Depreciation is an accounting charge that allows companies to spread the cost of a major capital asset over that asset's useful life. In essence, depreciation allows companies to account for the cost of a significant asset without distorting quarterly results. Accumulated depreciation is the total amount of depreciation that has been charged to an asset since that asset was purchased. It allows you to determine the book value of a capital asset by subtracting the total accumulated depreciation from the asset's purchase price.
Estimate the useful life of the asset being depreciated by comparing it to other assets that your company owns. Suppose you buy a machine that performs the same function as two other machines your company previously owned, and suppose that these two other machines wore out after four years and six years, respectively. You could use five years as the estimated useful life of the new machine.
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Determine the salvage value of the asset. Suppose the two machines mentioned in Step 1 were sold for $1,000 after they wore out. You could use $1,000 as the estimated salvage value for the new machine.
Subtract the asset's salvage value from its purchase price and divide the result by the asset's estimated useful life. This calculation will tell you the annual depreciation charge for the asset. If you purchased the new machine for $6,000, the annual depreciation expense will be ($6,000 - $1,000)/5 = $1,000.
Add the total annual depreciation charges for the asset to calculate accumulated depreciation. After one year, the machine in our example will have accumulated depreciation of $1,000. After two years, accumulated depreciation will equal $2,000. After three years, accumulated depreciation for the machine will equal $3,000, and so on.
To determine an asset’s book (or carrying) value, subtract total accumulated depreciation from the asset’s purchase price. After three years, the book value of the machine in our example will equal = $3,000 ($6,000 - $3,000).
The Internal Revenue Service provides guidance on how to estimate the useful life and salvage value of assets. Be sure that your estimates are following IRS regulations; consult an accountant or a tax professional if you are unsure.