What is Depreciation? How It Is Calculated?

As a business owner, you invest in machinery, company vehicles, and even office equipment to run your business. With time, these assets start to lose their value. Machines wear out, technology becomes outdated, and vehicles accumulate miles. This gradual loss of value of assets over time is called depreciation.

Depreciation is the process of distributing the cost of an asset (something expensive you buy for your business) over several years. Instead of deducting the full cost of the asset in the year it was purchased, you spread out the expense over the years, so that the financials depict the correct picture for the given period and are compliant with various Accounting standards. Depreciation helps business owners reduce their taxable income and save on taxes.

The number of years you can depreciate an item depends on how long it’s expected to be useful. For example, a laptop usually lasts about five years. Similarly, other assets, like machinery or office furniture, have their own specific useful life spans, which determine how depreciation is calculated.

For example:
Let’s say you buy a delivery van for $30,000, and you expect to use it for five years. Instead of recording the entire $30,000 as an expense and capitalizing it in the year of purchase, you would spread it out over the five years, reflecting the van’s declining value.

Why is Depreciation Important?

1. It Helps in Accurate Financial Reporting: Depreciation ensures your books reflect the true value of your assets over time.
2. Depreciation Provides Tax Benefits: Depreciation is treated as an expense, reducing your taxable income and helping you save on taxes.
3. It Helps in Better Decision-Making: By tracking asset value, businesses can more effectively plan for replacements and investments.

What Types of Assets Can Be Depreciated?

Both tangible and intangible assets can be depreciated. For intangible assets, the process of depreciation is called Amortization.

Vehicles, Real estate, Equipment, Office furniture, and Computers are some of the assets that businesses commonly depreciate.

Land is a significant exception to this rule because it is a fixed asset that is not subject to depreciation. It is considered a non-depleting asset because it does not become obsolete, wear out, or have a finite useful life.

However, to be eligible, an asset must meet the following criteria:

• You must own the asset.
• It must be used in your business or to generate income.
• The useful life of the asset must be measurable.
• It should have a lifespan of more than one year.

However, the amount of asset depreciation on your books (Book Depreciation) can be different from that on your tax return (Tax Depreciation).

Book Depreciation Versus Tax Depreciation

When managing depreciation for fixed assets, businesses often use different methods for their financial records and tax reporting. These differences exist because financial statements and tax returns serve distinct purposes.

Book Depreciation

Book depreciation is the depreciation expense that a company records in its general ledger and reports on its profit and loss (P&L) statement for a specific period. It reflects the decline in the value of assets over time. It is considered as a non-cash expense and does not directly affect cash flow.

Businesses use book depreciation to provide an accurate representation of their financial performance. Companies often choose a method, such as straight-line depreciation or double-declining balance, that best matches the asset’s actual usage and value reduction.

Tax Depreciation

Tax depreciation is the method used for reporting on a company’s income tax return. Unlike book depreciation, it must follow depreciation rules set by the Internal Revenue Service (IRS). These rules determine the acceptable methods, asset classes, and useful lives for various types of assets.

For tax purposes, a depreciation method, like the Modified Accelerated Cost Recovery System (MACRS), is commonly used.

Key Differences Between Book and Tax Depreciation

However, the total depreciation expense over the entire life of an asset should be similar with both methods.

Types of Depreciation

Different companies use different methods to calculate depreciation – based on the type of asset and their financial goals. While some methods consider depreciation as a function of usage, others are based on the passage of time. The most common ones include:

1. Straight Line Depreciation Method

A time-based method, the straight-line method of depreciation is one of the simplest and most commonly used methods to record depreciation. It reports an equal depreciation expense throughout the entire useful life of the asset until the asset reaches its salvage value. It is calculated as:

Annual Depreciation = (Cost – Salvage Value) /Estimated Useful Life

• Cost of Asset: The purchase price of the asset.
• Salvage Value: Estimated residual value of the asset at the end of its useful life that the business expects to receive when the asset is sold or disposed of after being fully depreciated.
• Useful Life: How many years the asset is expected to generate cash flows?

For example: You have bought a machine for $20,000. The salvage value of the machine is $2,000 and it has a useful life of 10 years. Using the straight-line method:

Depreciation Expense = (20,000 − 2,000) = 1,800 per year                         

                                            ———————-

                                                       10

2. Declining Balance Method

The declining balance method is also known as the reducing balance method. Businesses use to increase the depreciation of an asset in the early years and less in later years. It’s ideal for assets that lose value quickly, like computers, cell phones, and vehicles. It allows companies to save money on taxes by deferring them to later years. The depreciation rate is usually double the straight-line depreciation rate. It is calculated as: 

Depreciation Expense = CBR × DR

CRR (Current Book Value): The asset’s current value after previous depreciation.

DR (Depreciation Rate): A fixed percentage based on the asset’s useful life.

Example:

A $10,000 computer with a depreciation rate of 20% will depreciate as follows:

Year 1: $10,000 × 20% = $2,000

Year 2: ($10,000 – $2,000) × 20% = $1,600

And so on.

3. Double Declining Balance (DDB)

This is an accelerated depreciation method that depreciates the asset more quickly (twice as quickly as compared to the traditional Declining Balance method). The DDB method records bigger depreciation expenses during the initial years of an asset’s useful life and smaller ones during the later years. The DDB method is ideal for assets that are likely to lose their value (and become obsolete) more quickly, like vehicles or machinery.

DDB = 2 × Straight-line depreciation percent X Book value at the beginning of the period

Example:
Let’s say a business purchases a fleet of trucks for $30,000 with an expected useful life of 10 years. After 10 years, the truck is estimated to have a salvage value of $3,000.

Using the straight-line depreciation method, the company would deduct $2,700 per year, calculated as:

(30,000−3,000) / 10 = 2,700

However, with the double-declining balance method, the process differs. Here, we’ll first calculate the straight-line depreciation rate:

1/10 years = 10%

Now we double this rate to get 20% and then apply it to the truck’s book value:

• Year 1: 20% of $30,000 = $6,000
• Year 2: 20% of $24,000 (remaining book value) = $4,800

This process continues, reducing the deduction each year, until the book value reaches the salvage value of $3,000.

4. Units of Production Method

This method ties depreciation to the asset’s usage rather than time. It’s often used for machinery or vehicles where usage of machinery varies by year. It also reflects the wear and tear on machinery more accurately.

Depreciation Expense = (Cost of Asset – Salvage Value) × Units Produced in a Year

                                            —————————————

                                                     Total Estimated Output

Example:

A machine costing $50,000 with a salvage value of $5,000 is expected to produce 100,000 units. If it produces 20,000 units in the first year:

Depreciation Expense = 50,000 − 5,000

                               ——————– = 0.45 per unit

100,000

If the machine produces 20,000 units in its first year:

20,000 × 0.45 = 9,000

In the first year, $9,000 would be recorded as depreciation.

Now, if production drops to 15,000 units in the second year, depreciation will be

15,000 × 0.45 = 6,750

You can use this method only for financial accounting, The IRS doesn’t allow it for tax purposes.

5. MACRS Depreciation

The Modified Accelerated Cost Recovery System (MACRS) is the standard method for calculating depreciation on most of the tangible assets for U.S. tax purposes. Established by the IRS, it allows businesses to recover the cost of qualifying assets more quickly by using accelerated depreciation methods. This often results in higher deductions in the earlier years of an asset’s life.

In this method, assets are assigned to specific asset classes, which determine their useful life for depreciation purposes. These asset classes include categories like 3-year, 5-year, 7-year, and so on. Each class has its own depreciation schedule, and businesses must follow these schedules to calculate deductions.

For example: Vehicles fall under 5-year property, while office furniture falls under the 7-year MACRS depreciation category.

The IRS provides pre-calculated tables to simplify the process. These tables specify the percentage of an asset’s cost to deduct each year.

The MACRS system includes two primary methods of depreciation:

1. 200% Declining Balance (commonly used for shorter-lived assets like vehicles or computers).
2. 150% Declining Balance (used for assets with longer lives like farm machinery).

MACRS is mandatory for most businesses when calculating depreciation on their tax returns. It is particularly useful for:

• Businesses that want higher deductions in the early years of an asset’s life.
• Companies looking to align with IRS requirements for tax reporting.

Choosing the Right Depreciation Method

The method you choose depends on the type of asset and your financial goals:

• Straight Line Depreciation: Best for assets with consistent use over time, like office furniture.
• Declining Balance: Ideal for assets that lose value quickly, like electronics.
• Double Declining Balance: Suitable for assets that depreciate twice more quickly.   
• Units of Production: Perfect for machinery or vehicles with fluctuating usage.
• MACRS Depreciation: Designed for U.S. tax purposes, offering depreciation schedules as per the IRS-defined asset classes.

How to File Depreciation

To file and claim depreciation expense on your tax return, you need to file IRS Form 4562. Here’s a guide to Form 4562 that will provide you with all the information you need to accurately calculate and report depreciation and amortization for your business assets.

Conclusion

Depreciation is an important tool that makes managing your assets, finances, and taxes a lot easier. By spreading out the cost of your assets, you can save on taxes, and keep your financial records accurate.

If you’re unsure about which depreciation method is best for your business, consult with experienced accountants at KnowVisory Global. We can help you maximize your benefits and stay compliant with tax laws.