What is Depreciation and How to Calculate Depreciation Expense?

What is depreciation? For small business owners, knowing the depreciation definition and how to calculate depreciation is an important part of understanding their business’ accounting. Depreciation is fairly straightforward once you break it down. You probably know a car starts to lose value as soon as you drive it off the lot. Assets purchased for your business do the same. That may not sound like a good thing, but depreciation can actually save you money at tax time.

Depreciation is an asset’s reduction in value over time from wear and tear, discontinuance, or other factors. It’s a concept that plays a pivotal role in bookkeeping, tax, and overall decision-making for small business owners. 

Regularly updating and maintaining depreciation schedules provides an accurate picture of the business’s assets and their diminishing values over time. This information is valuable for stakeholders, including investors, creditors, and tax authorities, in assessing the financial health and performance of the business.

We’ll walk you through the basics of depreciation, including how to calculate depreciation in five different ways, and how understanding depreciation can help with financial planning.

What is depreciation and why is it important? 

We shard the basic depreciation definition and why it’s important for business owners above. Now, let’s dig into some of the finer details.

In summary, assets purchased for your business, like machinery or office equipment, lose value over time. Depreciation is a practice that businesses commonly use to spread the cost of those assets out over their useful lives. This allows businesses to reduce their total taxable income and, as a result, their tax liability each year.

Instead of deducting the entire expense of an asset in one tax year, the Internal Revenue Service (IRS) allows you to use the loss of value as a write-off on your business taxes over the course of a few years, depending on the asset’s useful life.

Need hands-on guidance? Get help with your small business taxes from the team at Block Advisors.

Different assets are sorted into different classes. Each depreciation class has its own useful life. In some instances it’s possible to take the entire deduction in the first year under Section 179 of the Internal Revenue Code, but you’ll only get those tax benefits once.

Finally, it’s important to note that the depreciation method used for financial reporting will be different than the method used for tax reporting. In this article we will mainly be discussing the methods used for tax reporting unless stated otherwise.

Accurate financial reporting

Depreciation is an important accounting concept that affects a company’s financial statement. Instead of showing a significant expense in the year an asset is purchased, spreading the cost over its useful life via depreciation aligns expenses with the revenue generated from using that asset. This process is called capitalization. This approach provides a truer reflection of a company’s profitability. It shows a more accurate depiction of a business’s income and expenses over a specific period.

Tax implications

Depreciation also plays a key role in tax calculations. Small businesses can lower their tax liabilities by reducing their taxable income through a depreciation expense. Lower taxes mean more cash on hand for payroll, growth, research, development, or even routine operations.

Asset management

Asset replacement and future planning is a process that focuses on how and when a business replaces aging or outdated assets with newer and more efficient ones. It takes into account the business’ future needs and goals and involves carefully assessing current assets, their performance, and potential replacements. This process ensures your business has the tools and resources it needs to achieve its objectives and stay competitive in the long run.

Loan and investment decisions

Depreciation is a non-cash expense. This means that it does not directly affect cash flows but it does impact net income. Lenders may consider the impact of depreciation on your net income to analyze and make financial decisions like loan approvals.

On the other hand, investors use depreciation to determine the actual value of assets. This allows them to assess the company’s overall performance. Accurate depreciation figures may positively influence the confidence of financial stakeholders.

Regulatory requirements

Depreciation may help you adhere to established bookkeeping standards and IRS regulations. Moreover, maintaining accurate and transparent records not only ensures regulatory compliance but also cultivates trust, reinforcing your status as a respected business within the community.

Depreciable assets 

Depreciation is all about assets, so what is an asset? An asset is anything with a dollar value that a company uses to run its business. Assets you can depreciate are called “capital assets,” sometimes referred to as “property” by the IRS. These assets also must be tangible assets. Intangible assets, like a patent or intellectual property, are expensed by a process called amortization, not by depreciation.

The IRS has certain guidelines for what a business can and cannot depreciate. The asset must meet the following criteria:

• It must be owned by you.
• It must be used for business purposes.
• Its useful life must be longer than a year.
• It must have a determinable useful life.

Common examples of depreciable business assets include:

• Buildings (but not the land itself)
• Furniture
• Machinery
• Office equipment
• Business vehicles

Which assets cannot be depreciated?

• Collectibles
• Current assets, such as bank accounts and inventory
• Investments
• Land
• Personal property
• Intangibles, such as a patent

Depreciation factors to know

Different inputs for calculating depreciation (or determining the value reduction for an asset) exist and should be used in different cases. Here are common ones:

Useful life:

This explains how long you will use the asset.

Salvage value:

The amount for which the asset can be sold at the end of its useful life. In most cases, it’s zero.

Depreciable base:

Over its useful life, an asset’s total cost can depreciate. Depreciable basis can be calculated by subtracting the asset’s cost from its salvage value. The depreciable base can be calculated with this equation: 

Cost of the asset – salvage value = depreciable base

Depreciation schedules: Calculating depreciation

You may be wondering, “What is a depreciation schedule?” Depreciation schedules show how the value of assets decreases over their useful lives. The value of an asset depreciates over time due to wear and tear, obsolescence, etc. This schedule is crucial for businesses as it helps in accurate financial reporting, tax planning, and asset management.

Before we examine the depreciation formulat, let’s go over what a typical depreciation schedule includes:

1. Asset information: Information about the asset, like its description, purchase date, cost, salvage value, and depreciation method (like straight line, double declining balance, etc.).

2. Usable life: Usable life answers how long an asset is expected to generate revenue or provide value to the business. Asset types, industry standards, and company estimations can all affect this.

3. Depreciation method: There are several ways to calculate depreciation, each with its own formula. The most common method is straight-line depreciation, which disperses the asset’s cost evenly over its useful life. Another method is accelerated depreciation, which front-loads more depreciation in the early years.

4. Annual depreciation expense: The yearly depreciation expense for each asset’s useful life is based on the chosen method. These figures reflect the decreasing value of the asset in financial statements.

5. Depreciation accumulated over time: This is the total depreciation expense accumulated over the years since the asset was acquired. It represents the total amount of depreciation charged to date.

6. Book value: It’s the asset’s original cost minus accumulated depreciation. On the balance sheet, it represents the remaining value of the asset.

How to calculate depreciation

You can deduct the cost of purchases used to generate income over a set period of time. To do this, you’ll need to determine the applicable depreciation schedule for the asset using the depreciation formula.

First, identify the property category. Assets are usually categorized based on how long they are depreciated. 

The three most common depreciation categories for tax purposes are:

• Three-year property – for example, certain livestock, manufacturing tools, and over-the-road tractor units 
• Five-year property – for example, office equipment, computers, vehicles, and construction assets 
• Seven-year property – for example, appliances, office furniture, and property that hasn’t been categorized 

You can also depreciate real property, like a building, if you use it for business purposes or if it generates income for you. In the case of residential rental property, the depreciable life is 27.5 years. The depreciable life of commercial rental real estate and buildings used for trade or business is 39 years. Remember, the land itself is not depreciable. However, you can depreciate land improvements and buildings on the land.

Common financial reporting depreciation schedules for financial accounting

After identifying each asset’s category, next choose the appropriate depreciation schedule. Below we share some common types of depreciation used in financial reporting.

Straight-line depreciation method

This is the most common and simplest method for calculating depreciation. This method splits the value evenly over the useful life of the asset and tells you how much you can deduct each year. The formula divides the depreciable base by its useful life. The depreciable base is simply the original cost of the asset minus its salvage value at the end of its useful life.

For example, let’s say your business bought a new piece of equipment for $10,000. Its salvage value is $500 and useful life is 10 years. The equation would look like this:

Yearly Depreciation = Depreciable Base / Useful Life = (Asset Cost – Salvage Value) / Useful Life = ($10,000 – $500) / 10 = $950/year.

According to the formula above, you’ll be able to write off $950 as a depreciable expense for this asset each year over its 10 year useful life.

Double-declining balance (DDB) method

The double-declining balance depreciation is a bit more complicated. However, some businesses prefer it because it allows them to write off more of an asset’s value in the days immediately after purchase. The DDB method accelerates depreciation. It is often best for businesses that want to recover more of an asset’s value upfront. Sometimes this is ideal if the asset loses value quickly in the first few years of its useful life.

But where does the “double” come into play with this method? In the first year your business depreciates an asset using the DDB method, you’ll take double the amount under the straight-line method. Then, over subsequent years, you’ll apply the rate of depreciation to the asset’s current book value rather than the original cost. Book value is the asset’s cost minus what you’ve already written off. The formula looks like this:

(2 x straight-line depreciation rate) x (book value at the beginning of the year)

Using our same example from above, since the asset depreciated over 10 years its straight-line depreciation rate is 10%.

The equation for the first year would look like this: (2 x 0.10) x ($10,000) = $2,000.

In year one, you can write off $2,000. However, that reduces the book value of the asset to $8,000.

The equation for the second year would look like this: (2 x 0.10) x ($8,000) = $1,600.

As you can see, the book value will decrease each year. This in turn reduces that depreciation amount year after year.

Sum-of-the-years’ digits (SYD) method

Like the DDB method, this option also lets businesses depreciate more of an asset’s cost in the early years. Businesses that want to recover more of the value upfront but with more distribution than the DDB method, tend to choose the SYD method. For the SYD method, you have to add up the digits in the asset’s useful life to get a fraction that applies to each year of depreciation.

The formula is: (remaining lifespan / SYD) x (depreciable base).

Let’s look at an example. Your business just purchased an asset for $50,000. Its salvage value is $5,000 and its useful life is five years.

First, calculate the sum-of-the-years’ digits. Add the digits of the useful life span of the asset. In this example, it looks like this: SYD = 1+2+3+4+5 = 15.

Then plug the SYD into the formula above for your first year: (5/15) x ($45,000) = $15,000

In the first year, you can write off $15,000. Year two will look different, since each year the remaining lifespan is reduced by one.

In the second year, you can write off: (4/15) x ($45,000) = $12,000

$12,000 is what you can deduct in year two. At the end of the five years, the total depreciation will add up to $45,000, which matches the original depreciable base.

Units of production depreciation

This method is a simple way to calculate the depreciation of a piece of equipment based on how many units are produced in a particular year. Many manufacturing companies use this method. It can be a useful option for companies with large production variations year-to-year. Businesses that want to write off equipment with a quantifiable output and take more depreciation in years when the asset is used more and less depreciation when they asset is used less may prefer this method. But, it’s generally used for high-value equipment and machinery.

The formula for the units of production method is: (units produced in a period / total estimated units) x (depreciable base).

For example, your business bought machinery for $100,000. Its salvage value is $10,000 and its useful life is 5 years. The machinery is expected to produce 50,000 units over its life. In year one, assume the machine produces 10,000 units.

The formula is: (10,000 / 50,000) x ($100,000-$10,000) = (1/5) x ($90,000) = $18,000

In the first year, your business can track $18,000 of depreciable expense for this piece of machinery.

Common tax reporting depreciation schedules

Here are the common schedules used when determining depreciation for tax purposes.

Modified accelerated cost recovery system (MACRS)

The modified accelerated cost recovery system is the method that is generally used on a U.S. tax return. With the MACRS, assets are assigned a specific asset class which determines the asset’s useful life. The full table of asset classes and tax depreciation method for each asset your business owns can be found in IRS Publication 946.

Section 179 depreciation

In addition to determining annual depreciation deductions, you need to consider whether you claimed bonus depreciation or Section 179 deductions in the year the asset was installed (as discussed below). Also account for the total amount of regular depreciation deductions you were allowed in the past year. 

There are special rules for business-use vehicles, including cars, vans, and SUVs. This is if you deduct actual vehicle expenses instead of the standard mileage rate. The maximum deduction depends on when you place the vehicle in service and whether you include bonus depreciation.

Bonus depreciation and Section 179 might also apply to assets you’re putting in service this year. Look at Form 4562 to better understand depreciation and amortization, what qualifies for bonus depreciation, and which deductions are relevant.

Depreciation expense vs. accumulated depreciation

Depreciation expense

This is the cost of an asset depreciated over a single period. It shows how much of the asset’s value has been used up in that time period. Depreciation expense is a tax deduction that you can usually claim on your tax return. Since it’s an expense, you record it as a debit on your ledger for financial accounting purposes. 

Accumulated depreciation

This is the sum of all the depreciation expenses you’ve allocated to an asset since it was purchased and put into use. You calculate accumulated depreciation by subtracting the asset’s current book value from its original value.

In financial accounting accumulated depreciation is called a “contra account” because it has a balance opposite that of the standard account classification. As mentioned above, your asset’s book value is the purchase price minus accumulated depreciation. Since it reduces the asset’s value, accumulated depreciation is a credit. Assets have a normal debit balance to further show the reverse impact of contra assets.

Reporting depreciation on your business tax return 

To calculate depreciation deductions on your tax return, you’ll use IRS Form 4562 Depreciation and Amortization. You’ll also use this form to claim a Section 179 deduction or bonus depreciation.

Get hands-on tax guidance with tax depreciation

In review, there are several ways to calculate depreciation. Whether or not you’re doing the number crunching yourself, understanding depreciation is important as a small business owner. If you don’t want to calculate depreciation yourself, Block Advisors’ accountants can help.

Get back to doing what you love and let our experts lighten your load, in person or virtually, year-round – as always – backed up by the Block Advisors guarantees. Our taxes, bookkeeping, payroll, and incorporation services are designed with small business owners like you in mind.

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This article is for informational purposes only. The content may not constitute the most up-to-date information and should not be construed as legal advice.