What is Depreciation?

Depreciation is the planned reduction in the recorded cost of a fixed asset over its useful life. It is calculated using either a straight-line, accelerated, or usage-based system. Depreciation is used to recognize the cost of a fixed asset over roughly the same period of time that the asset is providing value to the owner. In order to calculate depreciation, you need to understand the following concepts, which are incorporated into depreciation calculations:

Capitalization limit. The capitalization limit is the expenditure amount above which purchases are designated as fixed assets, and below which they are charged to expense in the current period.
Salvage value. This is the amount that the company expects to receive from the eventual disposal of the fixed asset. Many assets have no salvage value associated with them.
Useful life. This is the expected period over which a fixed asset will be used.

Types of Depreciation Methods

There are several types of depreciation methods that you can apply to an asset, which are noted below, along with the advantages and disadvantages of each one.

Straight-Line Method

The most common depreciation method is straight-line depreciation, because it is so simple to use, and reasonably reflects the gradual decline in value of most assets. The essential calculation is to subtract the salvage value from an asset to arrive at the amount that can be depreciated. Then divide this amount by the number of months that will be depreciated, to arrive at the depreciation expense per month. For example, a company acquires a machine for $11,000, and expects it to have a salvage value of $1,000 when it is no longer usable after five years. This means that the depreciable asset value is $10,000. We then divide this amount by five years to arrive at a depreciation rate of $2,000 per year.

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Depreciation Calculation Steps

While there are different depreciation methods, the basic depreciation calculation steps are the same in all cases. These steps are noted below:

Aggregate assets. Determine whether several expenditures should be aggregated together for purposes of designating a fixed asset. For example, a group of desks could be called a single fixed asset.
Expense or capitalize. Determine whether the purchased item (or group of items) should be recorded as a fixed asset or charged to expense. To be a fixed asset, it should have a usage period that is longer than an accounting period, and should cost at least as much as the corporate capitalization limit.
Determine salvage value. Estimate the amount of any salvage value. If the amount is minor, it is easier from a depreciation calculation perspective to ignore salvage value.
Determine asset group. Determine the asset group into which the fixed asset will be clustered.
Determine useful life. Assign a useful life to the fixed asset. In many cases, a standard useful life is assigned to every asset in an asset group.
Determine calculation convention. Decide whether to use the mid-month convention, where a half-month of depreciation is assigned to the first and last months of the useful life of the asset. Doing so increases the complexity of the calculation, and so is not recommended.
Calculate depreciation. Calculate depreciation. If you are using the straight-line method, subtract the salvage value from the cost of the asset, and divide the remainder by the number of periods in the useful life of the asset. Alternatively, accelerated depreciation methods are designed to recognize depreciation expense at a faster rate than the straight-line method, or based on an associated usage rate.
Record journal entry. Enter the depreciation figures in a spreadsheet for each accounting period to which the depreciation applies. Using the spreadsheet, aggregate the depreciation for the current accounting period for all fixed assets, and record a journal entry for the aggregate amount of depreciation. The entry is a debit to depreciation expense and a credit to the accumulated depreciation account.