Depreciation: What it is and How to Calculate it

2021-02-08

Shirley Zhao

As a small business owner, you’re responsible for managing all sides of your company’s operation. This can mean overseeing the onboarding of new employees, facilitating your day to day operations, and handling your firm’s accounting. If you’re an experienced owner, you’ve probably realized that your business’s success depends on how smoothly each of these processes can operate. 

While the consumer-facing side of your company may seem like the most important part of sustaining your business, there are a number of processes that happen behind the scenes that can be equally vital to your longevity. Perhaps the most common accounting procedure used to boost a company’s value is depreciation. Depreciation refers to a process by which an asset’s cost is covered over its entire life span. 

By depreciating an asset, small businesses accomplish two things. First, they save themselves the burden of having to cover the cost of a piece of equipment or machinery with one large purchase, a move which would greatly impact the firm’s net income for the period. Second, by extending the pay-off process and classifying their purchase as a depreciable asset, depreciating an asset allows your firm to lower its taxable income over the years in which you pay off the property. 

Purchasing tangible or intangible assets such as equipment, machinery, real estate, or vehicles can be a burdensome process for a small business. However, by taking the proper accounting steps and depreciating your assets over time, you can reap immediate benefits from your purchase while saving yourself a good deal of financial trouble at the outset.

What is Depreciation?

Depreciation allows a business to write-off the value of an asset over the course of several years. When purchasing a new piece of equipment, rather than cover the total cost of the purchase immediately, business owners may choose to instead stagger their payments over what is referred to as an asset’s “useful life”. 

An asset is anything with monetary value that is owned by your company. Assets can be tangible, think physical equipment such as computers, or intangible, e.g. patents, trademarks, or other intellectual agreements that hold inherent value. The phrase “useful life” is used to describe the length of time in which a business can rely on an asset to generate income; for example, a business might classify the “useful life” of a delivery truck as 10 years, because after that time frame the cost of repairs or wear and tear may make the asset a burden rather than a boost on their balance sheet. 

When depreciating an asset, a business, in effect, receives a tax boost over the course of that useful life. Because assets are essential to the functioning of most businesses, the IRS allows owners to file for tax deductions on large purchases of machinery or equipment. By paying off an asset over time, a business owner can prolong their receipt of those deductions. And further, by carrying over the cost of a purchase across time, a business owner reduces their taxable income in every year of the depreciation cycle, potentially saving thousands of dollars each year.

Recording Depreciation

When an asset is purchased by a company, it is recorded on its balance sheet as a debit to increase an asset account, meaning that its monetary value is shown under the firm’s “assets”. Concurrently, the asset will be listed as a credit to accounts payable on that same balance sheet. 

Basically, when purchasing an asset, a company’s balance sheet will reflect both the cost expected to be paid for the asset, and the value inherent in the asset itself. Companies seek to depreciate their purchases in order to move these expenses from their balance sheet – which references a company’s assets and liabilities at a given time – to their income statement, which reflects revenues and expenses across a time frame. 

When depreciating an asset, a company pays off a fraction of its cost each year. To record these payments, a debit to depreciation expense is applied to the income statement, indicating the costs already incurred for the asset. At the same time, a credit for accumulated depreciation appears on the balance sheet, signifying the total amount that’s been paid toward an assets cost; this credit serves to reduce the net value of a company’s assets until the purchase has been fully covered. 

As an asset is depreciated, its accumulated depreciation is combined with its initial net value on a balance sheet, giving what’s known as the “carrying value” of that asset at that point in time. The assets carrying value reflects the monetary gain that the company expects to receive from the asset before the end of its useful life. When that time comes, and the purchase has been totally depreciated (paid off), the balance sheet will reflect the amount the company expects to receive for the sale of the used equipment; this figure is known as the “salvage value”, and usually plays a significant role in determining if and how a company should depreciate an asset.

How to Calculate Types of Depreciation

Though the concept of depreciating an asset is fairly straightforward, there are a number of ways in which a business can go about determining the proper plan for depreciating their property.

Straight-line depreciation

How to Calculate: The most basic and common form of depreciation is known as straight-line depreciation. Using the straight-line method, business owners pay equal depreciation expenses each year until an asset has reached its salvage value. 

To determine the rate of depreciation using the straight-line method, you must first determine the expected useful life of the asset in question, and then decide on a reasonable estimate for the asset’s salvage value. Then, based on the purchase price of the asset, you determine the total amount of depreciation necessary to pay off the purchase before it ceases to be useful, and the annual depreciation expenses that will be incurred until then. 

Consider, for example, an online retailer that recently purchased a delivery vehicle for $30,000. After inspecting the vehicle, management determines that the vehicle will have a useful life of 12 years, and will have a salvage value of $6,000 at the end of that span. 

First, we determine the total depreciation expense as the difference between the cost of the asset and its salvage value. In this case: $30,000-$6,000=$24,000 in total depreciation expense. Next, we calculate the annual depreciation expenses necessary to pay off the cost of the asset over its useful life. Since we know the asset will be useful for 12 years, and since we have $24,000 in total depreciation to account for, we simply divide the total depreciation value over the assets useful life: here, $24,000/12 years = $2,000 per year in depreciation. Paying $2,000 per year out of the total $24,000 in depreciation expenses means that there is an annual depreciation rate of $2,000/$24,000, or 8.3%.

We’ve just determined that, rather than pay the full $30,000 in one year, the retailer’s accountants are able to instead pay just $2,000 per year over the truck’s life, boosting the company’s net income across those years. When those 12 years have passed, and the asset has been fully depreciated, the company should be able to collect a sum equal to the truck’s salvage value.

Declining balance depreciation

How to Calculate: While straight-line depreciation is the most common method of writing off an asset, it is not necessarily the most accurate, as it doesn’t reflect the changing value of an asset as it reaches the end of its useful life. To account for this, many firms choose to use Declining Balance Depreciation to cover the cost of purchases. 

Declining Balance Depreciation is a process that depreciates an asset at its straight-line rate times its remaining depreciable value. Recall that in the above example the retailer was able to pay off the truck at a constant rate of $2,000 per year over 12 years, or 8.3% depreciation each year. If the firm were to use the declining balance method, rather than pay the same $2,000 each year, they would pay decreasing sums in depreciation until the asset is paid off. 

To arrive at the declining balance depreciation schedule, first take the total depreciation value, $24,000 in this case, times the depreciation rate of 8.3%. For the first year of depreciation, the firm pays off (8.3% * $24,000) $2,000; in the next year, rather than applying the depreciation rate to the total depreciation sum, it is applied to the remaining sum — (8.3% * $22,000) = $1,800 in expenses. This calculation is repeated each year until the asset has been paid off to its salvage value, with annual depreciation expenses decreasing as more of the total sum is paid off.

Sum-of-the-year’s-digits depreciation

How to Calculate: Another type of depreciation that allows owners to pay decreasing sums to cover the cost of an asset — a concept known as accelerated depreciation — is the sum-of-the-year’s-digits (SYD) method. The process for arriving at the SYD rate is fairly straightforward. First, determine the useful life of your asset. In this example, we’ll refer to a laptop computer with a useful life of 4 years. Then, add together the number of years of the asset’s expected life and use that to calculate the yearly depreciation expense: 

A 4 year useful life translates into 1+2+3+4, or a total depreciation base of 10. In the first year of the laptop’s life, you’d pay off 4/10 of its cost; in the second, 3/10; the third, 2/10; eventually, in the final year of its useful life, you’ll pay off the final 1/10 of the laptops cost and be free to sell it for its salvage value.

Unit of production depreciation

How to Calculate: While the above methods of calculating depreciation rely mostly on the expectations of an asset’s useful life to determine annual payments, the Unit of Production Depreciation method allows you to calculate depreciation based on the tangible outputs of a certain piece of equipment. 

Beginning with an estimate for the total units produced by a machine over its lifetime, you then determine how much of that capacity was used in the previous year. For example, we’ll refer to a printing press that can produce a finite amount of pages over its lifetime. 

Say that a printing press cost a company $10,000, an expected salvage value of $2,000, can be expected to produce 4,000 pages in its lifetime, and was used to print 400 pages in the past year. To determine the annual depreciation expense using the unit of production method we take: 

[($10,000-$2,000)/4,000 pages] * 300 pages = $600 dollars in depreciation expenses on the year. 

Notice that there is a relatively low cost for depreciation in the given year; that’s because a fairly small portion of the machine’s lifetime production capacity was used up. That’s because the units of production method of depreciation is meant to concentrate most of the cost of a depreciable asset in the years in which it is most used. 

The standard equation for calculating units of production depreciation is: 

[(Original value-salvage value)/ Estimated Production Capability] * Units produced in the last year     =       Annual depreciation expenses.

Modified accelerated cost recovery system

How to Calculate: Depreciation for the purpose of tax deduction is a common procedure for small business owners. While the above methods of writing off asset costs do help toward that end, the IRS’s Modified Accelerated Cost Recovery System (MACRS) is the official means of depreciating an asset for tax purposes. Using IRS documents that classify the expected useful life and salvage value of certain types of assets, small businesses then depreciate an asset based on its original cost and the percentage of its productive capacity already used up. Alternatively, your business’s tax software or accounting branch should be able to complete this calculation based on IRS documentation and internal production figures. 

Important to note is that the MACRS method is designed to account for larger payments in the early years of an asset’s life, with sums decreasing in later years. This is particularly useful for tax purposes, as it reduces taxable income in the years of large payments and accounts for higher net income in years with low rates. 

For more information on how to classify your assets and calculate depreciation using the MACRS method, visit the IRS homepage for how to depreciate various types of property.

Why Depreciation Matters

Depreciating the cost of an asset over time allows a business to link the cost of a purchase with its value over time. For accounting purposes, it helps reduce taxable income over several years and may help boost net profits that would otherwise be saddled by huge costs. For these reasons, it’s vital for small business owners to not only understand the various forms of depreciation, but to take careful inventory each year to determine how quickly and how much their physical assets have depreciated.

For certain forms of financing like equipment loans, having an understanding of a particular asset’s depreciation will help ensure the soundness of any lending agreements.

Author:

Jeffrey Bumbales
Director, Marketing & Strategic Partnerships at Credibly