When you buy a tangible asset, its value decreases over time. Some decrease more quickly than others. This is something you'll probably come to realize when you try to re-sell the item—in most cases, you won't get the same price you originally paid. This is called depreciation. If you run a business, you can claim the value of depreciation of an asset as a tax deduction. Here are the basics of depreciation and the best way to calculate this value for tax purposes.
Key Takeaways
- Depreciation refers to how much of an asset's value is left over the course of time.
- Businesses can recover the cost of an eligible asset by writing off the expense over the course of its useful life.
- The straight-line method is the simplest and most commonly used way to calculate depreciation under generally accepted accounting principles.
- To calculate depreciation using the straight-line method, subtract the salvage value from the asset's purchase price, then divide that figure by the projected useful life of the asset.
What Is Depreciation?
Depreciation is an accounting practice used to spread the cost of a tangibleasset, such as a vehicle, piece of equipment, or property, over its useful life. It represents how much of the asset's value has been used up in any given time period.
If you purchase a vehicle, it immediately depreciates or loses value once it leaves the lot. It loses a certain percentage of that remaining value over time because of how it's driven, its condition, and other factors.
Depreciation is a tax-deductible business expense. It offers businesses a way to recover the cost of an eligible asset by writing off the expense over the course of its useful life. A business can expect a big impact on its profits if it doesn't account for the depreciation of its assets.
Not accounting for the depreciation of assets can have a significant impact on the profits of a business.
Depreciation Methods
A company has several different options available under generally accepted accounting principles (GAAP) to calculate how much an asset depreciates:
- Declining balance: Larger depreciation expenses are recorded during the earlier years of an asset’s life, while smaller expenses are accounted for in its later years.
- Double-declining: Using this method means that assets depreciate twice as fast as the traditional declining balance method. It also accounts for larger depreciation expenses during the earlier years of an asset’s life and smaller ones in its later years.
- Sum-of-the-years’ digits: To calculate depreciation using this method, the asset's expected life is added together. Each year is then divided by that figure, starting with the higher number in the first year.
- Units of production: Companies benefit from greater deductions when they use this method. That's because the value of an asset is related to the number of units it produces rather than how many years it's used.
- Straight-line method: This is the most commonly used method for calculating depreciation. To calculate the value, the difference between the asset's cost and the expectedsalvage value is divided by the total number of years a company expects to use it.
The Straight-Line Method
As mentioned above, the straight-line method or straight-line basis is the most commonly used method to calculate depreciation under GAAP. This method is also the simplest way to calculate depreciation. It results in fewer errors, is the most consistent, and transitions well from company-prepared statements to tax returns.
How the Straight-Line Method Is Calculated
Depreciation using the straight-line method reflects the consumption of the asset over time and is calculated by subtracting the salvage value from the asset's purchase price. That figure is then divided by the projected useful life of the asset.
Example
Here's an example. Say a catering company purchases a delivery van for $35,000. The expected salvage value is $10,000 and the company expects to use the van for five years. By using the formula for the straight-line method, the annual depreciation is calculated as:
($35,000 - 10,000) ÷ 5 = $5,000.
This means the van depreciates at a rate of $5,000 per year for the next five years.
In the event the asset is purchased on a date other than the beginning of the year, the straight-line method formula is multiplied by the fraction of months remaining in the year of purchase. Using the example above, if the van was purchased on October 1, depreciation is calculated as:
(3 months / 12 months) x {($35,000 - 10,000) / 5} = $1,250.
In the first year, the catering company writes off $1,250.
Advisor Insight
Morris Armstrong, Enrolled Agent
Armstrong Financial Strategies, Cheshire, Conn.
The "best method" is the one appropriate for your business and situation. That may sound snarky, but I don’t intend it to be. I just mean that sometimes people want to write something off as quickly as possible, even if they do not have the annual income to warrant it. So they accelerate the deduction schedule, only to realize later on that they would have been better off taking the depreciation at a slower, more consistent pace.
That is why, if given the choice, you should run the various depreciation-calculation scenarios through the tax program with an eye not only on the current return but on returns down the road, and the condition of your company in future years as well.
What Is an Example of Depreciation?
Most physical assets depreciate in value as they are consumed. If, for example, you buy a piece of machinery for your company, it will likely be worth less once the opportunity to trade it in for a refund expires and gradually decline in value from there onwards as it gets used and wears down. Depreciation allows a business to spread out the cost of this machinery on its books over several years.
How Is Depreciation Calculated?
There are several different depreciation methods and each has its own calculation. The most common method is the straight-line method, which basically involves expensing the same amount for each accounting period. The straight-line method is calculated by subtracting the salvage value from the asset's purchase price and then dividing the resulting figure by the projected useful life of the asset.
What Is the Benefit of Depreciation?
Depreciationenables companies to lower their tax bill and spread out the cost of expensive assets over time rather than taking a big financial hit in one year.
When Is the Straight-Line Method Not Useful?
A straight-line basis assumes that an asset's value declines at a steady and unchanging rate. If this isn't the case, which it sometimes won't be, a different method should be used.
Should All Assets Be Depreciated?
Depreciation is generally reserved for assets that are expensive and regularly used. If an asset didn’t cost much, it makes little sense to depreciate it.
The Bottom Line
There is no one best method of calculating depreciation for tax reporting purposes. Each approach has its merits and may be the most suitable for a specific asset and situation. That said, in most cases, the straight-line method is the go-to option. It is the simplest and most consistent way to calculate depreciation and is the logical choice when dealing with an asset whose value decreases steadily over time at around the same rate.
