How is Depreciation Expenses Calculated?

Fixed assets of a business such as computers and equipment, vehicles, machinery, furniture, and fixture lose value over time. The loss of value is known as depreciation which is calculated when preparing financial statements.

Business owners need to know about depreciation expenses and how the expense is recorded by outsourced bookkeeping service providers in the books. Here we will delve deep to learn more about the accounting concept.

What is Depreciation?

Depreciation refers to the loss of fixed value over time. Every fixed asset depreciates over its useful life. The value of the asset goes down over its lifecycle.

Accountants record depreciation as a contra-cash expense in the journals. The expense reduces the net income reported in the financial statements. The following entry is made in the accounts when recording depreciation expenses.

Depreciation expenses (Debit)

Accumulated Depreciation (Credit)

Depreciation expenses do not involve cash transactions. That is why the expense is not entered in the cash flow statement.

Difference between Depreciation and Accumulated Depreciation

Depreciation expenses and accumulated depreciation are related accounting terms. Both depreciation expense and accumulated depreciation represent the wear and tear of the fixed asset.

The depreciation expense mentioned in the financial statement is for a single period. In contrast, accumulated depreciation is the net depreciation expenses from the previous periods at a given time. It is the total depreciation expenses of the asset throughout the ownership of the business.

Accumulated depreciation amount appears on the balance sheet of a company. The amount is shown in the balance sheet as a contra asset. It is reduced from the fixed asset amount shown on the balance sheet. Contrarily, the amount mentioned in the  

Calculation of Depreciation Expenses

The depreciation expense will continue to be recorded in the balance sheet over the life of the asset. The accumulated depreciation in the balance sheet will be reversed when the asset is discarded or sold.

Professional CPAs use different methods to calculate depreciation expenses. Here are the four common methods used by accountants to calculate the depreciation expense.

1. Straight Line Method

The straight-line method involves depreciating the asset with an equal amount each year. The amount of depreciation remains the same over the life of the asset. Accountants use this method due to its simplicity and ease of calculation.

The following steps outline how the depreciation expenses are measured using the straight-line method.

Step 1: Salvage Value

Determine the salvage value of the asset. The salvage value refers to the value of the asset at the end of its useful life. It is the estimated market value of the asset at the end of its lifespan.

Step 2: Asset Lifespan

Experienced accountants must next determine the asset lifespan. The number of years that the asset will be used is determined through a review of similar assets.

Step 3: Deduct Salvage Value from Cost

The next step is to deduct the salvage value of the asset from its cost to find out the depreciated value of the asset.

Step 4: Divide by Asset Lifespan

The final step is to divide the resulting value in step 3 by the useful life of the asset. This will give the depreciation expenses that must be recorded each year in the financial statement.

2. Declining Balance Method

The declining balance method is also used to calculate the depreciation expense. The method involves deducting a larger depreciation amount during the early life of the asset. The depreciation expense reduces each year.

The following steps outline how the depreciation expenses are measured using the declining method.

Step 1: Asset Lifespan

Accounts must first determine the years of the useful life of the asset.

Step 2: Depreciation Rate

The next step is to calculate the depreciation rate of the asset. The depreciation rate is calculated by dividing 100 percent by the useful life of the asset.

Step 4: Multiply Net Book Value by Depreciation Rate

Next, multiply the net book value of the asset by the depreciation rate. The net book value refers to the book value of the asset at the start of a period minus the accumulated depreciation. The accumulated depreciation for the first year is zero.

Note that the depreciation expenses calculated using this method will be different for each period. But the rate of depreciation will be the same.

3. Sum-of-the-years’-digits (SYD) Method

The third method to calculate the depreciation expenses is the sum of the year’s digit method. The method involves determining the useful life of the asset and adding the digits each year. This method is also known as the accelerated depreciation method.

Let’s suppose that the useful life of the asset is seven years. The sum of digits of years will be added as follows.

7+6+5+4+3+2+1 = 28

Each digit of the year will be divided by the resulting amount to calculate the depreciation rate of the asset during that particular year. Unlike the declining method, the depreciation rate using this method will change each year.

4. Modified Accelerated Cost Recovery System (MACRS) Method

Businesses are also allowed to use the modified accelerated cost recovery (MACRS) method to calculate depreciation expenses. The method results in much larger depreciation expenses during the early years than other methods. This method of calculating depreciation expenses will result in a lower net profit figure during the early life of the asset.

The useful life of different assets is fixed based on the class of the asset. Here are the useful lives of common assets generally used for tax purposes.

The MACRS method for calculating depreciation is complex. Businesses can use the tables in IRS Publication 946 to get help in calculating depreciation expenses using this method.

Maxim Liberty Inc provided outsourced bookkeeping services to all types of businesses. We have a team of professional CPAs who can simplify the task of recording depreciation expenses using generally accepting accounting principles. Contact us today by dialing (703) 957-6938.