle, depreciation expense equals zero. Using this method, the fixed asset's useful life is expressed in the number of units it will produce during its useful life. Depreciation expense is calculated using the formula: (Number of units produced divided by useful life in number of units) multiplied by (cost basis minus salvage value).
Accelerated Depreciation Techniques
Thee two accelerated depreciation methods are the double declining balance technique and the sum of years' digits method.
Double Declining Balance Technique
The double declining balance technique staggers depreciation costs toward the beginning of an asset's useful life. It is similar to the straight-line method but doubles the depreciation amount in the first period, converts it into a percentage, or multiplier, and applies this to the asset's book value. This results in a rapid reduction in the asset's book value, because the same multiplier is continually applied to a shrinking book value.
Sum of Years' Digits
The formula for the sum of years' digits method is depreciable base multiplied by (useful life remaining divided by sum of years' digits). In this equation, depreciable base equals cost basis minus residual value, and sum of years' digits equals n(n+1)/2. Here, n equals useful life.
For example, if useful life equals 4, the sum of years' digits equals: 4(4+1)/2, or 4(5)/2, which results in 20/2, or 10. Over the asset's useful life, its depreciable base would be multiplied by 4/10 in the first year and 3/10 in the second year, 2/10 in the third year and 1/10 in the fourth and final year.