Depreciation formulas are used to calculate how much value a business asset loses each year. Different methods, such as straight-line, declining balance, and sum-of-years-digits, have their own formulas. Depreciation is important for tax purposes.
Depreciation formulas are used to calculate the amount of value a business asset loses during each year of its use. Each of the depreciation formulas used is based on the different depreciation methods, which are dictated by the type of asset being depreciated. Once the formula is decided, depreciation is calculated by connecting the cost of the asset in question and the expected useful life of the asset. Three popular depreciation methods are the straight-line method, the declining balance method, and the sum-of-years-digit method.
Any asset held by a company for a period of more than one year loses its value in the course of its use. This accounting principle is known as depreciation, and it’s a crucial concept for businesses because it allows them to include the depreciation amount of an asset on their income statement as an expense, thus providing a tax break. Each of the different depreciation methods contain depreciation formulas, which are used to calculate how much an asset depreciates each year.
The straight-line depreciation method provides the simplest of depreciation formulas. To calculate annual depreciation, simply divide the cost of the asset by the years it is expected to be in use. For example, an asset is purchased for $2,000 United States Dollars (USD) and is estimated to have a useful life of five years. In this case, the $2,000 is divided by five, which means the annual impairment expense for that asset is $400.
While the straight-line method allows the same depreciation expense each year, other methods such as the declining balance method allow the greatest amount of depreciation expense in the asset’s first year and then less each year thereafter. The formula for the declining balance method is determined by a fixed rate of depreciation, which is multiplied by the balance of the asset’s cost. For example, an asset with a cost of $1,000 that has a depreciation rate of 40 percent will depreciate in the first year by $400, or $1,000 times 0.4. In the next year, the 0.4 is multiplied by the balance of the asset’s cost, which after depreciation in the first year is $600, yielding a depreciation expense of $240 in the second year.
With the sum-of-years-digits method, the calculation requires adding the digits of the years in the object’s life to determine the depreciation rate, which varies each year. For example, an asset with a useful life of four years produces a sum of digits that equals 10, or one plus two plus three plus four. The first year rate is 0.4, or four divided by 10, while the second year rate is 0.3, or three divided by 10, and this process continues for each of the four years. Once the rate for each year is determined, it is multiplied by the balance to generate the depreciation expense for each year.
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