If an asset is not owned for an entire year, then an entire year of depreciation can not be taken. In this case, partial-year depreciation is the appropriate course of action. The organization can not take a full year of depreciation (expense) if the asset was not purchased until the end of the year. This is because it has not been used for the full year.
Basic Depreciation Formula
First things first, let's start with the basic depreciation formula. Understanding this is a prerequisite to understanding partial-year depreciation.
A fixed asset is purchased on January 1, 20XX for $50,000. This asset has an estimated life of 5 years (useful life). The salvage value, or the value that will be left once all depreciation has been taken and what the company believes they can salvage from it when sold, is $5,000.
On the simplest of terms (straight-line depreciation), the depreciation would be calculated as follows:
(Asset Purchase Price - Salvage Value) / Estimated Life = Depreciation for 20XX
($50,000 - $5,000) / 5 = $9,000 depreciation expense per year
Partial-Year Depreciation Formula
Using the same example above, but changing the purchase date to March 31, 20XX, partial-year depreciation would be calculated as follows:
Asset Purchase Price - Salvage Value / Estimated Life in MONTHS = Depreciation for 20XX
($50,000 - $5,000) / (5 x 12) = $750 depreciation expense per MONTH
$750 x 3 months = $2,250 year 1 depreciation
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Without a doubt, there will be times when an organization later realizes that an estimated life or salvage value is misstated. When this occurs, a correction needs to be made in order to properly record the depreciation expenses.
If the current value of an asset (i.e., machinery in the above example) significantly increases or decreases, that would be a reason to adjust the accounting records for a change in estimate. This is done by taking the book value (the asset value minus any depreciation taken at the time) and then spreading that figure out over the new estimated life.
Let's clarify with an example. We'll keep it similar to the example above for simplicity.
On January 1, 20X3 of owning the asset, it is determined that the estimated life is 7 years instead of 5 years. We know that for the last 2 years the asset has been depreciating $9,000 per year.
At this point, the book value is: $50,000 - ($9,000 x 2) = $32,000
We now need to spread the $32,000 out over the next 5 years (versus the original 3 that were left).
Using the same formula we covered above, this is calculated as follows:
($32,000 - $5,000) / 5 years = $5,400 depreciation each month moving forward.
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Depreciation is an important expense that organizations rely on in order to decrease their taxable income, and therefore their tax liability. As fixed assets are purchased, they must be depreciated each year to account for their time in use. A full-year of depreciation expense is calculated by dividing the asset value by the estimated useful life. When an asset is purchased in the middle of a year, a separate calculation is needed to account for the partial-year depreciation. The formula involves converting the estimated useful life of an asset into months (e.g., 5 years x 12 months = 60 months). Once that is done, divide the asset value by the previously calculated figure. This will give a monthly depreciation rate that can then be multiplied by the number of months owned in a given year.
The only thing that ever stays the same, is change. There could be a change in estimate for the estimated useful life or the salvage value of a fixed asset. When a significant increase or decrease in current value occurs, a correction needs to be made. This adjustment will realign the depreciation expense with the proper current value. In order to do this, the book value (the asset value minus any depreciation taken at the time) must first be determined. Once that is complete, the book value is then spread out over the new estimated life.
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Video Transcript
Taxes
You own a small business selling flower arrangements to people in your local neighborhood. You guarantee same-day delivery for purchases made before ten am. You can do this because you own your own delivery vehicle, and you have an employee that makes all the deliveries for you. Another year has passed, and it is time again to do your yearly taxes. Of course, you don't want to pay more taxes than you have to and you want to make sure your taxes are filed accurately.
Depreciation
One of the provisions that the government gives businesses is that you can take depreciation on your business vehicle. Depreciation is the value lost each year that you own a particular item. Cars, for example, lose value every year.
For example, if you buy a car for $24,000, you can't sell it for $24,000 because as soon as you use the car, it starts to lose value. With each passing year, your car is worth less and less. Because of this loss in value, the government allows you, a business owner, to claim this loss on your taxes so you don't have to pay taxes for this loss for your business.
Taxes are complicated, and there are charts that you need to refer to so that your depreciation calculations are correct. For the sake of this video lesson, though, we will make just a sample depreciation calculation. Don't rely on this calculation, though, to calculate your own taxes.
So, let's do a sample calculation for the depreciation of the delivery vehicle for your flower business. Say you bought the vehicle brand-new the year before in November for $40,000. The vehicle has an estimated life of ten years. You plan on keeping the vehicle for the life of the vehicle. So, your depreciation is based on this life of ten years. At the end of the ten years, your vehicle is considered to have a value of zero dollars. Based on this information, you divide the $40,000 (the original value of the vehicle) by ten years (the life of the vehicle) to calculate the per year depreciation of this vehicle. $40,000 / 10 = $4,000. So, each year you can claim a depreciation loss of $4,000 for this vehicle, if you've owned the vehicle for the whole year.
Partial-Year Depreciation
This means that if you've owned the vehicle for just part of the year, then you can't claim the full $4,000 for the depreciation. You would need to calculate the partial-year depreciation, the depreciation for an item used just part of the year.
For example, the previous year, you owned the vehicle for just two months, November and December. To calculate the amount of depreciation for just these two months, we take the full-year depreciation, divide it by the number of months in a year (12), and then multiply it by the number of months we've owned the item for. So, for your vehicle, since you owned it for just two months that year, you would take $4,000, the depreciation for the full year, divide it by 12 and then multiply it by 2. Doing that, you get $666.67 for this year's partial-year depreciation.
Change in Estimate
Now, if for whatever reason, the value of your vehicle changes the year that you do your taxes, your depreciation calculations will change. Your depreciation for that year and the following years will also change. This change in value is referred to as a change in estimate.
So, say, for example, that five years after you've owned the vehicle, the current value of the vehicle suddenly increases by $2,000 with a life expectancy left of five years. You would need to account for that in your depreciation calculations. To calculate this, you need to make depreciation calculations on this increase and then add it, since it's an increase, to the depreciation that you've already calculated. So, we take our increase of $2,000 and divide by the remaining life, five years. We get $400. So, this means that we can claim an extra $400 in addition to our $4,000 for the depreciation of the vehicle this year since we've owned the vehicle for the full year. So, our depreciation for year five is $4,400. If our change in estimate is a decrease, then our depreciation calculations will also decrease.
Lesson Summary
Let's review what we've learned now. Depreciation is the value lost each year that you own a particular item. This is something that you calculate on your taxes if you are a business owner. To calculate the depreciation, you take the original cost of the item and divide it by the estimated life of the item. This calculation gives you the full-year depreciation.
If you only owned the item for part of the year, then you will need to make a partial-year depreciation calculation. To make this calculation, you take your full-year depreciation, divide it by the number of months in a year, and then multiply it by the number of months you've owned the item.
If there is a change in estimate, a change in value or other, then you will need to make the depreciation calculations to this change and then add or subtract it from your original depreciation calculations, as needed.
Learning Outcomes
Once you've finished with this lesson, you will have the ability to:
- Define depreciation
- Explain how to calculate partial-year and full-year depreciation
- Describe how a change in estimate impacts depreciation calculations
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