Depreciation and the Three Methods to Calculate it

I would like to dedicate this article to depreciation

. Depreciation is a major concept accountants should keep in mind when working with companies and businesses that own plant assets. Plant assets include not just plants but also property and equipment that are tangible in nature, actively used in operations and are expected to benefit in future periods of time. The Financial Accounting Fundamentals textbook states that the definition of depreciation is the process of computing expense from allocating the cost of plant and equipment over their expected useful lives (Wild, 2009). When calculating depreciation one should notice that actual land is not a depreciable asset. Only land improvements are. Building costs include the purchase or construction price plus taxes and brokerage, title, attorney fees. When it comes to equipment and machinery the total cost of the plant asset includes the purchase price, taxes, costs of installing, assembling and testing the asset as well as transportation charges and insurance while in transit. When the accountant calculates the total cost of a plant asset he or she needs to know the plants salvage value and useful life to be able to calculate depreciation.

There are three methods that can be used to calculate the depreciation expense for a period of time. The first method is called straight-line. The straight-line depreciation formula is when cost is subtracted from the salvage value and divided by the assets' useful life. For example a company purchased equipment for $20,000 with a salvage value of $5,000 and useful life 5 years, the calculations will be made in the following manner: $20,000 - $5,000/ 5 years = $3000 depreciation expense. The result needs to be recorded in a journal entry by debiting the depreciation expense and crediting the accumulated depreciation expense, which is a contra asset account. The depreciation expense or what the asset has used up will later appear on the income statement and the accumulated depreciation expense will be deducted from the book value of the plant asset on the end of the year balance sheet. This depreciation method is commonly used and has a consistent value throughout the plant or equipments' useful life.

The second method to calculate the depreciation expense is by units-of-production. This method requires knowledge of how many units the plant asset is expected to produce during its useful life. Here two steps must be followed to get the depreciation expense. First the depreciation for one unit needs to be calculated following the formula of subtracting the salvage value from the cost and dividing it by the expected units of production during the assets useful life. The second step is to multiply the result by the total number of units produced that year. For example an industrial company bought a machine that is expected to produce 50,000 units during its useful life for $25,000 and has a salvage value of $5,000. If 18,000 units were produced in 2010 to calculate the depreciation expense first: $25,000 - $5,000/50,000 = $.4 per unit. Second: $.4 per unit * 18,000 units = $7,200 depreciation expense. After the second step the same journal entries are made as in the straight-line method and the results are similarly recorded on the end of the year income statement and balance sheet. The units-of-production method has a spontaneous pattern for every year's depreciation value due to the changing number of units produced by the plant each year.

Double-declining-balance is the third method to calculate depreciation. This method has a high depreciation expense in the beginning lifespan of the plant asset and the value decreases toward the later years of the plant asset. Similar to the method's name, the depreciation expense declines during its useful life.

Three steps are required to calculate the depreciation expense. The first step is to calculate the straight-line rate by dividing the assets' useful life by 100 % to get a percentage that resembles the straight-line rate. The next step is to double the percentage result. Finally, the third step is to multiply the double-declining-balance rate by the beginning period book value. For example if a company buys equipment for $30,000 that has 5 years of useful life the first year's depreciation expense will be step one: 100% / 5 years = 20%, step two: 2 * 20% = 40%, step three: 40% * $30,000 = $12,000. As mentioned earlier, the first depreciation expenses will be significantly more in value during the first years of the assets life, compared to the depreciation value of the later years of the asset.

After calculating the depreciation expense using any of the three methods the results must be recorded on the end of the year balance sheet under assets. The total cost of property, plant and equipment needs to be summed up and the total accumulated depreciation has to be subtracted from that sum to get the Net book value of those plant assets. Once an accountant does the end of the year statements the company is good until the next year to calculate their depreciation expense.

Depreciation and the Three Methods to Calculate it

By: Ksenia Svertilova

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