An Overview of Depreciation
A typical business will need to purchase many different types of supplies, equipment, and buildings to start or grow their business. If the business makes a significantly large purchase, say a building or heavy machinery, the purchase would most likely be considered an asset. This purchase will usually sit on the Balance Sheet as an asset and therefore not be reflected on your Income Statement as an expense.
Since, over time, most assets will decrease in value they are considered to have a useful life for a finite amount of time. Depreciation is the way for a business to move some of the value of the asset from the Balance Sheet and expense it on the Income Statement, thus allowing the business to potentially have a lower taxable income.
Before we look at the different types of depreciation it is important to understand what can and cannot be depreciated. As mentioned above, only assets can be depreciated. If a business purchased some office supplies for $100 the accountant would most likely expense the purchase. However, if a business purchased a large asset, such as a truck for $100,000, then it would be considered an asset and be eligible to be depreciated.
Only assets that have a finite amount of useful life can be depreciated. Land, for instance, is an asset, however its useful life does not run out, therefore it cannot be depreciated.
Once an asset has been fully depreciated, it can remain in use by the company, but the company cannot claim any additional depreciation. Likewise, if the asset is sold after it has been partially or fully depreciated the business must take that into consideration as you may have experienced a capital gain.
There are two major ways that you can calculate depreciation: Straight Line and Accelerated. Once you choose one method of depreciation you cannot switch to another method for that same asset. However, you generally can choose a different method for other types of assets.
In order to calculate the depreciation, regardless of method, you need three pieces of data: the initial cost of the asset, the useful life of the asset, and the salvage value. The IRS gives guidelines on what it considers the useful life on certain types of assets. Below are some examples of the useful lives for popular assets. A full listing can be found with the IRS on their website.
Three Years: Light assets such as tools and light farm equipment;
Five Years: Light construction equipment, vehicles, and office equipment including computers;
Seven Years: Office furniture including appliances;
Thirty Nine Years: Commercial buildings and facilities.
Below is an overview of each of these two types of depreciation.
Straight Line Depreciation
Of the two methods, this is the easiest to calculate as the amount that is depreciated is reduced at an equal rate for the entire useful life of the asset. The formula for the Straight Line Depreciation is:
(purchase price - salvage value) / total useful life
As an example, a company purchased a set of computers for the office that totals $20,000. Using the formula the purchase price would be $20,000. The salvage value is how much the asset is worth at the end of its useful life. In this case, the company determines that the computers would be worth $2,000 at the end of its useful life. Based on the useful life table above, we know that its useful life is considered five years.
Here is our calculation for depreciation:
($20,000 - $2,000) / 5 = $3,600
This means the company can expense $3,600 worth of depreciation each of the next five years.
This method is called “accelerated” because it allows the company to take a higher depreciation in the earlier years of the asset. This may be beneficial from a tax standpoint in that by having a higher depreciation expense the company would be able to lower their taxable income and thus pay fewer taxes in the early years of the business where cash needs to be saved.
There are two main methods for calculating accelerated depreciation: Declining Balance and Sum of the Year’s Digits .
The formula for Declining Balance is:
(2 / # of useful life years) x (purchase price - accumulated depreciation)
Using our example from above, we calculate how much the computers would be depreciated for each year using this method. We know the useful life years and the purchase price. The accumulated depreciation is simply the sum of the amount of depreciation that has already been depreciated. The number for the first year would be $0. The second year would be the total depreciation for the first year, and so on.
Here is our calculation for depreciation:
The 1st year: (2 / 5) x ($20,000 - $0) = $8,000 (The computers are now worth $12,000)
The 2nd year: (2 / 5) x ($20,000 - $8,000) = $4,800 (Now worth $7,200)
The 3rd year: (2 / 5) x ($20,000 - $12,800) = $2,880 (Now worth $4,320)
The 4th year: (2 / 5) x ($20,000 - $15,680) = $1,728 (Now worth $2,592)
The 5th year: (2 / 5) x ($20,000 - $17,408) = $1,037 (Now worth $1,555)
This method will let you know the amount to be deducted as depreciation for each year. However, the value of the asset at the end of its useful life cannot be worth less than the salvage value of $2,000. In the example above in the 5th year you can only depreciate $1,037 less the difference between $2,000 and $1,555. So the 5th year depreciation would be $1,037 - $445 = $592.
The formula for Sum of the Year’s Digits is:
((# of useful life years - the year number + 1) / n! ) x (purchase price - salvage value)
Using our example from above we will calculate how much the computers would be depreciated using the Sum of the Year’s Digits. We know the number of useful life years, the purchase price, and the salvage value. The year number is just the number of the year that the life of the asset is currently in. If you are in year 2, then the year number would be 2. The “n!” is the sum of all of the years together. So, in our example the computers will last 5 years so the sum of each of the years would be 15 (1+2+3+4+5=15).
Here is our calculation:
The 1st year: ((5 - 1 + 1) / 15) x ($20,000 - $2,000) = $6,000 (It is now worth $14,000)
The 2nd year: ((5 - 2 + 1) / 15) x ($20,000 - $2,000) = $4,800 (Now worth $9,200)
The 3rd year: ((5 - 3 + 1) / 15) x ($20,000 - $2,000) = $3,600 (Now worth $5,600)
The 4th year: ((5 - 4 + 1) / 15) x ($20,000 - $2,000) = $2,400 (Now worth $3,200)
The 5th year: ((5 - 5 + 1) / 15) x ($20,000 - $2,000) = $1,200 (Now worth $2,000)
This is an overview of the two major types of depreciation. It is advisable to consult with your accountant to determine the appropriate types of depreciation to take based on your company’s situation.