As a business uses its assets, the assets eventually get used up. Businesses track the use of their assets by calculating depreciation expenses. This post will introduce you to depreciation and the various methods that are used to calculate it. Through this post you can learn the very basic [and take practice] the various depreciation methods and learn how to track them within your bookkeeping system.
You probably think of depreciation as something that happens to a new car when you drive it off the lot after purchasing it. All of a sudden it is worth 20 to 30 percent less and it’s called depreciation. Well, for bookkeeping purposes it’s not quite the same thing. Accountants use depreciation to adjust the books based on the aging of a piece of equipment or other asset.
As an asset is used, its useful life is reduced. For example: when you drive a car 15,000 to 20,000 miles a year, you know that eventually it will need more and more repair until finally you decide it’s used up and you want to replace it with something new. That happens to manufacturing machineries and equipments, furniture and fixtures, as well as any other business asset held for more than a year. A company needs to track this use of assets to know the value of what it has and also to estimate repair and replacement costs based on the age of its assets.
Not everything can be depreciated. Any item that you expect to use up in a year is not eligible for depreciation. These types of items are written off as expenses instead. You also don’t depreciate land. Land does not get used up. While you cannot depreciate a building or car you rent or lease, if you do major renovations to a leased property you can depreciate the value of those improvements by capitalizing.
Assets you own that are used for both your business and your personal life can be partially depreciated based on percentage of use. The two most common types of partially depreciated assets for people who own a home business are their car and a portion of their house. For these situations the business owners are primarily looking to take advantage of the tax savings that can be generated by depreciation.
This post focuses on depreciation expenses. Depreciation for tax purposes is an entirely different topic. I will post it separately next time. So keep checking into this blog, or check with your accountant to find out more information about depreciation methods used for tax purposes or read IRS publication 946, “How to Depreciate Property” [irs.gov/publications/p946/index.html].
Figuring Out The Useful Life Of Fixed Asset
The first thing you must determine when you need to calculate the depreciation for an asset is how long that asset will be useful to the company. While you can set up your own table for periods of useful life for types of assets in your business, you will have to justify the lifespan you’ve chosen if it differs from IRS rules. So most businesses use the depreciation recovery periods set up by the IRS, which set an average useful life for business assets as shown below.
Depreciation Recovery Periods for Business Equipment
Property Class Business Equipment
3-year property Tractor units and horses over two years old
5-year property Cars, taxis, buses, trucks, computers,
office machines (faxes, copiers, calculators,
and so on), research equipment and cattle
7-year property Office furniture and fixtures
10-year property Water transportation equipment,
single-purpose agricultural or
horticultural structures, and fruit- or
nut-bearing vines and trees.
15-year property Land improvements, such as shrubbery,
fences, roads, and bridges
Some types of business will use a different depreciation schedule. For example: a rental car business may shorten the useful life of a car from five years (as estimated by the IRS) to two years because its cars are used much more frequently and get used up much quicker than they would in another type of business.
Determining the Cost Basis Of Fixed Asset
The other key factor in calculating depreciation is the cost basis of an asset.
The equation for cost basis is:
= Cost of the fixed asset + Sales tax + Shipping and delivery costs + Installation charges + Other costs [such as commissions or finder’s fees]
- Cost of the fixed asset; is what you paid for that equipment, furniture, building, vehicle, or any other asset you intend to use for more than 12 months
- Sales tax; is the actual taxes you were charged when purchasing that asset.
- Shipping and delivery; includes any charges that you paid to get that asset to your place of business.
- Installation charges; include any charges you paid to get that asset working in your business. That could include new electrical outlets, carpentry work, or any type of work that was needed to install the new asset.
- Other costs include any other costs involved in the purchase of the asset. This can include commissions or finder fees, as well as additional hardware such as wiring or monitors to put a new piece of equipment into operation.
Example: How to calculate the cost basis of a new desk for your office. You bought the desk for $1,500 and paid $90 in taxes. You paid $50 to have it delivered.
Here is how:
Cost basis = $1,500 + $90 + $50 =$1,640
Depreciation Methods That You Can Choose to Depreciate The Fixed Assets
Once you know your assets anticipated life span and its cost basis, you can then calculate how much you should write off for depreciation. Depreciation is not a cash expense. The cash expense happens when you buy the asset or a cash inflow can happen when you sell the asset. Depreciation just shows the use of that asset, so it does not involve the use of cash. I am going to show you how to record depreciation in the boooks after this section.
You actually can choose from four different methods to calculate depreciation — Straight-Line, Sum-of-Years-Digits, Double Declining Balance, and Units of Production. I am going to show you how to calculate each below and then give you a chance to practice.
Straight-line depreciation spreads out the cost of the asset over the entire useful life of an asset. It’s the simplest type of depreciation to calculate.
The formula is:
Annual depreciation expense = [Cost of the asset – Salvage] / Estimated useful life
The salvage value is the value you expect the asset will have when you sell it after you have finished using it for your business. For example, if you buy a car for $25,000 and expect to be able to sell it for $5,000, the salvage value of that car would be $5,000.
Example: How to calculate the annual depreciation expense for a car with a cost basis of $25,000 and a $5,000 salvage value using the IRS recovery period?
Looking at the IRS chart you see that a car has a 5-year lifespan according to the IRS. So you would calculate straight-line depreciation in this way:
($35,000 – $5,000) = $30,000 $30,000/5 = $6,000 annual depreciation expense
Sometimes a business determines that an asset is used up more quickly in the early years, so it decides to use the sum-of-years-digits (SYD) method. This is common for a trucking company when it buys a new truck. The SYD calculation is a three step process:
Step-1. Find the SYD for the current fiscal year using this formula:
N(N + 1) / 2 = SYD (N would be the number of years of useful life).
Note: The SYD would be the same each year of calculation.
Step-2. Find the application fraction using this formula:
N/SYD (N would be the number of years remaining of useful life).
Step-3. Calculate the depreciation expense formula:
(Cost – Salvage value) × Applicable fraction = Depreciation expense.
Calculate the first year of the depreciation expense for a car that had a cost basis of $35,000 and a salvage value of $5,000 using the sum-of-years-digits depreciation method. Assume the IRS recovery period of 5 years.
The answer is:
SYD = 5 (5 + 1) / 2 = 30/2 = 15
Applicable fraction = 5/15 = 1/3
Depreciation expense = ($35,000 – 5,000) × 1/3 = $30,000 × 1/3 = $10,000
Double-declining Balance Method [DB]
Sometimes businesses want to write off an asset even more quickly than they can use the SYD depreciation calculation because they believe the assets lose usefulness faster. In this case they use a method called double-declining balance, which is double the amount of depreciation allowed using straight-line depreciation. You must calculate a depreciation factor the first year you use double-declining depreciation by using this formula:
2 × [1/Estimated useful life] = Depreciation factor
You then multiply that factor by the book value at the beginning of each year. The depreciation factor will be the same for each year of the calculation. Salvage value should not be subtracted from the book value, but once the book value is equal to the salvage value, you can’t depreciate any more.
Example: How to calculate the first year of a car’s depreciation expense using the double-declining balance method?. The cost basis of the car is $35,000 with a salvage value of $5,000. Assume the IRS recovery period of 5 years
The calculation would be 2 × (1/5) = 0.40
Multiply it: $35,000 × 0.40 = $14,000
Units of Production [UOP]
The units of production (UOP) method of deprecation is used primarily in a manufacturing environment and you would not likely need to calculate depreciation expenses manually in that type of environment. Most likely there would be a computer program for calculating depreciation, so I won’t set up a problem to practice this calculation.
In this case the number of units to be produced by the machinery is the key factor that a company wants to track rather than the useful life in years. Rather than calculating a depreciation factor you calculate a UOP rate and then the depreciation expense using this two step process:
To find the UOP rate, use this formula:
[Cost – Salvage value] / Estimated number of units to be produced during the estimated useful life
To find the depreciation expense, use this formula:
Units produced during the year × UOP rate = Depreciation expense
Companies who choose to use this method usually have a wide variation in production levels each year.
Setting Depreciation Schedules
Remembering how much to depreciate for each asset you have in your business can be an overwhelming task. The best way to keep track of what you need to expense each year is to set up a depreciation schedule for each type of asset that lists the date it was put into service, the description of the asset, the cost basis, the recovery period, and the annual depreciation. Below is a sample of this type of schedule:
Depreciation Schedule: Vehicles
Date Put in Description Cost Recovery Annual
Service Period Depreciation
1/5/2006 Black Car $30,000 5 years $5,000
1/1/2007 Blue Truck $25,000 5 years $4,000
Recording Depreciation Expenses
Recording depreciation expenses can be a simple entry into your accounting system. Most businesses do the entry at the end of a quarter or the end of the year when they close the books. After calculating depreciation expense, here is the type of entry you would use for a depreciation expense of $4,000 for a vehicle:
[Debit]. Depreciation Expense = $4,000
[Credit]. Accumulated Depreciation = $4,000
Depreciation expense is a line item on the Income Statement and Accumulated Depreciation is a line item on the Balance Sheet.