Here at Depreciation Guru the most searches, questions and page visits we get are for Calculating Depreciation. We have a number of excellent posts in our archive on just this subject (read more about calculating depreciation here). Today, courtesy of the fine folks at The Motley Fool, we add to that knowledge base with an article on calculating straight-line depreciation.
Over time, the value of a company’s capital assets decline. This is a normal phenomenon driven by wear and tear, obsolescence, and other factors. This depreciation in the asset’s value must be accounted for on the company’s income statement and balance sheet to capture the loss in value over time as an expense and as a reduction in the asset’s actual value.
To calculate this capital expenditure depreciation expense, the company’s accounting team must use the asset’s purchase price, its useful life, and its residual value. Here’s how.
In this example, we’ll keep it simple and use the straight-line depreciation method. This method accounts for depreciation by taking the same amount as an expense each year over the asset’s useful life. Let’s assume that a farmer purchases a tractor for $25,000 that he expects will last him 10 years. At the end of this 10-year period, the farmer reckons he can sell the tractor on the used market for $8,000.
Using the straight-line method, we know that we will be creating a constant depreciation expense every year. We also know that the book value of the tractor should equal $8,000 after 10 years (this is its residual, or salvage, value).
To calculate how much should be expensed as depreciation each year, we first subtract the $8,000 residual value from the original $25,000 purchase price. That result, $17,000, is then divided by the number of years in the tractor’s useful life, in this case 10 years, to give us our annual depreciation expense for the tractor. $17,000 divided by 10 years is $1,700 per year.
From an accounting perspective, each year the income statement will show the $1,700 as a depreciation expense. On the balance sheet, each year’s depreciation expense will add into the accumulated depreciation account, which is subtracted from the tractor’s purchase price to give its book value, or net asset value. Depreciation is a non-cash expense. In the tractor example above, the only time the farmer actually reduced his cash on hand was when he purchased the tractor. For the next 10 years, though, the tractor spent thousands of hours around the farm and in the fields, rain or shine. The farm needs a working tractor to operate; every day the tractor fires up and gets to work is one day closer to the time it will need to be replaced. When that time comes, that means spending cash for a new tractor.
So while the tractor’s depreciation expense is a non-cash expense for all the years it is in use on the farm, the tractor was actually losing real value that will one day require a cash expense. Depreciation expense is just our way of accounting for that reality over time, balancing the fact that it costs cash to purchase an asset today and to replace it in the future, but we can only expense these purchases with the asset’s use over time.
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