Depreciation is a term used in accounting to describe the method a company uses to take into account the declining value of its assets.
This hub will teach you some simple techniques used in calculating depreciation for fixed assets. It will include two methods: straight line method and declining balance method.
About the Author
Dez has a master's degree in Applied Mathematics from one of the best schools in the Philippines. Majoring in Finance, she has taken accounting classes as well.
What is Depreciation?
To explain the concept of depreciation, imagine that you are in the market for a new car. Because of budget constraints, you are looking at second hand cars instead of brand new ones from dealerships. In my opinion, one of the most important things you should be looking at is when the car model was first sold as brand new in dealerships.
Compare a brand new car with an old one. The value of a brand new car is much higher than the value of the old car. The reason for this is because the old car has depreciated in value over its useful life. Depreciation refers to the decrease in value of assets. This may be due to the asset being worn down, depleted, or become obsolete.
Two Methods to Calculate Depreciation
Depreciation expense is calculated by using one of two methods: the straight line method and the accelerated method.
The straight line method spreads the cost evenly over the useful life of the fixed asset. This means that its depreciation expense for each year is the same every year. This is the easiest method used to calculate depreciation.
However, some disagree with this method. They argue that a fixed asset is more useful when it is new. This is where the accelerated method comes in. This method expenses a large part of the cost at the earlier years of the fixed asset and gradually decreases the expense as the years go by.
For the accelerated method, I will be showing how to calculate depreciation using the declining balance method. There are other possible ways to calculate depreciation, but these are the ones more commonly used.
There are three variables required for any method:
- the cost of the fixed asset;
- the expected life of the asset; and
- its salvage value.
Salvage value, also known as residual value, is the remaining value of an asset after it has been fully depreciated. Going back to the car example, after its useful life, you can still sell parts of your car to junk shops for money. So its salvage value is not zero. It is actually the price you get from selling what remains of your fully depreciated asset.
Straight Line Method (SL Method)
This is the formula for the straight line method:
If salvage value is not given, then consider it to be zero. The formula will then be:
Example for Straight Line Method
Suppose we just bought a new car for $30,000. Its useful life is 10 years with a salvage value of $2000.
Using the straight line method formula, we get:
Annual Depreciation Expense = ($30,000 - $2,000) / 10 = $2,800.
So, consider the following situation: If you want to sell your car 4 years from now, how much will its value be after depreciation?
Because we are using the straight line formula, to get the accumulated depreciation (total depreciation incurred by the asset from the beginning), we need to multiply the annual depreciation expense by the number of years passed. This is how the formula will look like:
Applying this formula to our example,
Accumulated Depreciation = 4 * $2,800 = $11,200.
Thus, the value of the car 4 years from now is $30,000 - $11,200 = $18,800.
Accelerated Method (The Declining Balance Method)
For the declining balance method, the process involves the use of the current value of an asset multiplied by a factor based on the remaining life of the asset. As time goes by, the current value of an asset is reduced by the accumulated depreciation from years past. The factor, on the other hand, relies on an accelerator multiplied by the percentage of the asset to be depreciated should a straight line method be used. The most common accelerator is two, for the double declining balance method.
So how do we account for the salvage value of the asset? Logically, the final value should never be less than the perceived salvage value. This is due to the fact that we are expecting to receive the salvage value at the end of its useful life. No amount of calculations would change that fact. So in cases where the final value is less than the salvage value in your calculations, use the latter value instead.
Example for Declining Balance Method
Going back to the car we want to buy for $30,000. With the useful life of 10 years and a salvage value of $2,000, suppose we are going to use the double declining balance method. As previously stated, the accelerator for this method is 2.
To find the factor, first we look at the percentage of the car to be depreciated should we use a straight line method. Just divide 1 by the total number of years, in this case, the percentage is 1/10. We multiply this percentage by the accelerator and we get 1/5.
I'll show the next calculations in the table below:
|Years||Current Value of Asset||Calculation||Depreciation Expense||Accumulated Depreciation|
$30,000 * 1/5
$30,000 - $6,000 = $24,000
$24,000 * 1/5
$6,000 + $4,800 = $10,800
$24,000 - $4,800 = $19,200
$19,200 * 1/5
$10,800 + $3,840 = $14,680
$19,200 - $3,840 = $15,360
$15,360 * 1/5
$14,780 + $3,072 = $17,852
$12,288 * 1/5
$9,690.40 * 1/5
$7,752.32 * 1/5
$6,201.86 * 1/5
$4,961.49 * 1/5
$3,969.19 * 1/5
So, to get the final value of the asset at year 10 after depreciation, we need to subtract the current value with the depreciation expense to get:
$3,969.19 - $793.84 = $3,175.35.
Because this value is greater than the salvage value, the answer remains the same.
But, suppose that our salvage value is $4,000. Because it is greater than the value of the asset at year 10, the depreciation expense in year 9 should be just enough to get the final value of $4,000.
Depreciation Expense on Year 9 = $4,961.49 - $4,000 = $961.49.
Then, the depreciation expense for year 10 is 0, and the value of the asset remains at $4,000. If there are more years left, all depreciation expenses after the value reaches $4,000 remains 0.