When purchasing assets for your company, it is important to consider their useful lives as well as how best to account for their costs. Depreciation costs allow you to capitalize expenses in a way that will give you an accurate picture of a company’s expenses versus their income.
In this article, we’ll explain what depreciation expense is, compare it to accumulated depreciation, walk you through how to choose the right depreciation expense method and provide examples of the various methods used in real-life scenarios.
Table of Contents
1 What is Depreciation Cost?
2 Depreciation Cost and Accumulated Depreciation
3 How to Choose the Depreciation Cost Method?
3.1 1. Will the asset maintain a consistent value?
3.2 2. Will the asset depreciate dramatically in the first few years?
3.3 3. Will the asset depreciate with use or production?
4 Case Examples in Calculating Depreciation Cost
4.1 Straight Line Shrink
4.2 Depreciation of declining balance
4.3 Production unit depreciation
What is Depreciation Cost?
Depreciation expense, also known as a noncash expense, refers to the amount of depreciation, or cost of an asset, that is recorded on a company’s income statement.
When a company buys an asset that they intend to use over a long period of time, they often take advantage of it instead of only issuing it in the accounting period in which the asset was purchased. This is mainly done because the asset will be used and useful beyond just that accounting period.
In other words, depreciation can match the long-term cost of an asset with the income it will generate in the future. If a company charges an asset in the accounting period it is purchased in, it will overstate the cost for that particular period and then understate the cost in all future accounting periods.
Depreciation Cost and Accumulated Depreciation
Accumulated depreciation refers to the total amount of depreciation for an asset that has been recorded on the company’s income statement. Unlike depreciation expense, accumulated depreciation is a contra asset, or asset credit balance, an account that is reported on a company’s balance sheet.
In accumulated depreciation, the original value of the asset is adjusted each fiscal year to reflect the updated depreciation value. In other words, it is the total depreciation of the asset and provides a more accurate estimate of the asset’s useful life.
The following is an example of how to use depreciation expense and accumulated depreciation:
A company purchases a new display rack for 84,000,000, with an estimated useful life of 7 years (84 months) and no salvage value. The company will likely choose to use the straight-line depreciation method, which means that the depreciation expense will be 1,000,000 per month (84,000,000/84 months = 1,000,000 per month).
However, the accumulated depreciation will appear on the balance sheet as 1,000,000 for the first month, 2,000,000 for the second month, 3,000,000 for the third month and so on until the accumulated depreciation matches the asset’s initial value of 84,000,000 in the 84th month.
How to Choose the Depreciation Cost Method?
There are three main methods for calculating depreciation expense:
- Straight-line shrinkage
- Decreased balance depreciation
- Production unit depreciation
The type of depreciation expense method you choose will largely depend on the nature and rate of depreciation of the asset. To choose the depreciation expense method, you must assess three aspects of the asset:
1. Will the asset maintain a consistent value?
In cases where an asset maintains a relatively consistent value, such as when buying a building, you would use the straight-line depreciation method.
This method for calculating depreciation expense is the most commonly used and also the easiest to calculate. The straight-line depreciation method distributes depreciation expense evenly over each year of the asset’s useful life. The equation you will use to calculate this is:
Depreciation Cost = (Purchase Value – Residual Value) / Asset Benefit
2. Will the asset depreciates dramatically in the first few years?
There are some assets, such as vehicles, that depreciate very quickly in the first few years of purchase. In this case, you can use the declining balance depreciation method.
Under this method, depreciation expense decreases over the life of the asset. When using the declining balance method, you can manipulate the depreciation factor to reflect the loss rate of the asset, as long as its value is greater than one.
The declining balance depreciation method provides a depreciation expense that changes annually over the useful life of the asset. This is because accumulated depreciation causes the initial value of the asset to decrease over time.
The double-declining balance depreciation schedule, also known as the double-declining balance method, is a popular method for calculating an accelerated depreciation schedule. This method uses a factor of 2x, or depreciation rate.
The equation you will use to calculate this is:
Depreciation Expense = Initial Value of Assets * Depreciation Rate / Useful Life of Assets
3. Will the asset depreciate with use or production?
When determining depreciation expense for production machines, it is best to use the unit-of-production depreciation method. This method is also commonly used in mining operations.
You would use the units-of-production depreciation method when calculating the useful life of a product based on the number of units, or products it can produce. In this method, you can also manipulate expenses when there is an increase or decrease in production.
Here is the formula for calculating depreciation expense with this method:
Unit Depreciation Expense = (Initial Asset Value – Residual Value) / Asset Benefit in Units. Depreciation Expense = Unit Depreciation Expense * Number of Units Produced
Case Example in Calculating Depreciation Cost
Here are some examples of each depreciation method:
Straight Line Shrinkage
A company purchases a new building for 480,000,000 to be used for 40 years, or 480 months, with no salvage value. The company’s monthly income statement will reflect a depreciation expense of 1,000,000. You can calculate it by dividing the cost of 480,000,000 by 480 months of the asset’s useful life (480,000,000/480).
A company purchases a vehicle for 100,000,000, with plans to use it for 5 years. Due to the depreciation nature of the vehicle, they wanted to use the double-declining balance method.
The depreciated cost for the first year is 40,000,000, which we will find by multiplying 100,000,000 times the declining balance, or two, and then dividing that number by the five years of the asset’s useful life (100,000,000 * 2/5).
The depreciation expense for the following year will be 24,000,000 because we need to subtract the salvage value from the initial value of the asset, multiply that number by the declining balance, by two, and then divide that number by the five years of the asset’s useful life ((100,000,000 – 40,000,000) ) * 2/5.
Production unit depreciation
A company purchases a machine for 100,000,000 that has a salvage value of 5,000,000. They hope to produce 95,000 units with the machine.
To determine depreciation expense, they would subtract the salvage value from the asset’s initial value and then divide that figure by the number of units they expect to produce, giving them a cost of 1.ooo per unit ((100,000,000 – 5,000,000) / 95,000).
The company produces 10,000 units in one year, giving them a depreciation expense of 10,000,000 (1*10,000,000).