Depreciation is the decrease in the cost of an asset over time. Companies report assets on their balance sheet; as the asset depreciates, the cost of the asset moves from the balance sheet to an expense on the income statement. This is how depreciation matches the use of the equipment to the expense of purchasing the equipment. Depreciation rates will vary from company to company because management may make several assumptions relating to depreciation. There is no right or wrong method to choose, but companies should aim to match the depreciation rate with the use of the asset.
Determine the type of depreciation the company will use. There are two forms of depreciation, either straight-line or accelerated. Straight-line keeps depreciation constant over the asset's life while accelerated creates a greater expense early in the asset's life and a smaller expense later in life.
Choose the method of depreciation, whether straight-line or accelerated. For accelerated depreciation, the two most common methods are double declining and sum of years' digits. Straight-line depreciation equals the current value minus the residual value divided by the life of the asset. Generally, for the double declining method, the depreciation expense equals the current value times, 2 divided by the life. Written algebraically, the formula is current value x (2 / life). Sum of years' digits add together all the years to create a depreciation base. For example, with a three-year asset life, the sum of years is 1 plus 2 plus 3, which equals 6. The formula then for sum of years' digits is the current value x (inverse of the year / sum of years). The inverse of the year is the opposite year. For example, in year 1 of the asset's life, the inverse of the year equals 3, and for year 3 the inverse of the year equals 2.
Estimate the assumptions needed to calculate depreciation: residual value and asset life. The residual value is the amount the asset is worth at the end of its life. Management estimates these numbers from research and prior use of similar assets. For example, if a company needs new trucks every three years, the company should estimate the asset lives of trucks at three years.
Depreciate the assets using the depreciation method chosen and the estimate made to determine the depreciation rate. For example, a $10,000 truck has a three-year asset life. With straight-line depreciation, the depreciation in year 1 is $10,000 divided by 3, which equals $333.33. With the double declining method, the depreciation for year 1 is $10,000 multiplied by 2/3, which equals $666.67. Using sum of years' digits, the depreciation for year 1 is $10,000 x 3/6, which equals $5,000.
Carter McBride started writing in 2007 with CMBA's IP section. He has written for Bureau of National Affairs, Inc and various websites. He received a CALI Award for The Actual Impact of MasterCard's Initial Public Offering in 2008. McBride is an attorney with a Juris Doctor from Case Western Reserve University and a Master of Science in accounting from the University of Connecticut.