Depreciation Expense

Used to match expense of PP&E with its revenue generation

Depreciation Expense

When a long-term asset is purchased, it is often capitalized instead of being expensed in the given period. This is because that asset will generally still be economically useful and generate returns beyond that period, so expensing it in each period will overstate the expense in that period and understate them in all future periods. To avoid this, depreciation expense is used to better match the expense of a long-term asset to the revenue it generates.

There are different methods used to calculate depreciation expense, and the type of depreciation accounting used is generally selected to match the nature of the equipment. For example, for vehicles that depreciation much faster in the first few years, an accelerated depreciation method is often chosen.

Depreciation Expense Methods

• Straight-line depreciation
• Declining Balance (Accelerated depreciation)
• Units-of-production

Straight-line depreciation

This is the most commonly used method of depreciation, and is also the most easy to calculate. This method simply takes an equal depreciation expense over the useful life of the asset.

Periodic Depreciation Expense = (Fair Value – Residual Value) / Useful life of Asset

For example, Company A purchases a building for \$50,000,000 to be used over 25 years with no residual value. Depreciation expense is \$2,000,000, which is found by dividing \$50,000,000 by 25.

Declining Balance

A declining balance depreciation is used when the asset depreciates faster in earlier years. As the name implies, the depreciation expense declines over time. To do this, the accountant picks a factor higher than one. In a straight line depreciation, the depreciation expense is found by multiplying the fair value with 1 / useful life. In this calculation, the factor is 1. In a declining balance, the factor can be 1.5, 2 or more. A 2 factor declining balance is known as a double-declining balance.

Periodic Depreciation Expense = Beginning Value of Asset x Factor / Useful Life

The depreciation expense changers every year, because it is multiplied with the beginning value of the asset, which decreases over time due to accumulated depreciation. Note that residual value is ignored under declining balance.

For example, Company A has a vehicle worth \$100,000, with a useful life of 5 years. They want to depreciate with the double-declining balance. In the first year, depreciation is expense is \$40,000 (\$100,000 x 2 / 5). In the next year, depreciation expense is \$24,000 ( (\$100,000 – \$40,000) * 2 / 5).

See how declining balance is used in our financial modelling course.

Units-of-Production

Under this method, the depreciation expense per unit produced is found by dividing the fair value less residual value of the asset with the useful life in units. This method sets a higher depreciation expense when production is high, to match the usage of the equipment. This method is also most useful for production machinery.

Unit Depreciation Expense = (Fair Value – Residual Value) / Useful Life in Units

Periodic Depreciation Expense = Unit Depreciation Expense x Units Produced

For example, Company A has a machine worth \$100,000 with a residual value of \$5,000. Production units is 95,000. Thus, unit depreciation expense is (\$100,000 – \$5,000) / 95,000 = \$1. In a year, company A produces 10,000 units and incurs a depreciation expense of \$10,000

Unit depreciation is commonly used in mining operations. Check out our financial modelling course specialized for the mining industry.