Understanding Depreciation: What It Is and How to Calculate It

Last Updated on December 2, 2024

Overview – Understanding Depreciation and Its Importance

If you’re familiar with the world of automobile financing, then you’ve probably heard of the term “depreciation” before. It’s common knowledge that, over time, a car slowly loses its value, with a large portion of that loss occurring in the first year of ownership (when dealing with new cars).

This loss of value starts to slow down past the first few years of ownership, and is largely the reason why it’s usually recommended to buy a used car that’s a few years older than the current model: the older car has already depreciated substantially during its first few years, resulting in a car that is thousands (or even tens of thousands) of dollars cheaper, while still remaining relatively new. Do you really need the 2021 model when the 2018 or 2017 models are still very good vehicles?

While depreciation is largely understood as “the loss of an item’s value over time”, this is true, to an extent. It’s important to note that the definition used in a daily, informal context varies slightly from the definition used in accounting/finance.

What Is Depreciation, Anyways?

Imagine you run a delivery business, and you plan to purchase a new van to add to your fleet. Put very simply, an asset (in this context) is something that will help a business generate revenue. Since you plan on using this vehicle to make deliveries, thereby helping you generate revenue, this van is, by definition, an asset.

Over time, an asset’s ability to produce revenue slowly declines, usually due to wear and tear. Back to our example, as the van ages, it may start to need more repairs and more frequent maintenance. Eventually, the van will reach a point where it barely even runs anymore, marking the end of its life for business purposes, making it essentially worthless.

This gradual loss of an asset’s ability to generate revenue as it goes through its finite lifetime results in a loss of value – this is depreciation.

Now, when an asset loses value this loss doesn’t just vanish into thin air: depreciation is recorded as an expense, so it shows up on the income statement as “depreciation expense” (or some other name).

However, what makes this expense unique is that it’s a non-cash expense, that is, just because it’s listed as an expense doesn’t mean any cash was spent to pay for it.

Because depreciation is a non-cash expense, the expense is actually added back to the cash balance in the cash flow statement, specifically under the “Cash from Operating Activities” section, usually as one of the first items listed as “adjustments to net income”.

(For more on the income statement and cash flow statement, read about them here).

If you want to calculate what your depreciation expense for a given asset will be, then you need to know three things (or a fourth one when using a specific depreciation method, more on this later):

• Acquisition Cost: all associated costs with acquiring an asset (e.g., if a van is worth $30,000 but you need to pay an additional $1,000 in miscellaneous one-time fees, then the acquisition cost is $31,000.)
• Useful Life: the expected duration which an asset is planned to be used for revenue-generating purposes (e.g., the delivery van will be in service for 10 years).
• Residual Value: the expected monetary value of the asset after it has exhausted its useful life (e.g., after 10 years of use the van will only be worth $5,000).
• Units of Production: In addition to an asset’s useful life, you’ll sometimes need to know the expected number of units it will produce over its life. For example, a piece of heavy machinery may be expected to run for 20,000 hours over 4 years, or a van may be expected to drive 300,000 km over 10 years.

Generally speaking, most assets are depreciable. The major exception to this is land. Land is said to have an indefinite useful life, so by definition is non-depreciable. While land cannot depreciate, the assets that reside on it can be – a building is depreciable, but the land that it sits on is not.

It’s important to note that depreciation only applies to tangible assets (equipment, buildings, vehicles, etc). Intangible assets also lose value over their useful life, but this non-cash expense recording process is known as amortization, which is beyond the scope of this article.

The Different Depreciation Methods

As you may have suspected, there is more than one way to calculate depreciation based on the circumstances surrounding the asset. In the following sections, we’ll be looking at three methods of depreciation.

For each method of depreciation we will use the same example, as follows:

“ABC Shipping Ltd. purchased a new semi-trailer truck for $220,000 on April 1, 2011. The company estimates that the truck will have a residual value of $20,000. The company also expects the truck to be used for 300,000 km during its four-year life.

The truck usage was 50,000 km in 2011, 75,000 km in 2012, 90,000 km in 2013, and 45,000 km in 2014, and 40,000 km in 2015. ABC Shipping Ltd. has a December 31 year-end.”

Problem Statement

Straight-Line Method

The straight-line method is by far the easiest method of depreciation. It’s very straightforward to calculate and isn’t very technical. Using straight-line depreciation for the semi-trailer:

• 1) Calculate the Depreciable Amount:
  • Depreciable Amount = Acquisition Cost – Residual Value
  • Depreciable Amount = $220,000 – $20,000
  • Depreciable Amount = $200,000

• 2) Divide the Depreciable Amount by the useful life of the truck to get the yearly depreciation expense:
  • Yearly Depreciation Expense = Depreciable Amount/Useful Life
  • Yearly Depreciation Expense = $200,000/4 years
  • Yearly Depreciation Expense* = $50,000/year

Notes:

• (*) In this context, 4 years means 48 months, not necessarily January to December (known as the calendar year). So, in this example, the yearly depreciation is from April 1 to March 31 of the following calendar year. In other words, the truck will finish depreciating on April 1, 2015.

Diminishing-Balance Method

Next, we have the diminishing-balance method. This method depreciates an asset very aggressively in its early years, but the depreciation expense starts to dwindle over time. Depreciating very aggressively early on can lead to some tax benefits.

This aggressive depreciation is due to a multiplier that’s applied to the straight-line rate. In the previous section, the semi-trailer truck lost $50,000/year of its $200,000 depreciable amount, which represents a 25% straight-line rate.

When the multiplier is 2, the term for this is a “double-declining balance” since the rate of depreciation has now doubled.

The depreciation rate is applied every year on the carrying amount of the depreciable cost. Keep in mind that you cannot depreciate below the residual value, leading to scenarios where the asset is finished depreciating before it reaches the end of its useful life.

A very important thing to know for this method is that residual value IS NOT included in the calculation. In other words, you start by depreciating the full amount of the asset’s acquisition cost.

To make sense of all of this, the example below will demonstrate:

• 1) Determine the accelerated depreciation rate:
  • Accelerated Depreciation Rate = Straight-Line Rate * Multiplier
  • Accelerated Depreciation Rate = 25% * 2 (2 because we want a double-declining balance, but the multiplier can be whatever you want)
  • Accelerated Depreciation Rate = 50%

• 2) Calculate the depreciation expense for 2011
  • The truck was purchased on April 1, so it was only used for the entirety of April and the remaining 8 months of the year, a total of 9 months out of the full 12. So, the depreciation cost for 2011 is only 75% of the full amount.
  • 2011 expense = Carrying Amount * Accelerated Depreciation Rate * 9/12 months used
  • 2011 expense = $220,000 * 50% * 75%
  • 2011 expense = $82,500

• 3) Calculate the Net Book Value (NBV) for 2011
  • The Net Book Value (NBV) is the value of the asset on a company’s financial statements after it has depreciated for the year. The NBV will be the depreciable amount (the carrying balance) for the following year, and so forth.
  • NBV = Prior NBV – Depreciation Cost for 2011
  • NBV = $220,000 – $82,500
  • NBV = $137,500 —> this will be the depreciable amount for 2012

• 4) The numbers for the remaining years are tabulated below:

Notes:

• (*) The numbers for 2014 is incorrect because the net book value is less than the residual value of $20,000. So, these numbers need to be adjusted, as shown in the following row.

Units-of-Production Method

Finally, the last method we’ll be looking at is units-of-production.

In the previous methods, depreciation was calculated over a period of time – it didn’t matter how often you used the asset. Now, by using this method, it’s calculated by how much an asset is used in a given time frame (e.g., X amount of hours in Y years).

Again, just like the double-declining method shown above, we start by depreciating the full acquisition cost of the asset then go from there.

Using this method on our example problem:

• 1) Calculate the depreciation expense per kilometre driven:
  • Expense per km= Depreciable Amount/Total Kilometres Driven
  • Expense per km= $200,000/300,000 km
  • Expense per km= $0.667/km -> multiply the total kilometres driven every year by this amount.
• 2) Calculate the depreciation expense for 2011:
  • 2011 expense = Kilometers driven * Expense per km
  • 2011 expense = 50,000 km * $0.667/km
  • 2011 expense = $33,333.33

• 3) Calculate the Net Book Value (NBV) for 2011
  • NBV = Prior NBV – Depreciation Cost for 2011
  • NBV = $220,000 – $33,333.33
  • NBV = $186,666.67

• 4) The numbers for the remaining years are tabulated below:

Wrapping Up

An asset, in the world of finance and accounting, is something used by a company to help generate revenue. Over time, physical assets such as vehicles, equipment, and heavy machinery degrade over their useful life, and as a result, can’t generate revenue as effectively as they did before.

This reduced ability to generate revenue reduces the value of the asset. This reduced value must be accounted for in a company’s financial records, and so it’s recorded as a non-cash expense known as depreciation.

There is more than one way to calculate this expense, and the method a company uses depends on how the asset plans to be used, as well as established conventions.