Depreciation formulas are used to calculate the amount of value that a business asset loses during each year of its use. Each of the depreciation formulas used are based on the different methods of depreciation, which are dictated by what type of asset is depreciating. Once the formula is decided, the depreciation is calculated by plugging in the cost of the asset in question and the asset's expected life span. Three popular methods of depreciation are the straight-line method, the declining balance method, and the sum-of-the-years digits method.
Any asset held by a business for a period of longer than a year loses its value over the course of its use. This accounting principle is known as depreciation, and it is a crucial concept for businesses because they are allowed to include the amount of depreciation of an asset on their income statement as an expense, thereby providing tax relief. Different methods of depreciation each contain depreciation formulas, which are used to calculate how much is depreciated from an asset each year.
The straight-line method of depreciation provides the simplest of the depreciation formulas. To calculate the yearly 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 US Dollars (USD) and is estimated to have a life span of five years. In this case, the $2,000 USD is divided by five, meaning that the yearly deprecation expense for that asset is $400 USD.
Whereas the straight-line method allows for the same depreciation expense each year, other methods like the declining balance method allow for the biggest amount of depreciation expense in the asset's first year and then less and less each succeeding year. The formula for the declining balance method is determined by a fixed rate of depreciation, which is multiplied by the balance of the cost of the asset. For example, an asset with a cost of $1,000 USD that has a depreciation rate of 40 percent will depreciate the first year by $400 USD, or $1,000 USD multiplied by 0.4. In the next year, the 0.4 is multiplied by the balance of the asset's cost, which after the first year's depreciation is $600 USD, yielding a depreciation expense of $240 in the second year.
With the sum-of-the-years digits method, calculation requires adding up the digits of the years in the life of the object to determine the depreciation rate, which varies each year. For example, an asset with a four-year lifespan yields a sum of digits that equals 10, or one plus two plus three plus four. The first year's rate is 0.4, or four divided by 10, while the second year's 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 then multiplied by the balance to yield the depreciation expense for each year.