Depreciation expense canbe a big portion of a companys total expense.And since expensesdecreaseincome, it affectsthe overall value ofa company.Understanding what itisand the methods can help you determine if a company is as good in real life asit is on paper.Thats why Ive put together this guide with depreciation expense methods, formulas and examples.
What is DepreciationExpense?
Depreciation is the decrease of a tangibleassetsvalue. It occurs over the span of its estimated useful life.This lets a companygraduallywrite off the asset.To record depreciation, a company willdebitan account called depreciation expense.This decreasesthe companys income.
But depreciation doesnt only affect companies. It affects everyone, including you. For example,you mighthave heardthe advice to never buy abrand-newcar.Thats because the second you drive off the lot, its value can drop10% or more.And that doesnt include the additional 10-20% you lose in the first year.Though, unlike companies, you dont have to record depreciation expense.
There are a few different methods to calculate depreciationexpense.Letstake a look…
What are theDepreciationMethods?
There are fourcommonmethods to calculate depreciation:
- Double-declining balance
- Sum-of-years digits
- Unitsof production
Each method is selected to fit the assets nature. Below you can find a description of each method and the types of assets itstypically used for.
Straight-line depreciation is commonand the easiest to calculate.In the method, the asset is depreciated by the same amount every year of its useful life.
Depreciation Expense = (Fair Value Salvage Value) / Useful Life
The fair value is what you bought the asset for. The salvage value is what the asset is worth at the end of its useful life.This is also known asresidualvalue.Lets look at an example…
You buy a building for $30 million. You expect the building to last 12 years with a salvage value of $6 million.Subtractthe $6 million from $30 million. The answer is $24 million. That means that over the next 12 years, the building will depreciate by $24 million.But rather than happening all at once, the depreciation is spread out across the 12 years. So,take $24 million and divide it by 12.
The annual depreciationexpense is $2 million.
(30 million 6 million) / 12= 2
The straight-line method can be applied to most assets. If there isnt a specifictrendto the assets use, straight-line depreciation isapplied.
This method is used when the asset depreciates more quickly in the earlier years, like your car.It has a 2x factor to accelerate depreciation. In straight-line, the factor is 1.But that doesnt mean you multiply the straight-line by two. The formula is as followed:
Depreciation Expense = (Beginning Book Value for Year * 2) / Useful Life
Lets use a car for an example.You buy a car for $50,000. Ithas a useful life of 5 years.In the first year, the depreciation would be calculated like this:
(50,000 * 2) / 5= 20,000
For the first year, the depreciation expense is $20,000.This decreases the book value to $30,000.When calculating the second years depreciation, $30,000 is the value you use.
Year 2- (30,000 * 2) / 5 = 12,000
Year 3- (18,000 * 2) / 5 = 7,200
Year 4- (10,800* 2) / 5 = 4,320
Year 5- (5,680* 2) / 5 =2,272
Net Book Value at end of Useful Life = $3,408
However, note that assets typically have a salvage value. If your cars salvage value is $3,500, thendontdepreciate the full $2,272 in the fifth year. It depreciatesyour car past its value. Instead, depreciate $2,180 to bring the value to $3,500.
Sum-of-yearsdigits (SYD)applies a percentage to determine the depreciation value. Likedouble-declining, this is an accelerated method.To calculateSYD, first determine the assets useful life. Then,find the sum of the digits leading to that number. This will be your base.
For example, you purchase a machine for $100,000.Its salvage value is $10,000.Itsuseful life isfiveyears.To find the base, add all the numbers from one to five.
1 + 2 + 3 + 4 + 5 = 15
Now, take thenumber of years left in theuseful lifeand divide it by the base.So, if its the first year, there are five years left the machine is usable.This will give you a percentage.
5 / 15 = 33.33%
You then take that percentage and apply it to thedepreciationvalue.In this case, thats $90,000 because its worth $10,000 after the five years.So, 33.33% of $90,000 is $30,000.
For the second year, there are four years remainingin the useful life.
4 / 15 = 26.67%
The depreciation value doesnt change. That means you still take a percentage of $90,000. And 29.67% of $90,000 is about $24,000.
This will continue until the end of the assets useful life. By then, the percentages should total 100% for a total depreciation of $90,000.
Units of Production
Units of production is a method of depreciation based on asset usage.Its mostly used by manufacturers because their machinerys usage varies with customer demands. Depreciating by units produced better matches expenses and revenues.It also is a more accurate representation of wear on the machinery or equipment.
Lets take the example above.You buy a machine for $100,000with a salvage value of $10,000. While you should know the useful life,its not needed to determine the depreciation expense. Instead, you estimate how many units the machine will produce over the span of its useful life.Lets say it will produce 45,000 units over five years.
Then, you determine the depreciation cost per unit.
(100,000 10,000) / 45,000 = 2
For every unit produced, it will cost $2 of depreciation. To determine the depreciation cost for one year, you multiply $2 by the number of units produced in thegiven year. If the machine produces 10,000 units in the first year, the depreciation expense is $20,000.If the machine produces 15,000 units in the second year, the depreciation expense is $30,000.This method can also be used with hours of usage instead of units produced. In the above example, it would be 45,000 hours over its useful life.
With a great knowledge of depreciation expense, youre better prepared for investment decisions. Check out our Investment Opportunities page to get started. And dont forget to sign up for our free e-letter below! It has great investment tips and advice.
The post 4 Depreciation Expense Methods with Formulas and Examples appeared first on Investment U.
By: Amber Deter
Title: 4 Depreciation Expense Methods with Formulas and Examples
Sourced From: investmentu.com/depreciation-expense-methods-formulas-and-examples/
Published Date: Fri, 31 Jan 2020 15:00:48 +0000