How to Calculate Depreciation

Depreciation is an expense charged in the profit and loss account for the consumption of a fixed asset over the period of its useful economic life. The business should calculate depreciation based on the rate at which the economic benefit from the asset is being used up by the business. In this way the consumption of the asset over its useful life is matched with the revenue earned from that asset in the same accounting periods. The estimate of the useful economic life of the asset assumes that it will be regularly maintained and repaired.

In accounting terms depreciation is a non-cash expense that is a debit to the profit and loss account and a credit against the cost of the asset on the balance sheet. Where an asset is revalued on the balance sheet, the depreciation charge applies to the revalued amount of the asset. The balance sheet would normally show the original cost or the market value of the fixed asset, the amount of depreciation charged over its useful life up to the balance sheet date, and the net value of the asset at the balance sheet date.

 Depreciation is not intended to be a reserve for providing a replacement asset but is intended to show the amount of economic benefit from the asset that has been used up in the accounting period. The depreciation charge therefore represents the expected wear and tear of the asset, or the expected rate at which the asset will become obsolete. This would include technical obsolescence, where more efficient machinery may be developed and used, or commercial obsolescence where the demand for the goods which the asset is used to produce may fall due to changes in fashion or taste. The depreciation charge may also reflect the effect of legal or other restrictions on the use of the fixed asset

The relevant international accounting standard is IAS 16 on Property, Plant and Equipment.The accounting standard asserts that the method of depreciation used should reflect the pattern in which the economic benefits of the asset are used up by the enterprise over its useful life. Under the accounting standard, the residual value and the useful economic life of the asset should be regularly reviewed.

A common method of calculating a depreciation charge is to allow for depreciation of the cost of the asset in a straight line over the useful economic life of the asset. The cost or valuation of the asset is therefore divided by the useful economic life and the resulting figure is charged as depreciation in each accounting period. The enterprise may calculate depreciation taking into account an estimated residual value at the end of the asset’s useful life if such a value can be predicted.

Therefore, an item of plant with an estimated useful life of ten years and a cost of $100,000 dollars would be depreciated at $100,000 divided by 10 giving an annual straight line depreciation charge of $10,000 (assuming no residual value). Under this method the enterprise will calculate depreciation assuming that the amount by which the asset depreciates remains constant over its economic life.