How to Calculate Depreciation and Amortization

Depreciation and amortization are accounting processes that systematically reduce asset value over their useful lives. This allocation spreads the cost of a long-term asset across periods it generates revenue, matching expense with revenue for accurate financial performance. These non-cash expenses provide a clearer picture of profitability and asset utilization.

Understanding Key Inputs for Calculation

Calculating depreciation requires several inputs.

The “Cost” of an asset includes its purchase price and all expenditures to get it ready for use, such as shipping, installation, and testing fees. For instance, a machine costing $50,000 with $5,000 in delivery and setup has a total cost of $55,000 for depreciation.

“Useful Life” is the estimated period a company expects to benefit from an asset, typically in years or units of production. This estimate considers wear and tear, obsolescence, and maintenance. For example, a delivery truck might have a five-year useful life, while a building could have 30 years. Companies use industry standards, past experience, or professional assessments.

“Salvage Value” is the estimated amount a company expects to receive from selling an asset at the end of its useful life. This value is subtracted from the asset’s cost to determine the depreciable base. For example, a machine costing $55,000 expected to sell for $5,000 after five years has a depreciable base of $50,000. Market research or historical data helps determine this value.

For intangible assets like patents or copyrights, “Cost” includes the acquisition price and related legal or development fees. Amortization uses the “Legal or Economic Life,” defined by legal terms (e.g., patent duration) or the period the asset generates economic benefits, whichever is shorter. A patent might have a 20-year legal life, but a shorter economic life due to rapid technological advances.

Common Depreciation Methods

The Straight-Line Method allocates an equal amount of an asset’s depreciable cost to each period of its useful life. The formula is (Cost – Salvage Value) / Useful Life. For instance, a machine purchased for $55,000 with a $5,000 salvage value and a five-year useful life has an annual depreciation expense of ($55,000 – $5,000) / 5 years = $10,000. This method provides a consistent expense.

The Double Declining Balance (DDB) method is an accelerated depreciation method recognizing more expense in early years. It does not subtract salvage value initially but stops depreciating when book value reaches salvage value. The DDB rate is (1 / Useful Life) 2. For a five-year useful life, the straight-line rate is 20%, so the DDB rate is 40%. In the first year, depreciation is 40% of the asset’s original cost, or 40% $55,000 = $22,000.

In the second year of the DDB method, depreciation is calculated on the remaining book value. For the machine, the book value after year one is $55,000 – $22,000 = $33,000. The second year’s depreciation is 40% of $33,000, equaling $13,200. This method is favored for assets that lose significant value or productivity early in their life.

The Sum-of-the-Years’ Digits (SYD) Method is an accelerated depreciation method using a declining fraction applied to the depreciable cost (Cost – Salvage Value). The denominator is the sum of the asset’s useful life years (e.g., 5-year life = 15). The numerator for each year is the remaining useful life. For the machine, with a depreciable cost of $50,000, the first year’s depreciation is (5/15) $50,000 = $16,666.67.

In the second year of the SYD method, the fraction applied to the depreciable cost is 4/15, yielding a depreciation expense of (4/15) $50,000 = $13,333.33. This method systematically reduces the depreciation amount each year, reflecting that assets are more productive or lose more value initially. The sum of depreciation expenses over the asset’s life equals its depreciable cost.

The Units of Production Method allocates depreciation based on an asset’s actual usage or output. This method suits assets whose wear and tear relate directly to activity levels. The depreciation rate per unit is (Cost – Salvage Value) / Total Estimated Units of Production. For example, if the machine produces 500,000 units over its life, the rate is ($55,000 – $5,000) / 500,000 units = $0.10 per unit.

If the machine produces 100,000 units in its first year, depreciation is 100,000 units $0.10/unit = $10,000. If it produces 80,000 units in the second year, depreciation is $8,000. This method aligns depreciation expense more closely with the asset’s actual contribution to revenue generation, which can fluctuate annually.

Amortization Calculation Methods

Amortization primarily uses the straight-line method to allocate the cost of an intangible asset over its useful or legal life. This process applies to assets lacking physical substance, such as patents, copyrights, or software. The calculation divides the intangible asset’s cost by its estimated useful life, which legal terms or economic factors can limit. For instance, a $100,000 patent with a 10-year legal life amortizes at $10,000 per year.

Goodwill, an intangible asset representing an acquired company’s value beyond its identifiable assets, is treated differently. Instead of systematic amortization, goodwill undergoes an annual impairment test. If the fair value of the reporting unit falls below its carrying amount, an impairment loss is recognized. Goodwill’s value is reduced only when its economic benefits diminish.

For other intangible assets, such as a copyright acquired for $20,000 with a 5-year economic life, the annual amortization expense is $20,000 divided by 5 years, resulting in $4,000 per year. This consistent expense reflects the gradual consumption of the asset’s economic benefits over its determined period.

Applying and Ceasing Calculations

Depreciation and amortization calculations begin when an asset is “placed in service,” meaning it is ready for its intended use, regardless of purchase date. For example, a machine bought in December but operational in January would begin depreciating in January. This ensures expenses match the period the asset contributes to operations.

A common depreciation convention is the half-year convention, which assumes assets acquired or disposed of during the year were placed in service or removed mid-year. This means only half a year’s depreciation is allowed in the first year an asset is placed in service and in the year it is disposed of. For example, if an asset with $10,000 full-year depreciation is placed in service in July, only $5,000 is recognized that first year. This simplifies accounting for numerous asset additions.

Depreciation and amortization calculations cease under several circumstances. Most commonly, when an asset is fully depreciated or amortized, its book value is reduced to salvage value (for depreciable assets) or zero (for many amortized intangibles). If an asset is sold, retired, or disposed of before full depreciation, calculations stop on the disposal date. For instance, if an asset is sold in April, only four months of depreciation are recognized that year.

When an asset is disposed of, any remaining book value not yet depreciated or amortized must be accounted for. If the sale price exceeds the asset’s book value, a gain is recognized; if less, a loss is incurred. This adjustment ensures accounting records accurately reflect the asset’s removal.