What is 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 accounting period, so expensing it in that period will overstate the expense in that period and understate it 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 depreciate much faster in the first few years, an accelerated depreciation method is often chosen.
Example of Depreciated Asset
What are the Depreciation Expense Methods?
There are three methods of calculating the depreciation expense for a company:
- Straight-line depreciation
- Declining Balance (accelerated depreciation)
#1 Straight-line depreciation
This is the most commonly used method of depreciation and is also the easiest to calculate. This method simply takes an equal 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.
To learn more, check out our free accounting fundamentals course.
#2 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 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 * Factor / Useful Life
The depreciation expense changes 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 * 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.
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 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 * 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 on a unit basis the expense is ($100,000 – $5,000) / 95,000 = $1. In a year, company A produces 10,000 units and incurs an expense of $10,000
Unit depreciation is commonly used in mining operations. Check out our financial modelling course specialized for the mining industry.
Learn more about the Balance Sheet
To keep learning and developing your career, please check out these additional, relevant resources: