How to Forecast Depreciation and Create a Schedule

Depreciation is an accounting method used to allocate the cost of a tangible asset over its useful life, representing the gradual reduction in its value from use or obsolescence. Forecasting this expense is a part of financial management, as it impacts the income statement and the balance sheet. Understanding future depreciation is also valuable for tax planning, as it is a non-cash expense that can reduce a company’s taxable income. These projections help a business decide when to purchase or replace assets by providing a clearer picture of future expenses and their effect on profitability.

Gathering Key Inputs for Depreciation

Before calculating depreciation, three pieces of information must be gathered for each asset. The accuracy of these inputs directly influences the reliability of the financial projections. Each input requires careful consideration based on the specific asset and its intended use.

Asset’s Cost Basis

The cost basis of an asset is its total acquisition cost, which includes the purchase price plus all expenditures necessary to get it ready for use. These costs encompass the invoice price, sales taxes, delivery charges, and installation fees. For real property, the basis can also include related legal fees, abstract costs, and surveys. When a property with a building is purchased, the cost must be allocated between the land and the building, as land is never depreciated.

Estimated Useful Life

An asset’s useful life is the estimated period it is expected to be in service and generate economic benefits. This estimation should reflect how long the business plans to use the asset before it becomes obsolete, inefficient, or is replaced. Factors influencing this estimate include the frequency of use, the operational environment, and the company’s maintenance policies. For guidance, businesses can refer to manufacturer specifications or historical data from similar assets, but this financial accounting estimate is distinct from recovery periods mandated by tax authorities.

Estimated Salvage Value

Salvage value, or residual value, is the estimated amount a business expects to receive for an asset at the end of its useful life. This value is what the asset could be sold for, considering any costs associated with its disposal. Determining this value involves looking at historical sale prices of similar used assets or consulting industry guides. For assets with long useful lives or those expected to have little value at the end of their service period, the salvage value may be estimated as zero.

Common Depreciation Calculation Methods

Once the necessary inputs are gathered, a business must select a method for calculating depreciation. The choice of method determines how the asset’s cost is allocated over its useful life, which can affect net income and the asset’s book value each year.

Straight-Line Method

The straight-line method is the most widely used approach due to its simplicity. It allocates an equal amount of depreciation expense to each full accounting period, assuming the asset’s utility declines uniformly over time. This makes it suitable for assets like buildings or office furniture. The calculation involves taking the asset’s cost basis, subtracting its estimated salvage value, and dividing the result by the total number of years in its useful life. For example, an asset purchased for $25,000 with a $5,000 salvage value and a 10-year life would have an annual depreciation expense of $2,000.

Double Declining Balance Method

The double-declining balance method is an accelerated approach that records higher depreciation expense in the early years of an asset’s life. This method is used for assets that lose value more rapidly when new, such as vehicles or high-tech equipment. To calculate depreciation using this method, you first determine the straight-line depreciation rate and then double it. For an asset with a five-year life, the straight-line rate is 20% (1/5), so the double-declining rate is 40%. This rate is applied to the asset’s book value at the beginning of each year, but the asset cannot be depreciated below its salvage value.

Units of Production Method

The units of production method ties depreciation expense directly to an asset’s usage rather than the passage of time. This approach is ideal for manufacturing equipment or vehicles, where wear and tear are related to operational output. Depreciation expense varies from period to period based on the asset’s activity level. The calculation begins by establishing a depreciation rate per unit of output. This is found by subtracting the salvage value from the asset’s cost and dividing that amount by the total estimated production capacity. To find the depreciation expense for a period, this per-unit rate is multiplied by the number of units produced.

Creating the Depreciation Forecast Schedule

After gathering inputs and selecting a method, the next step is to construct a depreciation forecast schedule. This schedule provides a year-by-year breakdown of an asset’s depreciation, its accumulating total, and its remaining book value.

To illustrate, consider equipment with a $50,000 cost basis, a five-year useful life, and a $10,000 salvage value. Using the straight-line method, the annual depreciation is calculated as ($50,000 cost – $10,000 salvage value) / 5 years, which equals $8,000 per year.

The schedule is set up with five columns: Year, Beginning Book Value, Depreciation Expense, Accumulated Depreciation, and Ending Book Value. For Year 1, the beginning book value is the asset’s original cost of $50,000. The depreciation expense is $8,000, making the accumulated depreciation for the first year also $8,000. The ending book value is calculated by subtracting the annual depreciation from the beginning book value ($50,000 – $8,000), resulting in $42,000.

The ending book value from Year 1 becomes the beginning book value for Year 2. The depreciation expense remains $8,000, while the accumulated depreciation grows to $16,000 ($8,000 + $8,000), making the ending book value for Year 2 $34,000. This pattern continues until the end of the asset’s useful life, at which point the ending book value will equal its estimated salvage value of $10,000.