How Do I Calculate Depreciation?

How Depreciation is Calculated
How Depreciation is Calculated. Claire Fraser/Getty Images

What is Depreciation?

Depreciation is defined as the value of a business asset over its useful life. How depreciation is calculated determines how much of a depreciation deduction you can take in any one year, so it is important to understand the methods of calculating depreciation.

Here's what happens to an asset over time: Let's say you purchased a piece of computer equipment for your business at a cost of $1000.

The average computer lasts 10 years, so it decreases in value 10% each year. 

It's important to remember that depreciation is just an accounting mechanism to show the expense of using an asset over time. It doesn't have anything to do with how you purchased the item or its real physical condition. 

Most business assets are depreciated, because they decrease in value over time, either through use or through obsolescence. When an asset becomes obsolete, it may be from technology passing it by or from physical wear and tear. 

Land, however, is not depreciated because it does not decrease in value. Some assets have a residual or salvage value at the end of their useful life. This value is not included in the depreciation calculation. 

How Is Depreciation Calculated?

The information needed for calculating depreciation on an asset is:

  • The useful life of the asset. This information is available in tables, based on the type of asset. You will probably need an accountant to tell you the useful life of a specific asset. 
  • Less the salvage value of the asset at the end of its useful life. Like the useful life, the salvage value is determined by a table.
  • Divided by the cost of the asset. The cost of the asset includes all costs for acquiring the asset, like transportation, set-up, and training. 

The resulting value is called the book value of the asset.

 

For example, the annual depreciation on a machine with a useful life of 20 years, a salvage value of $1000 and a cost of $50,000 is $2450 (($50,000-$1,000)/20).

For accounting and tax purposes, the asset must be placed in service (set up and used) in the first year that depreciation is calculated. 

If an asset is purchased in the middle of the year, the annual depreciation expense is divided by the number of months in that year since the purchase. For example, if the asset above was purchased in August, the first year depreciation would be $1021.84 ($2450/12 x 5). Then, the final year's depreciation would be $1429.68 ($2450/12 x 7). 

What Happens When the Asset Reaches its Useful life?

When an asset has been fully depreciated, it is considered to be "off the books" of the company. That doesn't mean the asset isn't still useful, but only that the company cannot take any more depreciation expense on that item. If the item has a salvage value, that value stays on the books until the item is sold or scrapped. 

What are the Different Ways to Calculate Depreciation?

There are several methods used to calculate depreciation. The method described above is called "straight-line" depreciation, in which the amount of of the deduction for depreciation is the same for each year of the life of the asset.

Here are the other two common ways to calculate depreciation:

  • Double Declining Balance
    This method includes an "accelerator," so the asset depreciates more in the beginning of its useful life. This depreciation method is used with cars, for example. You know that a new car depreciates more than an older one.
  • Sum of the Years' Digits
    In this method, the number of years in the useful life are summed. For example, if an asset had a useful life of 6 years, the digits would be added: 6+5+4+3+2+1=21. Then annual depreciation would be determined as follows:
    • Year 1 = 6/21 = 28.6% times the cost (or cost less salvage)
    • Year 2 = 5/21 = 23.8%
    • Year 3 = 4/21 = 19%
    • Year 4 = 3/21 = 14.3%
    • Year 5 = 2/21 = 9.5%
    • Year 6 = 1/21 = 4.8%

Accelerated Depreciation

Favorable tax plans are available to speed up the depreciation process so you can get more tax deductions faster.

These plans come two forms: 

Both of these accelerated depreciation features come with limits and qualifications, so check with your tax professional to see if you qualify. You can also read more about accelerated depreciation in general before you proceed.

How Do I Figure the Useful Life and Salvage Value of an Asset?

The IRS has classifications of assets and has calculated useful life on these classes. You can find a listing of the asset classes in IRS publication 946, or your CPA can help you to find these values and to calculate depreciation on your business assets.

Is Amortization the Same as Depreciation? 

Amortization is used for intangible assets, like intellectual property (copyrights, trademarks, patents). The amortization process differs from the depreciation process. 

Read more about How Depreciation Benefits Your Business

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