Calculating the devaluation of an asset is important for the preparation of accurate financial reports. Investors will analyze the value of a company’s assets when reviewing financial reports, so it is critical that the assets are carried at their correct values. The rate of devaluation for an asset depends upon the asset’s useful life as well as its acquisition price. Calculating the devaluation of an asset can be confusing because it involves the use of numerous accounting concepts. However, the process is much easier once you have done it several times.
Estimate the useful life of the asset you are analyzing by comparing it to similar assets that you have purchased in the past. For example, suppose you purchase a piece of manufacturing equipment to replace a similar piece of equipment that you acquired five years ago. Also, suppose that you know this type of equipment wears out after five years. Based on this information, you should use a useful life of five years for the equipment you purchased.
Determine the asset’s salvage value (which is the amount the asset can be sold for after it is fully devalued) based on comparable assets at your company. Salvage value is often equivalent to scrap value since an asset has little value left at the end of its useful life. In many cases, the salvage value may equal zero. Suppose your company has traditionally sold the type of equipment you purchased for $100 after five years of use. In this case, you can assume the new equipment has a salvage value of $100.
Subtract the salvage value of the asset from the asset’s purchase price to calculate total amount to be devalued. If you purchase the equipment for $1,100, the maximum amount of devaluation is calculated as $1,100 - $100 = $1,000.
Divide the maximum amount of the asset’s devaluation by its useful life to determine the total devaluation charge each year. In this case, the total devaluation expense for the asset each year is calculated as $1,000 ÷ 5 = $200.
Multiply the annual devaluation charge by the number of years that have passed since you purchased the asset. The resulting number equals the total amount of devaluation for the asset. If you purchased the asset in this example three years ago, the total amount of devaluation is calculated as 3 x $200 = $600.
The IRS provides guidance on estimating the useful life and salvage values of various assets. Be sure that your estimates conform to IRS guidelines when determining annual devaluation expense.