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What is depreciation? and how do you calculate it?

Many persons may be wondering what is depreciation and how does it work? The short answer is that it refers to the fall in value of an asset over a particular period of time or during its lifespan. In accountancy, depreciation refers to two aspects of the same concept: first, the actual decrease of fair value of an asset, such as the decrease in value of factory equipment each year as it is used and wears, and second, the allocation in accounting statements of the original cost of the assets to periods in which the assets are used (depreciation with the matching principle).

What is depreciation and how do businesses use it?

Businesses depreciate long-term assets for both accounting and tax purposes. The decrease in value of the asset affects the balance sheet of a business or entity, and the method of depreciating the asset, accounting-wise, affects the net income, and thus the income statement that they report. Generally, the cost is allocated as depreciation expense among the periods in which the asset is expected to be used.

What is depreciation?

Methods of computing depreciation, and the periods over which assets are depreciated, may vary between asset types within the same business and may vary for tax purposes. These may be specified by law or accounting standards, which may vary by country. There are several standard methods of computing depreciation expense, including fixed percentage, straight line, and declining balance methods. Depreciation expense generally begins when the asset is placed in service.

Depreciation as an accounting concept

In determining the net income (profits) from an activity, the receipts from the activity must be reduced by appropriate costs. One such cost is the cost of assets used but not immediately consumed in the activity. Such cost allocated in a given period is equal to the reduction in the value placed on the asset, which is initially equal to the amount paid for the asset and subsequently may or may not be related to the amount expected to be received upon its disposal. Depreciation is any method of allocating such net cost to those periods in which the organization is expected to benefit from the use of the asset

What is an asset?

An asset is anything with a dollar value. The IRS also refers to assets as “property.” It can be either tangible or intangible. A tangible asset can be touched think office building, delivery truck, or computer. An intangible asset can’t be touched but it can still be bought or sold. Examples include a patent, copyright, or other intellectual property. Both tangible and intangible assets can be depreciated. In the case of intangible assets, the act of depreciation is called amortization.

What kind of assets can you depreciate?

The IRS sets guidelines for what types of assets you can depreciate. It needs to meet the following criteria:

  • You own it
  • You use it in your business, or to produce income
  • You can determine its useful life
  • You expect it to last more than one year

Some common examples of assets depreciated by small businesses include:

  • Vehicles
  • Real estate
  • Equipment
  • Office furniture
  • Computers
What is a depreciation schedule?

A depreciation schedule is a table that shows you how much each of your assets will be depreciated over the years. It typically includes the following information:

  • A description of the asset
  • Date of purchase
  • The total price you paid for the asset
  • Expected useful life
  • Depreciation method used
  • Salvage value–how much you can sell it for once it’s past its useful life (e.g., how much a scrapyard would pay for your old work truck)
Types of depreciation

There are several ways to depreciate assets for your books or financial statements, but the IRS only allows one method of taking depreciation on your tax return. As a result, some small businesses use one method for their books and another for taxes, while others choose to keep things simple by using the tax method of depreciation for their books.

Let’s look at the options available for book and tax.

Straight-line depreciation

What it is: The most common (and simplest) way to depreciate a fixed asset is through the straight-line method. This splits the value evenly over the useful life of the asset.

Who it’s for: Small businesses with simple accounting systems, that may not have an accountant or tax advisor to handle their taxes for them.

Formula: (asset cost – salvage value) / useful life

How it works: You divide the cost of an asset, minus its salvage value, over its useful life. That determines how much depreciation you deduct each year.

Example:

Your party business buys a bouncy castle for $10,000. Its salvage value is $500, and the asset has a useful life of 10 years.

We plug those numbers into the equation:

Formula: (asset cost – salvage value) / useful life

(10,000 – 500) / 10 = $950

So, you’ll write off $950 from the bouncy castle’s value each year for 10 years.

Double-declining balance depreciation

What it is: The double-declining balance method is a slightly more complicated way to depreciate an asset. It lets you write off more of an asset’s value in the days immediately after you buy it and less later on.

Who it’s for: Businesses that want to recover more of an asset’s value upfront.

Formula: (2 x straight-line depreciation rate) x (book value at the beginning of the year)

How it works: For this approach, in the first year you depreciate an asset, you take double the amount you’d take under the straight-line method. In subsequent years, you’ll apply that rate of depreciation to the asset’s remaining book value rather than its original cost. Book value is the asset’s cost minus the amount you’ve already written off. The double-declining balance method doesn’t take salvage value into account.

Example:

We’ll use the bouncy castle example for straight-line depreciation above.

Since the asset is depreciated over 10 years, its straight-line depreciation rate is 10%.

In year one of the bouncy castle’s 10-year useful life, the equation looks like this:

Formula: (2 x straight-line depreciation rate) x book value at the beginning of the year

(2 x 0.10) x 10,000 = $2,000

You’ll write off $2,000 of the bouncy castle’s value in year one. Now, the book value of the bouncy castle is $8,000.

So, the equation for year two looks like:

(2 x 0.10) x 8,000 = $1,600

So, even though you wrote off $2,000 in the first year, by the second year, you’re only writing off $1,600. In the final year of depreciating the bouncy castle, you’ll write off just $268. To get a better sense of how this type of depreciation works, you can play around with this double-declining calculator.

Sum-of-the-year’s-digits depreciation

What it is: Sum-of-the-year’s-digits (SYD) depreciation is another method that lets you depreciate more of an asset’s cost in the early years of its useful life and less in the later years.

Who it’s for: Businesses that want to recover more of an asset’s value upfront—but with a slightly more even distribution than the double-declining balance method allows.

Formula: (remaining lifespan / SYD) x (asset cost – salvage value)

How it works: To calculate SYD depreciation, you add up the digits in the asset’s useful life to come up with a fraction that will apply to each year of depreciation. For example, the SYD for an asset with a useful life of five years is 15: 1 + 2 + 3 + 4 + 5 = 15.

You divide the asset’s remaining lifespan by the SYD, then multiply the number by the cost to get your write off for the year. That sounds complicated, but in practice it’s pretty simple, as you’ll see from the example below.

Example:

Sticking with the bouncy castle example, it costs $10,000, has a salvage value of $500, and will depreciate over a 10-year useful life. For the castle’s 10-year useful life, adding up the digits would look like this: 1+2+3+4+5+6+7+8+9+10 = 55

The first year you depreciate using the SYD method, your equation will look like this:

Formula: (remaining lifespan / SYD) x (asset cost – salvage value)

(10 / 55) x (10,000 – 500) = $1,727

So, for your first year, you’ll write off $1,727.

Keep in mind, each year, the bouncy castle’s remaining lifespan is reduced by one, So, in your second year of depreciation, your equation will look like this:

(9/55) x (10,000 – 500) = $1,555

In your last year of depreciation, you’ll write off $173. Play around with this SYD calculator to get a better sense of how it works.

Units of production depreciation

What it is: The units of production method is a simple way to depreciate a piece of equipment based on how much work it does. “Unit of production” can refer to either something the equipment creates–like widgets–or to the hours it’s in service.

Who it’s for: Small businesses writing off equipment with a quantifiable, widely accepted output during its lifespan (e.g., based on the manufacturer’s specifications) who want to take more depreciation in years when they use the asset more and less depreciation when they use the asset less. Because this method requires tracking the use of the equipment, it’s generally only used for high-value equipment or machinery.

Formula: (asset cost – salvage value) / units produced in useful life

How it works: Using the formula above, you figure out the dollar value in depreciation for each unit produced. By adding up all the units produced in one year, you get the amount to write off. Once all of the units have been written off, depreciation of the asset is complete–its useful life is technically over, and you can’t write off any more units.

Example:

Since hours can count as units, let’s stick with the bouncy castle example.

Remember, the bouncy castle costs $10,000 and has a salvage value of $500, so its book value is $9,500.

Let’s say that, according to the manufacturer, the bouncy castle can be used a total of 100,000 hours before its useful life is over. To get the depreciation cost of each hour, we divide the book value over the units of production expected from the asset.

9,500 / 100,000 = 0.095

So that’s an hourly depreciation of $0.095.

In its first year of use, the bouncy castle is bounced upon for a total of 12,000 hours. So our equation would look like this:

What is depreciation?

12,000 x 0.095 = $1,140

We can write off $1,140 of depreciation for the first year.

That number will change each year. Remember, you can write off a total of $9,500, or 100,000 hours. Learn more about this method with the units of depreciation calculator.

Modified accelerated cost recovery system

What it is: The Modified Accelerated Cost Recovery System (MACRS) is the depreciation method generally required on a tax return. Under MACRS, assets are assigned to a specific asset class, and that class determines the asset’s useful life. You can find a detailed table of asset classes in IRS Publication 946, Appendix B.

Who it’s for: Any business or rental property owner that claims depreciation expense on a U.S. federal income tax return.

How it works: Calculating MACRS depreciation is more complicated than calculating any of the book methods of depreciation. IRS Publication 946, Appendix A includes three different tables used to calculate a MACRS depreciation deduction. Rather than try to learn all the intricate details, it’s a good idea to let your tax software or accountant handle the calculations for you. You can also check out this MACRS depreciation calculator.

Thank you for reading this article and as always if you found this information to be informative and educational then please give us a follow and while you are at it why not follow our socials for all our latest blog posts. Have a good one!

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