When you purchase capital assets, such as buildings, manufacturing equipment or office furniture, you are allowed to depreciate the cost of the asset over several years instead of taking a large expense in the first year. The gradual decline in the asset's value on the books mimics the effect of wear and tear on its physical condition as time passes.
You must first estimate the salvage value of the asset, which is the remaining value after all depreciation has been applied. Subtract the salvage value from the asset's original cost to find the basis for depreciation. If an asset has a purchase price of $100,000 and you expect to be able to sell it for $20,000 when its useful life is over, the depreciable basis would be $80,000. The annual depreciation expense should be recorded to a contra account titled "Accumulated Depreciation." Subtract the balance of this account from the asset's original value to find the current cost basis for each subsequent year of depreciation.
The four commonly used methods for calculating depreciation are:
- Double-declining balance
- Sum of the years' digits
- Units of production
Straight-line depreciation is the easiest method to calculate. Simply divide the asset's basis by its useful life to find the annual depreciation. For example, an asset with a $10,000 basis and a useful life of five years would depreciate at a rate of $2,000 per year.
The double-declining balance method accelerates the depreciation so the first year has the highest expense. An asset with a useful life of five years would normally depreciate at a rate of 20 percent per year. With the double-declining balance method, you would record 40 percent of the asset's basis each year. After two and a half years, the depreciation will exceed the asset's remaining basis. You may only record the amount of depreciation necessary to zero out the basis. For example, if the asset's original basis was $10,000, you would record $4,000 of depreciation for each of the first two years and $2,000 in the third year.
To use the sum-of-the-years digits method, you will need to convert the asset's useful life into a series of fractions. The denominator of the series of fractions is the sum of the years of the useful life. For an asset with a five-year useful life, you would use 15 as the denominator (1 + 2 + 3 + 4 + 5). In the first year, multiply the asset's cost basis by 5/15 to find the annual depreciation expense. The fraction would change to 4/10 in the following year, 3/10 the year after that, 2/10 the next year and 1/10 in the final year of the asset's life.
Manufacturing companies often prefer the units-of-production method, which allocates depreciation expenses based on the number of units an asset produces. To use this method, you must estimate the number of total units the asset will produce during its useful life. Divide the asset's cost basis by the total expected units of production to find the per unit depreciation expense. For annual depreciation, multiply the number of units produced during the year by the depreciation per unit.