When you purchase a new piece of equipment, machinery, or other long-term asset for your business, you don’t report the full purchase price as an expense in the year you purchase it. Instead, you’ll need to allocate its cost over its useful life, a process known as depreciation.
As we’ll cover in further detail below, there are multiple formulas for depreciation. Each company will need to select the depreciation method that best suits the nature of their business and personal preferences.
So, how is depreciation calculated, and how does this differ between the various methods? Continue reading as we provide answers to each of these questions and more.
Depreciation is a concept in financial accounting that refers to the process of dispersing the cost of a long-term asset over its useful life. This compares to the practice of deducting the entire purchase price of the item during the year when the transaction is completed.
For example, if you purchase a delivery van for your business for $45,000, you won’t realize the full amount in the current year. Instead, you’ll need to deduct portions of the cost each year that the van remains in use.
The idea is that fixed assets depreciate, or decrease, in value over time due to consistent use and regular wear and tear. Thus, depreciation helps you match expenses with the actual usage of the item and the revenue it helps to generate in the current reporting period. In other words, the depreciation expense you record each year will represent the portion of the asset’s value that was used during the period.
Depreciation is an important accounting practice that helps businesses allocate the cost of an item over its useful life to represent its loss in value from year to year.
How does depreciation work from an accounting standpoint? When you first purchase a new piece of machinery or other long-term property, you will record it on the balance sheet as an increase to assets, and as a decrease to the cash account (or increase in payables if it was purchased on credit).
At the end of the accounting period, the team will record depreciation expense for a portion of the asset’s value, which will show up on the income statement to decrease the business’s taxable income for the year. They’ll also credit the accumulated depreciation account. This is done until the asset has reached the end of its useful life, and the value of the accumulated depreciation account equals the purchase price minus the salvage value.
In general, depreciation only applies to long-term assets that have a useful life longer than one year. In other words, you don’t depreciate the purchase of office supplies that you’ll use in the coming months, like paper, pens, or printer ink.
So, which assets do you depreciate? According to the IRS, an asset can be depreciated only if it meets this criteria:
Thus, not every property-related transaction can be depreciated. For example, if you lease a property to run your business out of, you cannot depreciate the costs because you don’t own it.
Commonly, businesses might think they can depreciate the value of their unsold inventory. However, the IRS makes it clear that it does not qualify since the business doesn’t “use” the assets. Similarly, land is also not a depreciable asset because it does not get “used up” or become obsolete and generally increases in value over time.
To summarize, here are some of the assets that are commonly depreciable:
If you need help determining which of your assets can be depreciated, reach out to Bob’s Bookkeepers’ and ask about our custom accounting and tax services.
Depreciation also has important tax implications, extending beyond the initial year the asset was purchased.
You can deduct its cost for a number of years rather than only doing so in the year it was bought. This creates more predictable and consistent reporting and tax liabilities for budgeting and planning purposes.
Review IRS Publication 946 for more information on how depreciation impacts your tax liability.
There’s a unique relationship between accumulated depreciation and book value, though it’s important to understand the distinction between the two.
Accumulated depreciation is the amount of the asset’s value that has been depreciated thus far. On the other hand, the book value is the difference between the accumulated depreciation and the asset’s initial purchase price.
Thus, as time passes, the accumulated depreciation account will goes up and the asset’s book value will go down.
There are four common formulas for depreciation. It’s important to note that each method will result in different depreciation expenses from year to year and may be better suited for certain businesses. Companies can choose any method, though they must stick to one after selecting it.
Below, we’ll provide an overview of the various depreciation methods, including the important considerations and benefits of each.
The straight-line depreciation method is often considered the most simple and straightforward. For this reason, it’s one of the most common among small businesses.
As the name might suggest, this method is used to steadily decrease the asset’s value in a straight line over its useful life.
The formula to calculate the depreciation expense using the straight-line method is:
Depreciation Expense = (Purchase price – Salvage value) / Useful life
In this case, you’ll need to know the salvage value of the asset, which is what you could sell it for at the end of its useful life. You’ll find the difference between the purchase cost and the salvage value, and divide it over the useful life to find the depreciation expense you’ll record for one year.
Example:
Let’s say you run a lumber yard, and you purchase a new forklift for $40,000. If you estimate that it will last you for five years before you’ll be able to sell it for $5,000, we can calculate the depreciation expense by plugging these values into the above formula:
Depreciation Expense = ($40,000 – $5,000) / 5 years
= $35,000 / 5 years
= $7,000 per year
The double-declining balance method of depreciation is a bit more involved. With this method, you’ll depreciate more of the asset’s value immediately following the purchase and less at the end of its useful life. Thus, you won’t record the same depreciation expense value each year as the previous method.
This is generally a good option for assets that quickly depreciate, like technology, representing their loss in value. The formula is as follows:
Depreciation expense = Starting book value * (2 * (1 / Useful life))
Unlike the straight-line method, this formula is not concerned with the asset’s salvage value. Instead, you’ll need to know the starting book value for the year, which is equal to the original cost minus the accumulated depreciation.
Example:
Using the above example of depreciation for the forklift, let’s use the same figures to see how the double-declining balance method compares.
For the first year, here’s how to find the depreciation expense:
Depreciation expense = $40,000 * (2 * (1 / 5))
= $16,000
The following year, this would be:
Depreciation expense = ($40,000 – $16,000) * (2 * (1 / 5))
= $9,600
In this case, the largest depreciation expense is recorded in the first year of ownership and decreases over time.
The next method is the sum-of-the-years’ digits (SYD) depreciation. Like the double-declining method, it’s used to depreciate more of the asset’s value earlier on. The distinction between the two is that the SYD method leads to a gentler decrease in depreciation expense from year to year.
The formula for the SYD method is:
Dep. expense = (Remaining life / SYD) * (Asset cost – Salvage value)
In this formula, SYD is the sum of digits in the asset’s useful life.
Example:
To continue on with the forklift example, let’s first find the SYD to use this method:
SYD = 1 + 2 + 3 + 4 + 5
= 15
We can then apply it to the formula to find the depreciation expense for the first year:
Dep. expense = (5 / 15) * ($40,000 – $5,000)
= (1 / 3) * $35,000
= $11,666.67
In the following year, the depreciation expense would be:
Dep. expense = (4 / 15) * ($40,000 – $5,000)
= (4 / 15) * $35,000
= $9,333.33
This would continue on until the end of the asset’s useful life.
The final depreciation method companies can use is the units of production method, which is a way to write off the asset’s value based on the number of units it produces during a given period.
The type of units in question will vary depending on the nature of the asset, whether it be the number of widgets it produces, the number of hours it operates, or something else.
It can be a bit tedious to track the number of units a piece of machinery produces, so it’s typically only helpful in certain cases where this figure is already well-documented.
Here is the formula for this method:
Depreciation = (Asset cost – Salvage value) / Units produced in useful life
With this method, you’ll calculate the depreciation expense that’s attributable to a single production unit. To find the total depreciation expense for the period, you’ll multiply this value by the number of units produced.
Example:
For the sake of comparison, let’s stick with the forklift example, using hours as the unit. We’ll assume the forklift has a useful life of 20,000 hours.
Here’s how we can calculate the depreciation per hour:
Depreciation per unit = ($40,000 – $5,000) / 20,000
= $35,000 / 20,000
= $1.75 per hour
Thus, if the forklift was used for 3,700 hours during the first year, the depreciation expense would be:
Depreciation = $1.75/hour * 3,700 hours
= $6,475
This value will vary over the years in proportion to the number of hours worked until reaching the end of the useful life.
To reiterate, businesses have the choice over which depreciation method they use. However, certain methods often make more sense for companies based on their goals, industry, and asset usage.
Here are some important considerations to help you choose the best method for your business:
If you need help selecting a depreciation method, the expert team at Bob’s Bookkeepers can provide guidance based on your unique needs and industry standards.
Though the word depreciation may have a negative connotation, it actually provides key benefits for businesses. It provides tax relief for several years after purchasing a fixed asset, while allowing the business to realize the cost over time without a large hit to profits initially.
Even still, figuring out how to calculate depreciation and select the best method for your business can be a challenge. That’s why working with a firm with years of experience in your industry, like Bob’s Bookkeepers, is extremely valuable. It gives you the confidence that you’re maintaining accurate financial records and meeting compliance with industry standards, without a drag on your in-house resources.
Contact us today if you’d like to partner with a friendly and knowledgeable team for your tax and accounting needs.
