When your business makes a big spend on something like a vehicle or piece of equipment, your bank account may take quite the hit. If you analyze business health solely be keeping track of your cash, a big purchase can make it look like you had a tough month when, in fact, you were simply investing in your business—a healthy and productive thing to do.
That’s where depreciation comes in. Depreciation helps businesses see the long-term implications of their purchases, rather than just the one-time hit to their cash reserves. It helps businesses plan for when they’ll need to replace those major purchases and monitor the state of their fixed assets.
Already know about depreciation but don’t want to calculate it by hand? Try out our free depreciation calculator. Select the depreciation type you want to use and input the purchase price, salvage value, and useful life to see your results.
For those less familiar, read on to learn what you need to know about depreciation and what the results of these calculations mean to your business.
What is Depreciation?
The rules and processes for properly depreciating an asset in your accounting can be quite complex. So before we get there, let’s examine what depreciation is in its simplest sense.
Depreciation is defined as:
Depreciation: decrease in value due to wear and tear, decay, decline in price, etc.
When you drive a new car off the dealership lot, it begins to lose value immediately. If you were to try to sell the car the next year, you’d expect to sell it for less than you paid. The reason? Because over the course of the year you spent driving it, the car began to decay. There may not be visible rust stains or a cracked windshield, but a year of that car’s expected lifespan has been shaved off nonetheless.
The concept of depreciation simply breaks down how long something like a car is expected to last and spreads the up-front cost of the purchase over that many years. Of course, after the initial payment, no money may is physically changing hands, but your accounting reflects how the value of the asset is changing over time.
We’ll get into how that’s recorded in your books shortly, as well as the different depreciation methods available to you. But first, there are three primary concepts that are important to understand: asset cost, useful life, and salvage value.
Cost of Asset
Depreciation is only calculated on fixed assets, or tangible items that will not be consumed or resold within one year of purchase. If you run a tee shirt business and buy a new screen printing machine, that’s probably a fixed asset that should be depreciated. If, however, you just buy a lot of tee shirts for your staff, you wouldn’t depreciate those since they’ll be worn (consumed) immediately.
If you’re making a purchase that fits the criteria for depreciation, the first step is to take note of its initial cost. How much does that new screen printing machine cost? How much would a new delivery van cost? If you finance a purchase, this is not necessarily how much you’re putting down in up-front payment. Instead, it’s the purchase price of the asset. Knowing the total cost of the asset is the first step to calculating depreciation.
The next step is to analyze how long you expect the asset to last. This is called its useful life. Luckily, the IRS provides quite a bit of guidance here so you don’t have to guess at how long that new delivery van will last. They’ve put together a detailed table of standard useful life timelines. So before inputting your values in the calculator tool, check out Appendix B of this document to find the IRS’s depreciation requirements.
When you estimate the number of years an asset will last (or how long it will serve its purpose), you can start to break down the cost of the asset over that time period.
An asset’s salvage value is the last major component of depreciation. It is the value you can expect to receive for the asset once it’s reached the end of its useful life. Remember the car you purchased above? The salvage value would be the same as trade-in value, or how much the dealer would give you when you sell it back.
Salvage value is also commonly referred to as book value, so you may see those terms used interchangeably. Unfortunately, the IRS doesn’t provide as much guidance here, and it’s up to the small business to set a “reasonable” salvage value for each asset.
Business owners know best what their specific equipment could sell for, but they shouldn’t make those decisions on gut instinct alone. The more accurate your salvage value, the more accurate your financial statements and projections will be. So do your research.
With these three pieces in place—asset cost, useful life, and salvage value—the next step is to determine the right method of depreciation to use.
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Methods of Depreciation
There are a handful of ways that you can depreciate an asset over time. Here, we’ll talk about three of the most commonly used options, but there are more out there that could be explored.
The primary difference between each method is the depreciation rate that’s used each year. Using straight-line depreciation, the asset is depreciated by the same amount each year. However, accelerated methods allow you to depreciate more in the early years and less in the later years. The total depreciation is the same no matter the method, but the accelerated methods are particularly helpful when you’re dealing with assets that lose their value quickly.
The key is to think about the value of the asset at each year of its useful life. Does simply unboxing a new computer cause it to lose a significant amount of its value right away? Or will its value gradually decline?
Understanding the rate that the asset will lose its value will help you and your accountant decide on the best depreciation method for it.
Straight Line Depreciation
Straight-line depreciation is the simplest and most commonly used method. It’s best for those assets that lose their value gradually over time. This method looks at the total depreciation cost and divides it evenly over the useful life of an asset.
The basic formula for calculating your annual depreciation costs using the straight-line method is:
(Asset Cost – Salvage Value) / Useful Life = Depreciation Per Year
Let’s take a piece of furniture as an example. Your office’s new couch cost $1,500, and you expect to keep it for 3 years. At that point, you think you can get $300 for it at resale. Using straight-line depreciation, your depreciation cost would be $400 per year.
($1,500 – $300) / 3 years = $400/year
To test it out on an asset of your own, try our straight line depreciation calculator option to the right.
Declining Balance Depreciation
Things get a little more complicated when we look at the accelerated methods of depreciation, like the declining balance method. Unlike straight-line depreciation where the depreciation amount is the same each year, the depreciation rate is the same each year using declining balance.
To use this method, there’s one more term we need to define.
Net Book Value: Net book value is essentially the same as salvage value. After each year of the asset’s useful life, you will have depreciated it by a certain amount. Once that depreciation has been accounted for, you are left with the net book value, which you will then use to calculate next year’s depreciation amount.
Without getting too deep in the weeds, declining balance works by subtracting the salvage value from the original cost and multiplying that number by the depreciation rate. The depreciation rate is found, in this case, by simply dividing 1 by the useful life. So if the useful life is four years, your depreciation rate will be 25% each year.
This gives you the net book value after the first year.
Next, you’ll multiply that net book value by the depreciation rate again to receive the next year’s depreciation amount. Subtract the depreciation amount from last year’s net book value, and you’ve got the following year’s net book value. And the pattern repeats.
For each year of the useful life, you’ll multiply the net book value by the depreciation rate, subtract that value, and on it goes.
The primary benefit of the declining method is that you can accelerate the speed of depreciation as needed. If your asset will lose its value even more rapidly than 25% per year over four years, for example, you can double the speed at which it will lose value. This is called the double-declining balance method.
The declining method is a flexible option that can help you better approximate the true loss of value that’s occurring over time.
Sum of Years’ Digits Depreciation
Next up is the sum of years’ digits method, which is also an accelerated method. This method gets its name from how the depreciation rate is calculated—by adding together the useful life’s years. It’s similar to the declining balance method in that the depreciation amounts are higher in earlier years. However, in this method both the depreciation amount and the depreciation rate change depending on the year.
Let’s assume that you’ve purchased a new piece of equipment that will last seven years. The first step to figuring out the depreciation rate is to add up all the digits in the number seven.
7 + 6 + 5 + 4 + 3 + 2 + 1 = 28
Next, you’ll divide each year’s digit by the sum. In other words, the depreciation rate in the first year will be 7 divided by 28, which equals 25%
In year two, you’ll divide 6 by 28, which equals 21.4%. You’ll continue the pattern to find the rate of depreciation for each year of the useful life.
Then, you’ll multiply that rate by the residual value of the asset each year, or the net book value. This will give you the depreciation amount each year.
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Creating a Depreciation Schedule
As a business, you might have several different assets using different depreciation methods. A depreciation schedule is the key to keeping all of the math straight.
A depreciation schedule is simply a table that lists each asset you’re currently depreciating, which depreciation method you’re using, the salvage value, this year’s depreciation amount, how much you’ve depreciated in total, and how much value is left.
When you start to see all your depreciating assets side by side, you begin to see the impact that depreciation can have on your books. While it’s a theoretical concept at heart, understanding depreciation and accounting for it properly, will give you greater insight into the health of your business.
Ready to start depreciating your assets? Give the depreciation calculator a try and see how each method impacts the depreciation amount, depreciation rate, and speed of depreciation.
Want to talk with a ScaleFactor expert about the next steps you can take to get your books in order? Request a demonstration today.
Insert the beginning cost of your asset, the expected salvage value, and its expected useful lifespan. Then, select the depreciation method you want to employ.