Depreciation is calculated using either a straight-line, accelerated, or usage-based system. The intent behind depreciation is to spread its cost over the period when a fixed asset is assumed to be contributing to the generation of revenue. In many cases, there is not a direct linkage between changes in revenue levels and the cost of a fixed asset; instead, we simply estimate the useful life of an asset and use that as the basis for depreciation.
Before engaging in a depreciation calculation, it is useful to understand the following terms:
- Capitalization limit. This 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.
- Useful life. This is the expected period over which a fixed asset will be used.
The depreciation calculation steps are as follows:
- 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.
- 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.
- 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 the asset group into which the fixed asset will be clustered.
- Assign a useful life to the fixed asset. In many cases, a standard useful life is assigned to every asset in an asset group.
- Decide whether to use the mid-month convention, where you assign a half-month of depreciation 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. 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.
- 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.