How Is Depreciation Estimated?
Depreciation is not a true cash expense. Rather it represents only a portion of the full purchase price of the asset. The annual depreciation expense is estimated based on the asset's cost, useful life and salvage value. The most common method used to depreciate assets is referred to as the straight-line method.
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Depreciable Assets
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The goal of depreciation is to provide an estimate for the value associated with asset usage. Not all assets are depreciated -- only the ones that provide revenue for more than one year. Those assets that provide revenue for less than one year are written off in the year they are purchased. It is therefore unnecessary to estimate the annual depreciation expense associated with the asset if it will only provide value for one year.
Matching Principle
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Due to accounting convention, accountants like to match expenses with revenues. That is, expenses should be written off in the period in which they produced revenues. This convention is referred to as the matching principle. The method used to estimate the amount written off (depreciation) depends on the use of the asset being depreciated. If the asset is used more in the beginning of its useful life, the accountant will use a depreciation method which accelerates depreciation.
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Depreciation Variables
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In general, depreciation expense is a function of three different variables. The useful life of the asset, the cost of the asset and the salvage value of the asset. The useful life of the asset refers to the number of years the asset will create revenue for the business. The cost of the asset is the amount paid for the asset, not the market value of the asset. The salvage value of the asset is the value of the asset at the end of its useful life.
Straight-line Method
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The straight-line method is the most common form of depreciation used to estimate annual depreciation expense. As an example, assume a company purchases $100,000 in assets that have a useful life of 10 years and a salvage value of $20,000. The depreciation expense is calculated by subtracting the salvage value of the asset from the cost of the asset and then dividing the answer by the useful life. The answer in this example is $100,000 minus $20,000 divided by 10 or $8,000.
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