How to Calculate Depreciation
In most cases, the value of the items you purchase goes down over time. This is why you can never sell your used car for as much as you paid for it new — it has accumulated wear and tear and is no longer worth the original purchase price. The same thing happens with many business purchases (e.g., a new computer tends to be worth less over time).
Depreciation is the loss in value of purchased assets over time. When it comes to small business accounting, recording the loss can save you money during income tax time in the same way other business losses do because it is tax-deductible. Hence, it is important to know how to track and calculate the depreciation of purchased assets.
What Is Depreciation?
Simply put, the accumulated depreciation cost of a fixed asset is the difference between the original cost of the asset and its current value. It's important to distinguish between accumulated depreciation and annual depreciation, however. Accumulated depreciation is the total amount of depreciation from the time of purchase to the current date, as described, whereas annual depreciation is the amount the asset depreciates each year.
Because taxes are completed annually, depreciation is calculated annually and is usually based on a predetermined depreciation schedule. A depreciation schedule indicates how much the item depreciates each year from the time of purchase to the end of its useful life. Exactly how those annual amounts are determined varies based on which depreciation method you use.
Before getting into the different depreciation calculation methods, though, it's important to understand what qualifies as a depreciating asset.
What Is a Depreciating Asset?
For a business owner to claim depreciation of an asset, that asset must meet certain IRS guidelines. First, the property must be owned and purchased by the business, primarily used by the business, and have a determinable useful life of more than one year.
If the useful life of an asset is a year or less, it shouldn't be counted as a depreciation expense. Instead, the cost of the asset can simply count as a business expense. Examples of depreciating assets include the following:
- Real estate
- Office furniture
- Production equipment
Four Different Methods for Depreciation
Now that you understand what types of assets can be depreciated, it's time to learn about the different methods of depreciation. The method that's right for you depends on the rate at which the value of the asset in question decreases, as well as your business's financial situation. The four depreciation methods are as follows.
Perhaps the most intuitive and straightforward method is the straight-line depreciation method. In this method, the asset depreciates by the same amount each year. Calculating this amount involves determining the useful life of the asset (the number of years before its value equals the scrap value) and the difference between the original cost of the asset and its scrap value. That difference is then divided evenly by the number of years.
Double-Declining Balance Method
Double-declining balance depreciation is an accelerated depreciation method. This means the rate of depreciation changes over time, usually with the largest loss in value occurring during the first year and declining in later years.
This method aims to account for the fact that some assets quickly lose value early in their life span rather than later. It is also useful if your business is better served by claiming a greater annual depreciation expense soon after the asset is purchased, which might be the case if the asset provides more value and gets more use in its early years.
Sum-of-the-Year's-Digits Method (SYD)
The method in which depreciation is quicker early on (but not as quick as with the double-declining balance method) and slows down later is called the sum-of-the-year's-digits depreciation method. First, determine the number of years in the useful life of the asset and then add those years.
For example, if the item will last three years, you would add 1+2+3 = 6. You then assign the digits 1, 2, and 3 to the years in reverse order (i.e., assign a value of 3 for the asset's first year, a value of 2 for the second year, and a value of 1 for the last year). The depreciation rate is then the straight-line depreciation value multiplied by the fraction obtained by dividing the year's value by the sum of the years. (The first year's fraction would be 3/6, or 1/2.)
This method is useful when an asset depreciates quicker than the straight-line model predicts but not as fast as a more accelerated depreciation model.
Units of Production Method
The units of production depreciation method is best used for the depreciation of production equipment. The equipment's depreciation value is based on how much work it does or how many items it processes.
First, determine the difference between the cost of the asset and its scrap value (also called its residual value). Then, divide this difference by the number of units produced or processed by the asset during its useful life. This gives you the asset's depreciation per unit produced. The depreciation for a given accounting period can then be calculated by multiplying this value by the number of units produced during that period.
How Do You Calculate Depreciation?
Calculating depreciation requires first choosing a method, then finding the variables needed to perform the calculation using that method, and finally applying the appropriate formula. Each of these steps is outlined below with examples.
Step 1: Determine Which Type of Depreciation Method to Use
There are four methods to choose from. Carefully review each method and consider its implications in light of the particular assets you are depreciating. Suppose, for example, you want to depreciate a computer, office furniture, and a printer.
You might choose the double-declining balance method for the computer since it loses value more quickly near the beginning of its useful life, the straight-line method for the furniture since the calculation is simpler and furniture tends to lose its functionality in a more steady fashion, and the units of production method for the printer, which may wear out based on how many pages it prints.
Step 2: Understand the Depreciation Variables
As you prepare to calculate depreciation, you need to be familiar with the variables used in the formulas. Each is defined as follows:
- Asset cost: The initial cost of the asset when purchased
- Salvage value: The value the asset is worth at the end of its useful life, also called scrap value or residual value
- Useful life: The number of years the asset remains useful
- Units produced in useful life: The number of units created or processed by a piece of equipment during its useful life
- SYD: Sum-of-the-year's-digits, which is the sum of ascending numbers labeling each year of an asset's useful life
- Remaining life span: The number of years between the current date and the end of the asset's useful life
- Book value at the beginning of the year: The value of an asset at the beginning of the year taken as the difference between its original cost and the accumulated depreciation
Step 3. Calculate the Depreciation
Now you can calculate the depreciation using your chosen method and the necessary variables. Consider the example of the computer, office furniture, and printer. Suppose the office furniture's asset cost was $4,000. The furniture is expected to last 10 years, after which its salvage value is estimated to be around $500. The formula for annual straight-line depreciation is:
|Annual Straight-Line Depreciation
Entering the values for the office furniture gives:
|Annual Straight-Line Depreciation
Now suppose the computer's asset cost was $2,000. It is expected to last five years, at which its salvage value will be $200. The formula for double-declining balance depreciation is as follows:
|Depreciation for the Year
|(2 x Straight-Line Depreciation Rate)
x Book Value at the Beginning of the Year
The straight-line depreciation rate is the rate it would decrease annually using that method. Computing the annual straight-line depreciation gives $360/year. The rate is then $360/$2,000 = 0.18. If you assume the computer was just purchased at the beginning of the year, its depreciation is:
|Depreciation for the Year
|(2 x 0.18) x $2,000
(Note that the following year, the calculation becomes (2 x 0.18) x $1,280 = $460.8 and declines each subsequent year, as well.)
Finally, for the printer, suppose its asset cost was $800 and it is expected to print 50,000 pages before it is salvaged for $300. Using the units of production method, the depreciation per unit is calculated using the formula:
|Depreciation per Unit
Using the numbers above, this gives:
|Depreciation per Unit
If you print 15,000 pages in a year, the annual depreciation = 15,000 x $0.01 = $150.
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Notice to the Reader
The content within this article is meant to be used as general guidelines and may not apply to your specific situation. Always consult with a professional accountant to ensure you're meeting accounting standards.