Depreciation is the allocation of cost spread out through the life of a fixed tangible asset. Assets like machinery, buildings, etc. However land is never depreciated. There are many depreciation methods that can be used for financial accounting and tax purposes.
First to calculate the depreciation base, first take the cost of the asset and subtract it by the salvage value. The salvage value is the amount an asset is expected to be worth after it has been used up completely. Second is to take the “depreciation base” and divide it by the useful life of the asset.
An example:
On January 1st, 201X, Adequate Disclosure purchases a car for $12,000. The car has an estimated life of 5 years and an estimated salvage value is $2,000.
First year depreciation expense:
1- $12,000 – 2,000 (Depreciation Base) = $10,000
2- $10,000 / 5 (years) = $2,000
December 31st, 201X
Depreciation Expense $2,000
Accumulated Depreciation $2,000
The second method is the “sum of the years” digits method is a progressive depreciation method. The first couple of years of depreciation are higher than the later years. The “sum of the years” part of the method is referring to adding all the years as the denominator. An example is if an asset is expected to have an estimated life of 5 years, you would add the following years (1+2+3+4+5) = 15 years. The 15 is the total amount of the years which is considered the denominator of the depreciation ratio. The formula to calculate the depreciation ratio is N(N+1)/2. [N is the number of useful years]
An example: (Click on the picture to enlarge)
The third method is the "double declining" method. This method accelerates depreciation expense in the earlier years. This method does not require the calculation of the depreciation base. Here is the following formula to follow to calculate the depreciation expense for every year: Asset Amount x 2/N (N is the number of useful years). Once the net book value (book value - depreciation) can never go below salvage value.
