How to Calculate Depreciation for Your Business

Knowing how to calculate depreciation is essential. It allows you to reduce your taxable income to save on taxes owed throughout the year, helping you better manage your finances. This article includes the definition, formulas for the different calculating methods, and more.

What is Depreciation?

Depreciation is an accounting term used to describe the gradual reduction in the value of an asset over time. You can use it to account for the decline in value of an asset due to usage, age, wear and tear, obsolescence, or other factors. Depreciation is a non-cash expense recorded on the business's profit and loss statement but does not involve any cash outflow.

Example of Depreciation

Imagine a company purchases essential equipment for $50,000. The business will record it as an asset on its balance sheet and depreciate the asset over time, reducing its total net value. A year after the purchase, the asset could be worth $40,000–in this case, the company would depreciate assets by $10,000. When the company makes the initial $50,000 purchase, it may lose value quickly or have the asset's value written off over its lifecycle. When the asset is no longer helpful, the company can scrap it and receive the remaining depreciation value, known as the salvage value. Other examples of depreciating assets include:

• vehicles
• furniture
• machinery
• office equipment
• tools
• computer software

What is a Depreciation Schedule?

A depreciation schedule is a document that lists all of a company's assets and their depreciation rates. This document explains the depreciation of each asset over its useful life and includes the following:

• Dates at which the company purchased the assets
• Descriptions for the assets
• Initial price paid for the asset
• The estimated useful life for the assets
• Depreciation methods to calculate it
• Salvage value
• Cumulative depreciation amount
• Depreciation amount deductible for the current year
• Net book value for an asset

How Does Depreciation Works?

Depreciation spreads an asset's total initial cost over its estimated useful life. Businesses can take deductions for the total cost when purchasing property assets. They do this by spreading the cost over several years with depreciation. If you purchase furniture for $5,000 that lasts for ten years, the asset will decrease by 10% annually. This means you could take a yearly deduction of $500 for your company's business tax returns. Are Loans Tax Deductible?

Types and Methods of Depreciation + Formulas

Straight-Line Depreciation

Straight-line depreciation is basically for small businesses with less complex accounting depreciation systems. These businesses may need an official accountant or tax advisor and require a simple way to calculate depreciation. This method determines how much a company can deduct from its annual taxable income. The straight-line depreciation method is the most common and simplest method of depreciation. It gradually reduces an asset's value uniformly until it reaches the salvage value. The formula is:

Annual depreciation expense = (Cost of an asset - salvage value) / Useful life of the asset

Declining Balance Depreciation

Declining balance depreciation is for companies whose assets need additional repairs or maintenance over their useful life. It works by depreciating equipment at a straight-line depreciation percentage and multiplying it by the remaining depreciable amount annually. The formula is:

Declining balance depreciation = (Net book value - Salvage value) x (1 / Useful life) x Depreciation rate

Double Declining Balance (DDB) Depreciation

Double declining balance depreciation is an accelerated depreciation method. You should use it if you want to recover an asset's value upfront because it will lose value over the years. This happens typically due to technical errors and the need for repairs and maintenance. The DDB method takes the reciprocal value of an asset's useful life and doubles it. Then applies the rate to the asset's depreciable base, or book value, for the rest of its useful life. It's similar to the declining balance method but twice as fast. The formula is:

Double Declining Balance = (Net book value - Salvage value) x (2 / Useful life) x Depreciation Rate

Sum-of-the-Years' Digits (SYD) Depreciation

SYD depreciation is best for businesses hoping to recover an asset's value upfront. While similar to double declining balance depreciation, this one is more evenly distributed. This depreciation method is another accelerated method for depreciation. The method begins when an accountant combines all digits for an asset's expected life. If an asset has an expected life of five years, its base would be the sum of numbers one through five–for instance, 1 + 2 + 3 + 4 + 5 = 15. Once combined, the asset depreciates annually. For instance, this method would depreciate 5/15 of the asset's base value in the first depreciation year. In the second year, the method would depreciate 4/15 of the base, and so on. This method continues for the expected lifecycle, devaluing until year five, when 1/15 of the base remains.

Units of Production Depreciation

Companies using this method want more depreciation when the asset uses them more and less during years when the asset does not use them often. This method is generally for high-value and expensive purchases. This method depreciates equipment based on the amount of work it completes. Units of production depreciation refer to either what the asset creates or the hours it is in service at a company. With this method, accountants use the formula to determine the total dollar value in depreciation for the units produced. The formula is:

Units of production depreciation = (Asset cost - Salvage value) / Units produced in useful life

How to Calculate Depreciation

Asset's Cost/Asset Basis

You will need to estimate how long each asset can remain productive throughout its useful life span. Before you can calculate the deprecation costs of each item under consideration, you need to review various factors like:

• expected wear and tear
• any applicable warranty period or service agreement terms

This estimate varies from industry to industry. You need to do efficient research before developing practical assumptions relevant to your business scenario. You can achieve accurate results later on while taking necessary action on the due date of the replacement of that asset.

Useful Life

It's important to estimate its useful life or 'life expectancy.' This figure represents the time that an asset could reasonably remain productive. This will help determine how long it should take for all of its worth (less salvage) to diminish before having a zero book value at end-of-life. Depending on the type of asset, its usage patterns, and economic lifespan characteristics, you may need to use different methods. Some are:

• straight line
• declining balance

Salvage Value

The salvage value describes an asset's estimated value at the end of its useful life. It depends on the expected amount a company anticipates receiving when selling or exchanging its assets when they are no longer helpful. An accountant calculates the depreciation of fixed assets and the asset's total depreciation expense using its:

• cost
• salvage value
• useful life

Choose A Depreciation Method

It is essential to select an appropriate method for your specific situation. The Straight Line Method (SLM) and Declining Balance Method (DBM) are the most popular methods. With SLM, each year's amount remains the same, whereas DBM calculates a larger initial amount than subsequent amounts. Other specialty methods, such as Sum-of-the Years Digits (SYD), may be suitable depending on individual needs such as tax obligations, etc. Now that you've chosen your preferred method, make the relevant calculations to find the depreciation amount for each year.

What is the Difference Between Depreciation Expense and Accumulated Depreciation?

• Depreciation expense is the amount of depreciation deducted from a tax return. Because it is an expense, you can record this depreciation as a debit for tax depreciation.
• Accumulated depreciation describes the total depreciation recorded on individual assets to a specific date. It is the total depreciation recorded for an asset since the company purchased it.

Achieve Financial Success With Camino Financial

Depreciation can help manage expenses and reduce taxable income, but it also requires careful planning and record-keeping. It's essential to ensure you fully understand the implications of doing so and how to apply it correctly. In addition, you may want to consider applying for a business loan to help cover significant investments that may be subject to depreciation. Doing so can provide additional financial security and peace of mind. A business loan can also grant you access to funds that would not otherwise be available. If you are seeking a small business loan, Camino Financial can help you. We offer transparent small business loans with fixed terms to suit your needs. Apply For A Business Loan!