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The method by which a corporation "writes down" the cost of an asset over a period of years is called depreciation, as opposed to immediate expensing.
To understand how to calculate depreciation, there are a few steps you can follow:
1. Determine the cost of the asset: This includes the purchase price, as well as any additional expenses incurred to acquire and prepare the asset for use, such as shipping and installation costs.
2. Determine the useful life of the asset: This refers to the estimated period over which the asset will be used by the company before it becomes obsolete or loses its value. The useful life is typically expressed in years.
3. Determine the salvage value: This is the estimated residual value of the asset at the end of its useful life. It represents the amount the company expects to receive from selling the asset when it is no longer needed.
4. Calculate the depreciation expense: There are several methods to calculate depreciation, including straight-line depreciation, declining balance depreciation, and units-of-production depreciation. Let's focus on the straight-line method, which is one of the most commonly used methods.
- Straight-line depreciation: With this method, the depreciation expense is evenly spread over the useful life of the asset.
The formula for straight-line depreciation is:
Depreciation Expense = (Cost of Asset - Salvage Value) / Useful Life
Example: Assuming a company purchased a machine for $10,000, with an estimated useful life of 5 years and a salvage value of $2,000. The calculation would be:
Depreciation Expense = ($10,000 - $2,000) / 5 = $1,600 per year
By following these steps and understanding the concept of depreciation, a corporation can "write down" the cost of an asset over a period of years instead of immediately expensing it. This allows the company to spread out the cost and reflect the asset's decrease in value over time.