In the course of running your small business, depreciation is an accounting term that you'll need to be familiar with to understand your financial statements and tax calculations. Depreciation is applied to equipment and other physical assets you use in your business's day-to-day operations.

The monetary value of your business assets declines over time due to wear and tear. Depreciation accounts for that decrease in value. It's calculated and allocated over the period that the property is useful to your business activities.

Properly accounting for the depreciation of your assets, such as tools, equipment, and vehicles, can help you:

  • Accurately match your business expenses to your earnings over a specific period (e.g., quarterly or annually).
  • Write off the cost of large business purchases and potentially lower your tax liability.
  • Establish a reasonable number for the value of your business's assets, which is useful and generally a requirement if you want to apply for a business loan. This information is also essential for your business planning. As your tools get obsolete and used, you'll have to plan and save to replace them.

There are several ways to calculate depreciation. There's the straight-line method, accelerated depreciation method, and double declining balance method, to name a few. In this guide, we'll review the straight-line depreciation method, why it's vital for your business, and how to calculate it.

Understanding Straight-Line Depreciation

Straight-line depreciation is the most popular and straightforward method of calculating depreciation. This approach assumes a constant rate of depreciation. The total cost of the asset is reduced by the same amount every year of its useful life.

How Do You Calculate Straight-Line Depreciation?

To calculate an asset's depreciation amount using the straight-line method, you'll need three variables: the asset's total cost, its salvage value, if any, and its estimated useful life.

Here's the straight-line depreciation formula:

Annual Depreciation Expense
= (Total Cost of Asset - Salvage Value)
Estimated Useful Life of Asset

To calculate the straight-line depreciation rate, here's the formula:

Depreciation Rate
= Annual Depreciation Expense
(Total Cost of Asset - Salvage Value)

Follow along for a step-by-step explanation of the process.

Step 1: Determine the Initial Cost of the Asset

For accounting and tax purposes, the total cost of your business asset may include:

  • The purchase price
  • Taxes, such as sales taxes or import duties
  • The cost of labor and materials incurred if you've had it custom made or made it yourself
  • Assembly and installation costs
  • Shipping and handling costs
  • Repairs and maintenance that keep the asset in efficient operating condition or anything that extends its useful life (such as getting new tires for your delivery truck)

Suppose you bought an asset initially for personal use and converted it to use for your business. In this case, accounting principles and the Internal Revenue Service (IRS) recommend that you calculate your depreciation expense using the fair market value (FMV) of the property. FMV is the price that the particular item would sell for on the open market, and the amount should represent an accurate valuation of the item's worth.

Step 2: Determine the Estimated Salvage Value of the Asset, If Any

The salvage value, otherwise known as scrap value or residual value, is the estimated amount that you can sell the asset for at the end of its useful life. For items with minimal or no residual value, you can fully expense it to zero.

Your depreciation expense affects your net income and the valuation of your business; you must set a reasonable salvage value for your fixed assets and avoid estimating amounts that are too high or too low.

Step 3: Determine the Estimated Useful Life of the Asset

If you're calculating your depreciation expense for tax purposes, the IRS has a guideline classifying assets into seven property classes that depreciate over three, five, seven, 10, 15, 20, and 25 years.

Here are some examples of depreciable assets and their classifications:

Properties with a useful life of three years

  • Tractor units for over-the-road use

Properties with a useful life of five years

  • Vehicles
  • Technological equipment
  • Office machinery, such as calculators and copiers
  • Appliances, carpets, furniture, etc., used in a residential rental real estate activity

Properties with a useful life of seven years

  • Office furniture and fixtures, such as desks, files, and safes
  • Agricultural machinery and equipment
  • Any asset that doesn't have a class life and hasn't been designated by law as being in any other class

Step 4: Calculate the Annual Depreciation Amount Using the Straight-Line Method

It's now time to calculate the amount of depreciation for your asset.

Let's say you have a plumbing business. At the beginning of the year, you bought a truck to get you from job to job. The vehicle's total cost is $35,000 and you estimate the salvage value at $5,000. We'll use the IRS's useful life guideline for vehicles, which is five years.

Annual Depreciation Expense
(Value of Asset - Salvage Value)
Estimated Useful Life of Asset
$35,000 - 5,000
5 years
= $6,000
Depreciation Rate
Annual Depreciation Expense
(Total Cost of Asset - Salvage Value)
= 0.20 or 20%

This depreciation expense figure means you can claim a $6,000 expense for your truck in the tax year that you bought it and for the next four more or until you sell it.

At any time, or if the rules aren't clear to you, it's recommended that you consult with a tax professional or with your accountant before you claim any business expense or deductible on your income tax. The IRS has the right to audit you for any expense claims, and you can still be asked to pay back taxes even if you made an honest mistake. It's best to have a professional look over your expense claims and tax return before submitting them.

Straight-Line Depreciation Examples

Below are a few examples of calculating depreciation expense using the straight-line method for your small business assets.

Depreciation Expense for a Baker

Let's say you are a baker who bought an industrial-size oven for your growing custom cake business. Using the straight-line method of depreciation, let's calculate your depreciation expense for your big-ticket item. The depreciable cost of the oven, including delivery and installation, is $16,500. You checked online for what most used ovens are selling for and set $2,500 as a reasonable salvage value amount.

Annual Depreciation Expense
(Total Cost of Asset - Salvage Value)
Estimated Useful Life of Asset
$16,500 - $2,500
7 years
= $2,000

Your annual depreciation expense is $2,000. You can claim this amount for seven years or until you decide to sell the oven.

Depreciation Expense for a Freelance Photographer

Let's say you're a freelance photographer who decided to buy a drone camera for aerial photography shoots. Let's calculate your annual depreciation expense for your new toy. After accounting for shipping, you paid a total of $2,200 for the drone. Since you're not sure you can sell the item afterward, you set the salvage as $0.

Annual Depreciation Expense
(Total Cost of Asset - Salvage Value)
Estimated Useful Life of Asset
$2,200 - $0
5 years
= $440

As this equation shows, you can claim $440 as an expense. And since we're using the straight-line method of depreciation calculation, your depreciation schedule will look like this:

First year: $440
Second year: $440
Third year: $440
Fourth year: $440
Fifth year: $440

At the end of the fifth year, your accumulated depreciation would be $2,200 and the value of your asset would be zero.

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