If you are a business owner, then you know that equipment depreciation is an important part of your financial planning. This deduction can help offset the cost of new equipment and keep your business running smoothly. An added benefit is that businesses can claim a federal tax deduction for machinery and equipment depreciation. But how does equipment depreciation work, and how is it calculated?
What Is Equipment Depreciation?
Depreciation is an essential factor to consider when purchasing new or used equipment. It is a method of allocating acquisition, installation, and maintenance costs over the equipment’s estimated useful life. The depreciation allows a company to account for the wear and tear on its equipment and to plan for the replacement of that equipment in the future. The assumption is that the benefits of the equipment will be realized during its useful life.
The useful life of a piece of equipment is the amount of time that it can be used for its intended purpose. For example, a computer has a shorter useful life than an office chair because technology changes so rapidly.
What Equipment Can You Depreciate?
According to the IRS, you can depreciate equipment if it meets the following criteria:
- You own the equipment and use it in your business or produce an income with it.
- You can determine the equipment’s useful life.
- You expect the equipment to last over a year.
What Is the Depreciation Rate?
The depreciation rate is the amount of the equipment’s cost that will be deducted each year. The rate is usually a percentage, and it is based on the useful life of the equipment. For example, if you have a piece of equipment with a useful life of five years, then the depreciation rate would be 20%.
How Many Years Do You Depreciate Equipment?
The most common non-real estate assets and the designated number of years over which they can be depreciated are as follows:
- Three years: Tractors, certain manufacturing tools, some livestock.
- Five years: Computers, office equipment, cars, light trucks, construction assets.
- Seven years: Office furniture and appliances.
Setting Up a Depreciation Schedule
A depreciation schedule is a table that lists the amount of depreciation expense that a company can claim for each year of an asset’s useful life. The schedule is used to calculate the tax deduction that the company can take for the asset. It also acts as a guide for stakeholders, so they know when to expect to replace assets.
To create a depreciation schedule, you will need to determine the following:
- The purchase price of the asset
- The salvage value of the asset
- The useful life of the asset
- The depreciation method to be used
Once you have this information, you can use a depreciation schedule calculator to determine the amount of depreciation expense for each year.
Commonly Used Depreciation Calculations
There are four methods commonly used to calculate depreciation on equipment: straight-line, declining balance, units of production, and sum-of-the-years’-digits. The choice of depreciation method will affect the amount of depreciation expense reported on the income statement and the book value of the equipment on the balance sheet.
- Straight-line depreciation is the simplest and most commonly used method. It allocates an equal amount of the equipment’s cost to each year of its useful life. The straight-line method results in a higher depreciation expense in the early years and a lower expense in the later years. This formula is asset cost – salvage value (this is the amount you can sell the item for once it’s past its useful life), divided by its useful life.
- The declining balance method allocates a larger portion of the cost in the earlier years of the equipment’s life and a smaller portion to later. The formula is (2 x straight-line depreciation rate) x book value at the beginning of the year.
This method is best for businesses looking to recover more of an asset’s upfront value since it loses value quicker in the first few years of ownership.
- Units of production depreciation allocates the cost of the equipment based on how much it is used. This depreciation calculation is for small businesses who want to take more depreciation in years when they use the asset more often. The formula is (asset cost – salvage cost)/units produced in useful life.
- The sum-of-the-years’-digits method allocates more of the cost to the earlier years, but not as much as the declining balance. The formula is (remaining lifespan/sum-of-the-year’s digits or SYD) x (asset cost – salvage value).
The choice of depreciation method is a matter of judgment and depends on many factors, including the purpose of the financial statements, tax considerations, and management’s preference. While depreciation can be a complex topic, by understanding the basics of depreciation, you can make sure that you’re properly accounting for the value of your equipment.
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