Factors for Calculating Depreciation

Factors Affecting Depreciation Expense

There are four main factors to consider when calculating depreciation expense:

1. The cost of the asset
2. The estimated salvage value of the asset. Salvage value (or residual value) is the amount of money the company expects to recover, less disposal costs, on the date the asset is scrapped, sold, or traded in.
3. Estimated useful life of the asset. Useful life refers to the window of time that a company plans to use an asset. Useful life can be expressed in years, months, working hours, or units produced.
4. Obsolescence should be considered when determining an asset's useful life and will affect the calculation of depreciation. For example, a machine capable of producing units for 20 years may be obsolete in six years; therefore, the asset's useful life is six years.

Factors Affecting the Depreciation Method

A company is free to adopt the most appropriate depreciation method for its business operations. Accounting theory suggests that companies use a depreciation method that closely reflects the operations' economic circumstances. So, companies can choose a method that allocates asset cost to accounting periods according to benefits received from the use of the asset. Most companies use the straight-line method for financial reporting purposes, but they may also use different methods for different assets. The most important criteria to follow: Use a depreciation method that allocates asset cost to accounting periods in a systematic and rational manner.

Types of Depreciation Methods

The following four methods allocate asset cost in a systematic and rational manner: straight line, units of production, sum-of-years-digits, and double-declining balance.

Examples of Depreciation Expense Calculations

Here is an example of how to calculate depreciation expense under the straight-line method. Assume a purchased truck is valued at $10,000, has a residual value of $5,000, and a useful life of 5 years. Its depreciation expense for year 1 is $\frac{$10000-$5000}{5}=$1000$. The journal entry for this transaction is a debit to Depreciation Expense for $1,000 and a credit to Accumulated Depreciation for $1,000. The depreciation expense is reported on the income statement as a reduction to revenues and accumulated depreciation is reported as a contra account to its related Delivery Truck asset account (reduces the asset's cost to its book value) on the balance sheet.

Here is an example of how to calculate depreciation expense under the units of production. Assume a piece of machinery, purchased for $100,000 with a residual value of $40,000, is expected to produce 10,000 units over its useful life. First, calculate the depreciation per unit:

$\dfrac{$100,000 - $40,000}{10,000} = $6$

The depreciation expense for the period is the per unit amount multiplied by the period's production amount: if 1,000 units were produced, the depreciation expense is $1000 \cdot $6 = $6000$. This amount is disclosed on the income statement and is part of the asset's accumulated depreciation on the balance sheet.

Here is an example of how to calculate depreciation expense under the sum-of-years-digits. Assume a piece of machinery is purchased for USD 100,000 with a residual value of $40,000 and a useful life of 5 years. First, calculate the depreciation rate by adding the years of useful life, or $1+2+3+4+5=15$. Second, calculate the depreciation expense for year 5: 

$\dfrac{($100,000-$40,000) \cdot 5}{15} = $20,000$

For year 4, the calculation uses the asset's book value  ($$100,000 - $20,000$) subtracted by its residual value ($$40,000$) and multiplied by the rate for year 4 $\left( \frac{4}{15} \right)$.

To calculate depreciation using the double-declining method, its possible to double the amount of depreciation expense under the straight-line method. To do this, divide 100 per cent by the number of years of useful life of the asset. Then, multiply this rate by 2. Next, apply the resulting double-declining rate to the declining book value of the asset (cost subtracted by accumulated depreciation). Ignore salvage value in making the calculations. At the point where book value is equal to the salvage value, no more depreciation is taken.