Anyone who has bought a vehicle is already familiar with depreciation. It is an inevitable fact that cars lose 20% of their value in the first year of ownership. After that, they retain only 40% of their original value after five years! Depreciation also applies to other tangible assets that are purchased for your business. 

In this article, we will further discuss asset depreciation, how it works, and how business owners can best absorb these losses of value within their businesses. 

Depreciation and amortization sign in a notebook

What is Depreciation of an Asset?

Asset depreciation refers to the use of an accounting method to allocate the cost of a tangible business asset over its useful life instead of in the period of time it was purchased. This allows the business to earn revenue from the asset immediately since the expense is spread out over time. 

Depreciation is not to be confused with amortization, which is the accounting method used to decrease the cost of the asset over time. Depreciation instead represents the loss in value of the asset over time. The Internal Revenue Service (IRS) stipulates that only certain assets can be depreciated in your accounting practices.

These assets must be owned by you, must have business use or produce income for your business, and have a useful life of more than one year. Types of assets that businesses can depreciate are: 

  • Buildings
  • Computers and other electronics
  • Equipment
  • Machinery
  • Office equipment or office furniture
  • Work vehicles
  • Some intangible assets like patents, computer software, or copyrights

Things that do not wear out or become obsolete would not be included in this list. So, businesses can’t depreciate things like: 

  • Land
  • Collectibles 
  • Investments like stocks, bonds, or crypto
  • Personal property
  • Assets used less than one tax year

Accounting Principles For Depreciation

There are two main principles when it comes to the role of depreciating these assets in a business: 

1. Assets decrease in value over time. If you think about it, tangible assets like computers, hair salon chairs, and real estate all break down over time. The value of an asset decreases over its lifespan. Eventually, they become unusable and can be either salvaged or disposed of.

2. You must allocate the cost of the asset purchase over the useful life of the asset. The useful life refers to the amount of time the asset can be used by the business.

Businesses can use depreciation for both tax and accounting purposes. However, to do so, you must know the difference between depreciation expense and the accumulated depreciation of the asset. When an asset is purchased, the transaction is recorded as a debit to assets on the balance sheet.

In exchange, there is a credit from the cash account or an increase in accounts payable (both of which are on the balance sheet). When that accounting period is over, the accountant will apply depreciation to all capitalized assets, which are all the assets that have not been “expensed” yet.

This is done every accounting period so the asset’s cost can be moved from the balance sheets to income statements. These journal entries will result: 

  • A debit to depreciation expense: This is recorded in the income statement as an expense or debit, reducing net income. Depreciation expense will be a tax depreciation deduction for the asset’s cost, which will reduce income tax. Business expenses of these types are recorded as debits on your taxes rather than credits. To claim depreciation expense on your tax return, you will need to file Form 4562 along with your taxes.

 

  • A credit to accumulated depreciation: This is recorded in a contra-asset account, reducing the value of fixed assets. Accumulated depreciation is the amount that is subtracted from the asset’s value. This will be a credit rather than a debit because the asset is losing value. 

The IRS stipulates that businesses must spread these costs out over time. 

Depreciation Schedule

To keep track of how much long-term assets depreciate over time, businesses use a depreciation schedule. Typically this is presented in a chart or table form to review and compare. Each asset should have its own schedule. However, you can combine the data into another depreciable asset schedule that gives an overview of all your assets at once. 

This data can be collected in a spreadsheet of your own or through a template. Then, during the end of the accounting period, you can transform the data into charts and graphs for easier readability. Each depreciation schedule should include the following: 

  • Asset description
  • Date of purchase
  • Purchase price
  • Estimated useful life
  • The method of depreciation used
  • Salvage value: This is the amount the business could sell it for once it has reached the end of its useful life
  • The current year’s depreciation amount to be deducted 
  • The total depreciation amount till now
  • The present-day net book value of the asset: This will be the total price paid minus any cumulative depreciation

When we depreciate our assets, we must determine the best method to allocate these costs. Since all businesses are different, there are different methods that will work better for each one. Let’s explore how these depreciation methods work so you can find the best method for your business. 

Annual meeting of business colleagues the company

How Does Asset Depreciation Work?

Assets can be depreciated through various methods. We will study each of these methods to see how each one works, and what businesses and assets they will work best for. There are four commonly used depreciation methods for accounting purposes and one method used for tax purposes.

Keep in mind that the amount of depreciation that goes on your books or financial statements may not be equal to the amount deducted in your tax statements. This is why it is not uncommon to have one method for books and another method for taxes. Here are the options for depreciating assets: 

Straight-line Method

What it does: This is the most common depreciation method used for a fixed asset. The value of the asset will be split evenly throughout its useful life. 

Best used for: Small businesses can benefit most from this method, especially since they probably use simple accounting systems that they manage on their own. It is the easiest to understand and manage throughout the number of years of depreciation.

Formula: This formula is calculated by the cost of the asset subtracted by salvage value or residual value (this is the amount you can sell the item for once it’s past its useful life), then divided by its useful life. Like so: 

(Asset cost – Salvage value) / Useful life

The answer will be a fixed cost represented as an accumulated depreciation value. You can deduct this amount each year from the asset’s original cost to find the asset’s current value. 

Example: A business asset purchased for $225,000 with a salvage value of $25,000 and useful life of 4 years, would have a yearly straight-line depreciation value of $50,000. 

Declining Balance/Accelerated Method

What it does: This method is a bit more complicated than the straight-line method because it allows you to write off a larger portion of the asset’s cost in the earlier years of useful life and a smaller portion for later years. 

Best used for: The declining balance depreciation method can be used for businesses that would like to recover more of the value upfront. This can be beneficial for those assets that lose their value quickly after purchase, like work vehicles

Formula: Typically companies will employ the double-declining method that uses a depreciation factor of 2. However, the yearly write-offs for this method can decline by a set depreciation factor of your choosing. The formula is (Depreciation factor x straight-line depreciation rate) multiplied by the book value at the beginning of the year. Like so: 

 (Depreciation factor x Straight-line depreciation rate) x Book value at the beginning of year

In the first year the asset is depreciated, you can compound the depreciation you would get if you used the straight-line method. This could be a depreciation factor of 2 or whatever you choose. The straight-line depreciation rate is found by dividing 100% by the useful life.

After the first year, you will apply the same depreciation rate to the asset’s remaining book value. This means the asset’s original cost minus the amount you’ve written off. Note that salvage value is not taken into account in this method. 

Example: Your business purchases an asset for a book value of $575,000 with a salvage value of $5,000 and useful life of 10 years. You decide you want a 150% accelerated depreciation factor, also expressed as a factor of 1.5. The straight-line depreciation rate calculation would be 100%/10= 10% 

In this case, the calculation would be (1.5 x 10%) $575,000=$86,250 for the first year. For the next year, you would subtract $86,250 from the original book value to get the book value for the second year. You would then plug that number into the same formula.

Units of Production Method

What it does: This method allows you to depreciate equipment based on how much work it does. Unit of production refers to the amount of whatever the equipment creates or the amount of time it is working. 

Best used for: A business that needs a quantifiable way to track the use of its high-value equipment or machinery. Depreciation will be taken more in the years the equipment is more frequently used, and less depreciation when it is not used. This is also a helpful method for reflecting the wear and tear of the equipment. 

Formula: The formula is (asset cost – salvage cost) divided by units produced in its useful life. The depreciation expense is then calculated by multiplying the actual units of production from the year with the units of production rate. The formula goes like so:

(Asset cost – Salvage value) / Units produced in useful life

Example: Let’s take a look at the purchase of a piece of equipment that cost $7,000. It can be salvaged for $700 and is estimated to produce 91,000 units over its useful life of 7 years. To find the units of production rate: ($7,000-$700)/91,000= .069

You would then multiply that by the actual units produced in the first year. The calculation for the equipment’s annual depreciation expense would be (91,000/7) x .069= $897. Depreciation expenses using this method will be a variable cost from year to year. 

Sum-of-the-years’-digits Method

What it does: This method is used to allocate more of the original cost to the earlier years, but not as much as the declining balance method. However, it has a slightly more even distribution. This allows the allocation of a set dollar amount of an asset each year throughout its useful life. 

Best used for: As with the declining balance method, the sum-of-the-years’-digits method is best used when a business wants to recover the asset’s value upfront. 

Formula: The digits for every year of the asset’s useful life will be added together, then divided by the total to get the depreciation percentage. For example, if the useful life is five years, the sum of years digits (SYD) would be added together as follows: 5+4+3+2+1= 15. Then that number is plugged into this formula: 

(Remaining lifespan/SYD) x (Asset cost – Salvage value) 

Example: If a vehicle is $20,000 at the time of purchase and has an estimated $5,000 expenses for future maintenance and repairs, the asset’s total cost would be $25,000. If the useful life is five years and the asset’s salvage value is $2,000, the depreciation expense for the first year would be: (4/15) x ($25,000-$2,000)= $6,133 

Modified Accelerated Cost Recovery System (MACRS)

This is the primary depreciation method used for tax purposes (and sometimes for books and financial statements if you want to keep things simple). Assets are labeled under specific asset classes which will determine the useful life of that asset. 

MACRS should be used by anyone claiming a depreciation expense on their business taxes or rental property taxes. This system is a little more complicated than the previous four methods and should be left to a qualified CPA to handle. But if you are curious, try plugging in your values to this MACRS depreciation calculator to learn more about how it works. 

Properly Absorb Loss of Asset Value

After you’ve received your small business loan to buy equipment, furniture, computers, vehicles, or buildings, you will need to depreciate these assets in your books and tax returns. You can choose one of the depreciation methods we’ve learned about in order to properly absorb the inevitable loss of value that comes from owning intangible assets.