Depreciation, Amortization and Determining the useful life of an asset.
Depreciation
Depreciation is the expensing of a fixed asset over its useful life. Fixed assets are tangible assets, meaning they are physical assets that can be touched. Some examples of fixed or tangible assets that are commonly depreciated include:
- Buildings
- Equipment
- Office furniture
- Vehicles
- Land
- Machinery
Since tangible assets might have some value at the end of their life, depreciation is calculated by subtracting the asset's salvage value or resale value from its original cost. The difference is depreciated evenly over the years of the expected life of the asset. In other words, the depreciated amount expensed in each year is a tax deduction for the company until the useful life of the asset has expired.
For example, an office building can be used for many years before it becomes rundown and is sold. The cost of the building is spread out over the predicted life of the building, with a portion of the cost being expensed in each accounting year.
Depreciation of some fixed assets can be done on an accelerated basis, meaning that a larger portion of the asset's value is expensed in the early years of the asset's life. For example, vehicles are typically depreciated on an accelerated basis.
Amortization
Amortization is the practice of spreading an intangible asset's cost over that asset's useful life. Intangible assets are not physical assets, per se. Examples of intangible assets that are expensed through amortization might include:
- Patents and trademarks
- Franchise agreements
- Proprietary processes, such as copyrights
- Cost of issuing bonds to raise capital
- Organizational costs
Unlike depreciation, amortization is typically expensed on a straight line basis, meaning the same amount is expensed in each period over the asset's useful life. Additionally, assets that are expensed using the amortization method typically don't have any resale or salvage value, unlike with depreciation.
How to Determine the Useful Life of an Asset
The useful life of an asset is an estimate of the number of years it will remain in profitable service. The purpose of a useful life estimate is to determine how long an asset will remain in useable condition. From a financial standpoint, this means the period of time in which an asset will generate an economic benefit for the business.
Most commonly, the depreciation of assets is calculated by dividing the cost of the asset by the estimated number of years in its life.
Various factors, such as frequency of usage, working environment, and maintenance performed on the asset all affect its useful life, so it can be difficult to calculate an absolute value.
Useful Life Estimates
What is the useful life of a computer? How about an automobile? What about athletic equipment? Here are some examples of the useful life estimates recommended.
| CATEGORY | DESCRIPTION | USEFUL LIFE (yrs) |
| Machinery and Equipment | Books and Multimedia Materials | 5 |
| Machinery and Equipment | Computer Equipment | 5 |
| Licensed Vehicles | General Automobile | 8 |
| Machinery and Equipment | Science and Engineering Equipment | 10 |
| Machinery and Equipment | Audiovisual Equipment | 10 |
| Machinery and Equipment | Athletic Equipment | 10 |
| Machinery and Equipment | Grounds and Maintenance Equipment | 15 |
| Land Improvements | Fencing | 20 |
| Machinery and Equipment | Playground Structures | 20 |
How is Depreciation Calculated?
While there are several forms of depreciation including straight-line and various accelerated methods, many entities choose to apply straight line depreciation. Below is an example of how straight-line depreciation can be calculated for a playground structure.
1. To calculate depreciation, we must first identify the acquisition cost, salvage value, and useful life. For our playground structure, let’s say the cost was $21,500. We’ll use a salvage value of 0 and based on the chart above, a useful life of 20 years.
2. If we apply the equation for straight line depreciation, we would subtract the salvage value from the cost and then divide by the useful life.
The result would look something like this: ($21,500 – $0) / 20 years = $1075 annual depreciation.