How To Calculate Depreciation

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Looking for a step by step tutorial on how to calculate depreciation? You’ve come to the right place! In this tutorial, we will explore how to calculate depreciation using [1] the straight line method, [2] double declining balance method, [3] units of production method and finally [4] sum of the years digits method. Not only that, you will also see how accounting journal entries correspond to each method also.

Brief Primer Before Learning How To Calculate Depreciation:

The balance sheet separates assets into two broad categories called current assets and fixed assets. Current assets are those that are either cash or anything else that can be converted to cash in a relatively short period of time such as marketable securities, accounts receivable and inventory. Fixed assets on the other hand are those held by the company for long term use. They are generally not available for sale as part of normal business operations.

Fixed assets are classified as

(1) tangible (property, plant & equipment [PP&E])

(2) intangible (patents, copyrights, goodwill etc.) or investments (long lived assets not intended for operational use in the near future).

Other than land (which is determined to have indefinite life) all other fixed assets lose their usefulness over time. That is, they depreciate in value (book value to be more specific). In observing the matching principle of GAAP, the expense associated with the purchase of a fixed asset should be allocated over its useful life. How long a particular asset is expected to live can be determined through historical experience, industry benchmarks and publications from the IRS.

In order to determine the depreciation expense for a particular accounting period, four things are needed:

  • Total cost of the fixed asset (which also includes things like sales tax, professional consulting fees, permits, installation, etc., basically any cost related to getting that fixed asset into service.)
  • The assets salvage value or sometimes referred to as residual value (the $ amount for which the asset can be sold for at the end of its useful life).
  • The assets useful life in years or expected production capacity
  • And finally, the depreciation method that will be used to allocate the overall expense of that fixed asset.

*** The difference between total cost and the salvage value of the asset is the depreciable cost. Depreciable cost will be allocated over the useful life of the asset and based on the depreciation method chosen, there will be a specific depreciation expense amount recorded in a given accounting period. This will become more clear to you as you read through the tutorial and learn how to calculate depreciation using those various methods. Let’s jump right in …

DEPRECIATION METHODS:

There are 4 prevalent methods used in depreciating fixed assets. By far, the most widely used method is the Straight-Line method of depreciation. This method is preferred by many companies because of its simplicity. The other methods used are Double-Declining-Balance, Units-of-Production and Sum-of-the-Years-Digits.  A closer look by way of an illustrative example for each method follows.

How to calculate depreciation using the Straight Line Method:

Using this method, the depreciation expense that is recognized each period will be the same dollar amount. To illustrate, assume that your company bought equipment on July 1, 2009 for a total cost of $250,000 and determined that its useful life is 10 years with a salvage value of $75,000. You as the accountant for this company, needs to figure out the depreciable cost, periodic interest expense (by way of determining the rate of depreciation) and make the appropriate journal entries to recognize that expense in the company’s books.

Given the information above, you first determine the depreciable cost which equals, $250,000 – $75,000 = $175,000.

The next step is to determine the rate of depreciation. In this case, the equipment is expected to have a useful life of 10 years and since depreciation expense will be equal each period, the rate of depreciation on an annual basis will be 1/10 or 10% of the depreciable cost.

Following that, determine what the straight-line depreciation expense amount will be on an annual basis. In this case, it will be $175,000 * 10% = $17,500.

Finally, make the appropriate journal entries beginning with the acquisition of the asset.

How To Calculate Depreciation

The next journal entry that needs to be made will come at year end in 2009 on December 31st, at which time an entry will be made to recognize the depreciation expense. At this point, be mindful of two things. 1) The asset was acquired during the middle of the year, so your depreciation expense will be prorated to reflect how long it has been in service. In this case July 1, 2009 to December 31, 2009 is exactly 6 months or ½ of the annual depreciation expense of $17,500 = $8,750.

And 2) every journal entry has a debit and a credit. While there is a

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