Depreciation Expense: How to Calculate Depreciation Expense

A depreciation expense is a non-cash expense that companies deduct from their net income. It represents the dollar amount of depreciation a capital asset will incur over the course of an accounting period. Depreciation expenses are based on the idea that long-term assets like machinery, computers, software, and vehicles have an expected useful life, and over the course of that lifecycle, the value of those assets will decrease.

A depreciation expense refers to the amount of depreciation recorded on a company's balance sheet for a single accounting period. Accumulated depreciation represents the total amount of depreciation of an asset up to a given point. If you were to add up all the depreciation expenses for a capital asset over the course of ownership, the total amount would represent its accumulated depreciation.

Under standard accounting practices, accumulated depreciation is a contra asset that should appear on a company’s balance sheet. Meanwhile, regular depreciation expenses should be debited from income statements.

You can calculate a depreciation expense using the straight-line depreciation method. The straight-line method involves a few simple inputs and a straightforward formula for calculating depreciation.

1. 1. Begin with the initial cost of the asset. Start your straight-line depreciation calculation by noting the purchase price of your capital asset.
2. 2. Determine the salvage value of the asset. The salvage value—also called the residual value—is the amount of money you could reasonably expect to receive at the end of an asset's useful life. For tangible assets like cars and computers, this might be the total amount of money you could get if you sold those items for parts.
3. 3. Subtract the salvage value from the original cost of the asset. The difference between these amounts represents the total depreciation you can claim over the life of the asset.
4. 4. Divide the total depreciation amount by the number of years you expect to hold the capital asset. This quotient will give you the annual depreciation amount for each year you own the asset. The first year and the final year of ownership will both show the same amount of depreciation.
5. 5. Divide your depreciable amount into smaller accounting periods. Some companies register annual depreciation expenses, while others calculate depreciation on a quarterly or monthly basis. You can divide your annual depreciation amount by four (for quarters) or by twelve (for months) to find the depreciated valuation for each accounting period.

Accelerated depreciation methods include the declining balance method, the double-declining balance method, and the "sum of the years' digits" method. These methods are based on the idea that depreciation rates tend to be steeper in the early years of ownership. The benefit is a greater tax write-off in the short term because the carrying value of an asset rapidly declines in the first few years after it is purchased. The drawback is that toward the end of the asset's useful life, the net book value of the asset changes very little; most of the tax benefits have already been exhausted.

The units of production is another method that involves estimating how many units of a product the asset will produce over the course of its useful life.

For a simple example of a depreciation expense, imagine that a warehousing company buys five compact forklifts to use in its facility over the next ten years.

1. 1. Start with the cost of an asset and multiply by the number of units. The purchase price of these hypothetical forklifts is $7,000 apiece for a total of $35,000.
2. 2. Calculate the salvage value at the end of the useful life of the asset. The estimated salvage value of each forklift after ten years will be $750. This produces a total salvage value of $3,750.
3. 3. Choose a method of depreciation. Using the straight-line method of depreciation, the warehousing company subtracts the salvage value from the purchase price to determine that its capital assets will depreciate by $31,250 over five years. This is the accumulated depreciation amount. After dividing $31,250 by ten (the expected lifecycle of the forklifts), the company further determines an annual depreciation expense of $3,125.
4. 4. Divide the annual expense for monthly or quarterly accounting schedules. The warehousing company uses quarterly accounting, so it divides $3,125 by four. This comes out to a quarterly depreciation expense of $781.25.
5. 5. Apply the depreciation expense to taxable income. The IRS permits businesses to deduct annual depreciation expenses from their taxable income. Keeping accurate financial statements can provide a tax benefit to small businesses and corporations that have invested in capital assets.

Under generally accepted accounting principles (GAAP), annual depreciation expenses should be reflected in a contra asset account on a company balance sheet. Contra accounts work in the opposite direction of related accounts on cash flow statements. This accounting concept applies to accumulated depreciation as well because a company may be simultaneously buying a capital asset using installment payments—in a process called amortization—while also reporting a declining asset value thanks to depreciation.

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