Depreciation: What Is It and How Is It Calculated?

What Is Depreciation?

Depreciation is a way to allocate the cost of an asset over its useful life. Basically, when you buy something, it loses value over time due to use, wear and tear, and simply because it becomes outdated. While there might be nothing wrong with your iPhone 11, depreciation is the reason you can barely get $100 for it even though you bought it for $700 a few years ago.

Buildings, equipment, and computers aren’t the only things that depreciate. Your intangible assets like patents, copyrights, and software can all depreciate, too.

Depreciation can save your net income when it comes to the assets your business needs. For example, if you’re in the trucking business and need a big ol’ $150,000 truck to operate, you know you’re not going to recoup that cost for years to come—and depreciation understands that, too. 

That’s why depreciation empowers you to expense the value of your asset over the life of its usefulness. Thanks to this method, you’re not going to suffer an annual loss every time you make a major investment in your business—which is a huge perk when you’re trying to get a bank or alternative lender to loan you some cash.

What Assets Depreciate?

According to the IRS’s Publication 946, vehicles, machinery, heavy equipment, computers and office equipment, and real estate (excluding land) are all depreciable assets. In addition, assets must meet the following requirements:

1. You must own the asset.
2. You must use the asset for business- or income-producing activities. 
3. Your asset must have a determinable useful life.
4. Your asset must be expected to last at least 1 year.

In certain scenarios, even intangible assets like patents, copyrights, and software can be listed as depreciable.

How Depreciation Can Help Your Business

As a business owner, you’ll inevitably take out a loan or front the costs to acquire specific items for your business. Whether that’s a fleet vehicle, a new piece of specialized equipment, or some other asset doesn’t matter. Whatever you purchase will likely lose its value over time. Instead of deducting the total amount of the purchase up front as an expense, depreciation allows you to recover the cost of the property over the course of its life. That means you can make some of the money you spent on it back each time you file your taxes—or at least reduce the amount of your taxable income, which boosts your tax savings.

Here are a few fantastic advantages that will make depreciation your business’s best friend:

Tax Savings

Several business expenses are tax-deductible, and depreciation is no exception. By claiming depreciation expenses on your assets, you lower your taxable income, increasing your tax savings. When business is slow and the revenue is trickling, some small business owners decide to depreciate using the accelerated method: this method allows you to claim larger deductions early on, helping to offset the price of the asset (more on this later).

Expense Reporting

Depreciation expensing paints a clear picture of how you’re using your capital. When you estimate the cost of an asset’s use over a period of time, you’re then able to compare how much revenue it generated (over that same period of time). When you can compare the expense and the resulting income side-by-side, you’ll have a good idea of your efficiencies or inefficiencies and be able to adjust accordingly.

Accurate Asset Valuations

It’d be misleading to you (and potential investors and lenders) if you only recorded the initial value of every asset you purchased. Because the truth is, that van you bought for the company a few years ago may be worth less than half its purchase value now. By depreciating your assets, you’ll know at any given time how much potential liquidated capital you actually have.   

Cost Recovery

If you bought a $5,000 freezer and it depreciates over the 5 years of its useful life, then each year you’d depreciate the asset by $1,000. You’d also know that you should save $1,000 each year so that in 5 years, you’ll have enough money to replace the freezer. Without the depreciation expense, you may not have saved enough money by the time the asset needed replacing, or you could have saved too much—needlessly tying up a portion of your capital.

Types of Depreciation

There are 4 standard depreciation methods businesses use. One isn’t better than the other, per se—you’ll just need to run the numbers for each scenario and see which is most appropriate for your operations. While the straight-line method is the most common, take your time before you choose. The hassle of calculating a more complicated method may be worth the immediate thousands in tax savings.

1. Straight-Line Depreciation Method

The straight-line depreciation method expenses an asset at an equal amount each year over its useful life. Most small business owners love this method because the formula is so downright simple: you just subtract the asset’s salvage value from its initial cost, and you divide that number by its useful life. Voilà—that’s the amount you depreciate each year. Here’s the equation:

(Asset Cost – Salvage Value) / Years of Useful Life

Let’s look at a practical example. Let’s say you want to depreciate a copy machine for your business. You’d open the IRS’s Publication 946 and find that a copy machine is classified as a 5-year asset. You bought the copy machine for $2,000, and you estimate you’ll be able to salvage the copy machine for $200:

($2,000 – $200) / 5 = $360

There you have it—each year, you’d depreciate the copy machine by $360.

2. Units of Production Depreciation Method

The units of production depreciation method is more appropriately applied to assets used to produce goods or services. If the age of an asset matters less than how much it can produce before it dies, then consider using this method. For example, you might want to use units of product depreciation on a mold used in your assembly line or on a piece of equipment used to make a t-shirt.

Units of production depreciation makes sense to use when the use of your asset fluctuates. If your use is consistent, then it’s more simple to use the straight-line method. However, if varying seasonal demand puts an inconsistent strain on your asset, units of production depreciation might give more accurate insights about the life of your equipment.

Here’s the equation you’d use to calculate units of production depreciation:

(Asset Cost – Salvage Value) / Estimated Total Units of Production

Let’s look at an example. Let’s say you bought a stone oven that you estimated could produce 10,000 pizzas before you needed to replace it. The oven cost $10,000, and you believe it’ll salvage for about $1,000:

($10,000 – $1,000) / 10,000 = $0.9

So each pizza you produce would incur a $0.9 depreciation expense for your oven. If you cooked up 1,500 pizzas over a year, your oven would have depreciated $1,350.

Since you’re likely not counting how many pizzas come out of your oven, units of production depreciation may not be the best method for every business. Manufacturers will benefit the most from this depreciation schedule since they keep a closer eye on the inputs and outputs of all their operations.

3. Double-Declining Balance Depreciation Method

The double-declining balance method may sound like a hip new dance the youngsters are doing, but it’s much cooler than that. With this method, you depreciate more of an asset’s value upfront and less and less over time. It’s similar to how you might approach your dinner plate when you’re dangerously hungry—you attack and eat your first helping lightning quick, and then you peter off and eat at a more mellow pace for the rest of the meal.

This depreciation method leads to bigger tax write-offs in the years right after you’ve purchased your asset and smaller write-offs towards the end of its useful life. Here is the formula for calculating double-declining balance depreciation:

2 x Basic Depreciation Rate x Book Value

Let’s break the formula down. First, let’s find the basic yearly write-off. The basic yearly write-off is the cost of your asset divided by its years of useful life:

Basic Yearly Write-Off = Cost of Asset / Years of Useful Life

To find the basic depreciation rate, divide your basic yearly write-off by the cost of the asset:

Basic Depreciation Rate = Basic Yearly Write-Off / Cost of Asset

Confused yet? Don’t worry. Let’s look at a practical example, and then you’ll have a good understanding.

Let’s say you bought a taxi for $10,000. According to the IRS, a taxi would depreciate on a 5-year schedule. So the taxi’s basic yearly write-off would be $10,000 divided by 5:

Taxi Basic Yearly Write-Off: $10,000 / 5 = $2,000

Now, let’s find the taxi’s basic depreciation rate. You’d divide the basic yearly write-off ($2,000) by the cost of the taxi ($10,000):

Taxi Basic Depreciation Rate: $2,000 / $10,000 = 0.2%

Now, plug that number into our double-declining balance depreciation formula:

Taxi Double-Declining Balance Depreciation: 2 x 0.2% x $10,000 = $4,000

So, after the first year, you’d have a $4,000 depreciation expense for the taxi. But next year, when you calculate the depreciation, the taxi’s book value will only be $6,000 ($10,000 – $4,000). At that rate, the second year’s depreciation expense will be $2,400. Then, the third year’s depreciation expense would be $1,440.

Hopefully, with this example, you can see how the asset starts at a super high depreciation expense, and that number starts to dwindle over time. So, why would anyone want to use the double-declining balance depreciation method when the straight-line method is obviously more straightforward?

4. Sum-of-the-Years-Digits Depreciation Method

The sum-of-the-years-digits depreciation method (SYD method), like the double-declining balance method, is another form of accelerated depreciation. It’s not quite as fast as double-declinching, but it’s still quicker than straight-line depreciation.

To calculate depreciation using the SYD method, assume you bought a pickup truck for $30,000 with a salvage price of $10,000 after 5 years. Here’s the formula you’d follow:

(Remaining life / Sum of the Years Digits) x (Cost of Asset – Salvage value)

Remaining life would be how many more years of useful life the asset has left. So, the first year you depreciate, it’d have 5 years of useful life. The second year you depreciate, it’d have 4 years of useful life remaining.

Find the sum of years digits by adding how many remaining years of usefulness are left after each year. So, for a 5-year asset, the sum of years digits would be 5 + 4+ 3 + 2 + 1 = 15.

Plug those numbers into the equation for the first year, and you’d get…

SYD Depreciation Expense Year 1: (5 / 15) x ($30,000 – $10,000) = $6,666

Do it again for the second year, and you’d get…

SYD Depreciation Expense Year 2: (4 / 15) x ($30,000 – $10,000) = $5,333

Choosing the Right Depreciation Method

There’s no one right way to depreciate your assets. Your business is free to adopt whichever method is most appropriate (and beneficial) to your operations. Depending on your current financial situation or even your predicted tax bracket in the coming years, you may opt for one method over another.

The straight-line method is the most commonly used because it’s easy to calculate, causes fewer reporting errors, and is simple to report on tax returns. However, you may use an asset heavily at the beginning of its useful life and less as times goes on (maybe because you expect to buy more of that asset as you expand). If that’s the case, the double-declining depreciation method may more accurately describe the asset’s expense.

“The “best method” is the one appropriate for your business and situation, says Morris Armstrong, an agent at Armstrong Financial Strategies. “Sometimes, people want to write something off as quickly as possible, even if they do not have the annual income to warrant it. So they accelerate the deduction schedule, only to realize later on that they would have been better off taking the depreciation at a slower, more consistent pace. You should run the various depreciation-calculation scenarios through the tax program with an eye not only on the current return but on returns down the road and the condition of your company in future years as well.”

In the end, it’s up to you to decide how you’re going to depreciate an asset. You don’t have to depreciate all your assets the same way, but you need to make sure you’re consistent with each asset.

The Bottom Line

For those of us non-accountants out there, we don’t have to pretend that depreciation is fun. Because it’s not. But, hopefully, you can now see how incredibly useful it can be for your small business. Get your depreciation strategy right, and you could save a boatload of cash when you need it. Get it wrong, and you could find yourself in an unnecessary tax crunch at an inopportune time.

While you may have an accountant or defer all your tax obligations to one, it’s still good to understand the fundamentals so you can help make important business decisions. With this basic understanding, you now have the knowledge you need to leverage depreciation to its maximum potential. Congratulations, entrepreneur!

While it’s easy to dislike depreciation (what’s to like about a whole bunch of math?), keep in mind all the good it can do for you and your business. Remember: don’t hate, depreciate.