fixed asset depreciation explained
These are long-term or relatively permanent assets such as equipment, machinery, buildings and land that may be used by the company to generate revenue. Fixed assets exist in two forms: tangible fixed assets and intangible fixed assets.
Tangible fixed assets
These are assets that can be seen and touched physically. Examples of tangible fixed assets are: land, machinery, buildings, computers, and other company assets that can be touched.
Intangible fixed assets
These are assets that do not posses any physical form. These assets are important because of the special rights they carry. Examples of intangible fixed assets are: copyrights, patents, and trademarks are some of intangible assets a company can own.
The cost of fixed assets
In addition to purchase price, the costs of acquiring fixed assets include all amounts spent getting the asset in place and ready for use. These costs involve transport fee, any tax cost if involved, and other costs that can be directly traced to the purchase of asset.
Fixed assets Depreciation accounting
Depreciation is the process of allocating fixed asset cost over an estimated useful life of the asset. Depreciation can be calculated using one of these methods: straight-line depreciation, units-of-output method, and double-declining balance method or accelerated depreciation. We can choose one of these methods depending on the nature of the asset and other factors like which method will favor paying less income tax.
Requirement for calculating depreciation
In order to calculate depreciation of an asset, we need to know these three factors or values. The one is known and other two need to be estimated.
- The initial cost of an asset
- Estimated useful life on an asset
- Estimated residual value of an asset
This method of calculating asset depreciation is very simple and easy. The straight-line method provides for the same amount of depreciation expense for each year of the asset's useful life. The straight-line method is by far the most widely used depreciation method.
Example: let say company A purchase machinery with initial cost of 25,000 dollars. The machine is estimated to be useful for 5 years, and it estimated its residual value will be 5,000 dollars. To calculate its depreciation using straight-line method.
initial cost 25,000
expected useful life 5 years
estimated residual value 5,000
The annual straight-line depreciation of $4,000 is computed as follows:
- Annual depreciation = (initial cost - estimated residual value) / 5 years.
- Annual depreciation = (25,000 - 5,000) / 5;
- Annual depreciation = $4,000;
If an asset is used for only part of year, the annual depreciation is prorated.
The unit-of-output method provides the same amount of depreciation expense for each unit of output of the asset. Depending of the nature of the asset, the units of output can be expressed in terms of hours, miles, driven or quantity produced.
Calculation of Depreciation using units-of-output method involves two:
- Determine the depreciation per unit as:
Depreciation per unit = (cost - residual value) / total units of output.
- Compute the depreciation expense by multiplying depreciation per unit by the total units of output used as:
Depreciation expense = Depreciation per unit X total units of output used.
To illustrate this, we use company A new purchased truck.
- Initial cost 25,000 dollars
- Estimated miles to go 10,000 miles
- Residual estimated value 5,000 dollars
- Annual miles traveled 3,000 miles
Depreciation per mile = (25,000 - 5,000) / 10,000 miles.
Depreciation per mile = $2 per mile.
Depreciation expense = $2 per mile x 3000 miles.
Depreciation expense = $6000;
The depreciation cost for the truck is $6000 for 3000 miles traveled. We are going to calculate depreciation expense like this for the remained 7000 miles.
The double-declining-method provides for a declining periodic expense over the expected useful life of the asset. Double-declining involves three steps:
- Calculate the straight-line percentage, using the expected useful life.
- Calculate the double-declining-balance by multiplying the straight-line percentage by two.
- Calculate the depreciation expense by multiplying the double-declining-balance rate by asset book value.
To illustrate this, we use company B purchases of machinery.
- Initial cost 25,000 dollars
- Estimated useful life 5 years
- Residual estimated value 5,000
Calculate the straight-line percentage:
- straight-line percentage = (100/ 5 years); straight-line percentage is equal to 20%
Calculate the double-declining rate:
- Double-declining rate = straight-declining percentage (20%) x 2; Double-declining rate is equal to 40%
Calculate the double-declining balance:
- double-declining balance = double-declining rate (40%) x asset book value (25,000); Double-declining balance is equal to 10,000;
For the first year, depreciation expense is going to be $10,000 and the book the value of asset will be $15,000 (25,000 - depreciation expense of 10,000). The second-year depreciation will be $6,000 and the book value will of the asset will be $9,000 (15,000 - depreciation expense of 6,000). This is repeated until the estimated residual value is reached.