Depreciation Expense Meaning and Calculation Methods
Overview
Any depreciation is expressed in monetary terms. In the process of production and work, there is gradual wear of fixed assets, therefore, they require replacement later. Since everything becomes obsolete over time and becomes unusable, depreciation expense is expressed in a very specific amount that is added to the product cost. There are different ways to estimate how much of a fixed asset’s cost the company should allocate to the actual goods or services. The company can apply one that suits the situation the best within the limits of the applicable rules and regulations.
Calculation
Straight Line Method
The straight line method is the most common due to its simplicity and unpretentiousness. To determine the amount of monthly depreciation deductions using this approach, it is necessary to know the initial cost of the object, its operational life and calculate the depreciation rate.
The initial cost of an object is calculated by summing up all the costs of its purchase or creation. The operational period is established by studying the classification list of fixed assets. If the object is not recorded in the list, then the period is assigned depending on: the projected time of use, estimated physical wear and tear, and expected operating conditions.
The annual depreciation rate is expressed as a percentage of the initial value of the asset and is calculated as follows:
This approach implies that the physical condition of fixed assets deteriorates evenly, from the moment of purchase until the full repayment of the cost. Seasonality, intensity of use of objects are not taken into account. This approach is most justified in taking into account the deterioration of buildings and other stationary structures.
Of course, the influence of environmental factors and the mode of operation of property cannot be disregarded. However, it is often impossible to accurately determine the actual percentage of wear of a particular object. Therefore, the method in which the cost is written off evenly and in constant amounts seems to be the most convenient for many organizations.
Salvage Value Method
The basis for the calculation in this approach is not the initial value, but the residual. Residual value is the initial cost less total depreciation expense (depreciation accrued). This is the amount the management expects to get for the assets when it gets rid of them after the assets can no longer be used as intended.
Fredrich & Co. bought new lawnmowers for $9,000. The company expects to use them for 8 years and then be able to sell the mowers for $1,000 (residual value). The depreciation cost, accordingly, is $8,000. This cost will be expensed over the 8 years, which will equal to $1,000 in annual depreciation. To find the amount to be recorded on monthly basis, simply divide $1,000 by 12 months.
Units of Production Method
The cost of fixed assets is written off in proportion to the volume of products manufactured or services rendered. The method is used only for those objects, the documentation of which indicates the expected volume of production.
In this case, the depreciation rate is determined by dividing the initial cost of the object (less residual value) by the amount of work planned by the manufacturer. For instance, some manufacturers measure the service life of their lawnmowers in hours of use. To find the amount to be recorded on monthly basis, the number of units produced or services provided is multiplied by the depreciation rate.