How to Calculate Depreciation (2024)

For purposes of financial reporting and tax liability, businesses need to demonstrate howtheir assets decrease in value, an accounting process known as depreciation.

What Is Depreciation?

The concept of depreciation recognizes that assets decline in value over time and it spreadstheir cost over their useful life. Depreciation is a methodical way to write off the cost ofa fixed asset a little at a time, over the course of its useful life.

By smoothing out the financial impact of asset purchases, depreciation affects abusiness’sincome statement and balance sheet, two of the company’s most important financialstatements, as well as its annual tax liabilities. It can eliminate swings in profitabilitythat would otherwise be caused by expensing major asset purchases upfront.

Key Takeaways

• Depreciation is the accounting process of allocating the cost of tangible, fixed assetsover the time frame a company expects to benefit from their use.
• There are several methods to calculate depreciation, each requiring the use of hard dataand informed estimates.
• Companies may use different methods to calculate depreciation for profit and loss(P&L) statements and tax purposes.
• It’s important to calculate depreciation accurately, because it can significantlyimpacta company’s financial results and tax liability.

What Is an Asset and Which Types of Assets Depreciate?

Accountants have a very specific definition of an asset that differs from the everyday use ofthe word. Capital assets are items witha future economic benefit that are purchased or otherwise controlled by a business. Capitalassets can be tangible (such as equipment and buildings), or intangible (such as patents ortrademarks). Companies also have current assets, which are short-term and include cash/cashequivalents, inventory, accounts receivable, etc.

Depreciation is applied to certain tangible assets, known as fixed assets. A different costallocation process, called amortization, is applied to intangible assets.

Fixed assets are a subset of tangible assets that are expected to last morethan one year and decrease in value over time. For example, a computer is a fixed asset because it will likely bein service for several years and will decrease in value every year. Fixed assets aredifferent from current assets like inventory, which are expected to be converted into cashwithin a year and are therefore not subject to depreciation. Fixed assets are sometimesreferred to as capital assets, property plant and equipment, long-term assets or noncurrentassets.

Fixed assets tend to be higher-value items, but for bookkeeping purposes every company setsits own dollar threshold for determining whether an item should be treated as an asset thatdepreciates over time, instead of recognizing its full cost in the period that it waspurchased. Recording an item as a fixed asset is also known as capitalization. However, fortax purposes, the IRS issues a threshold for what assets should be capitalized (see thedifference between book depreciation and tax depreciation later in this article).

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

Depreciation Explained

When thinking about the nature of fixed assets, especially the length of their service lives,cost should be reflected over the accounting periods during which they will be useful,rather than just in the period in which they were paid for. This approach reflects their useby the business and provides a clearer picture of business performance.

Depreciation is an example of the matching principle, one of the basic tenets of GenerallyAccepted Accounting Principles (GAAP), where expenses are recognized in the same period asthe revenue they help generate, rather than when they are paid.

However, depreciation is not designed to estimate the fair market value of an asset at anypoint in time, which could be subjective or difficult to measure. Calculating depreciationcombines some hard facts (such as the initial cost of an asset) with some estimates (such asits useful life or salvage value).

Examples of Depreciation in Business

A business can depreciate any fixed asset except land. Assets can be large, like airplanes,skyscrapers or windmills. Or they can be small, like laptops, furniture or cell phones.Depreciation is a large expense for many businesses and is represented on the P&Lstatements of publicly traded companies. For example, Coca-Cola recorded more than $1 billion in depreciation expenses during 2019. An airline mightrecord even higher annual depreciation expenses because it is depreciating a large number ofvery expensive aircraft, while a software company might only record a fraction of thatamount because it doesn’t have many high-value fixed assets.

Book Depreciation vs. Tax Depreciation

A company may calculate the depreciation of its fixed assets differently for its P&L thanfor tax reporting.

Book depreciation is the amount recorded in a company’s general ledgerandshown as an expense on a company’s P&L statement for each reporting period.It’sconsidered a non-cash expense that doesn’t directly affect cash flow.

Tax depreciation refers to the way a company reports depreciation on itsincome tax returns. Tax depreciation must be calculated based on specific rules set by theIRS.

The differences between book depreciation and tax depreciation mostly relate to the length oftime over which an asset can be depreciated. However, the total depreciation expense overthe entire life of an asset should be similar with both methods.

The IRS also sets guidelines for the threshold value above which assets should becapitalized for tax purposes (currently $2,500 or $5,000, depending on whether the companyhas an applicable financial statement). Items costing less than that amount are considered“de minimis” and can be fully expensed when they are purchased. Those guidelineschange fromtime to time and businesses should monitor those changes.

Recording Depreciation

Depreciation impacts both a company’s P&L statement and its balance sheet. Thedepreciation expense during a specific period reduces the income recorded on the P&L.The accumulated depreciation reduces the value of the asset on the balance sheet.

Example of Depreciation

Here is an example of the journal entries required to record depreciation of a laptop with ananticipated service life of five years.

To record the cash purchase of a laptop:

To record one month of depreciation expense based on the laptop’s five-year life (usingthestraight-line method, described later in this article, and assuming no salvage value):

The net result of these entries shows cash being spent and the depreciation expense hittingthe P&L. The value of the asset also decreases on the company’s balance sheet:

What Is a Depreciation Schedule?

Each asset has its own depreciation schedule, or chart, that shows a timetable of monthlydepreciation expense and a rolling net asset value. The deprecation schedule is usuallyestablished when the asset is purchased, and it is used to compute recurring depreciationexpense amounts. At the end of the schedule, the asset should be depreciated down to itssalvage value.

Common elements of a depreciation schedule include:

• Asset name and description
• Date of purchase
• Acquisition cost of the asset
• Estimated useful life
• Estimated salvage value
• Method of depreciation

How to Calculate Depreciation

There are three key items to consider when establishing a depreciation schedule for aparticular asset:

1. Depreciable base: The original cost of the asset minus its salvagevalue. The original cost includes the amount paid for the asset as well as any costsincurred to put it into service for a specific use. The salvage value is an estimate ofhow much the asset could be sold for when it has been removed from service.
2. Useful life: The estimated period that the asset can be in servicebefore it will become obsolete or wear down. The useful life may be different than theasset’s physical life.
3. Best method: The method used to calculate depreciation. This must besystematic and rational related to the nature of the asset. Some methods assumedepreciation is a function of usage, while others are based on the passage of time. Theselection of a method often comes down to simplicity, to reduce recordkeeping costs.

Methods of Depreciation

The most commonly used methods of depreciation fall into three categories, although there areother specialty methods that can be applied for specific situations.

Time-based Methods

These methods assume that an asset’s economic usefulness is the same each year of itsusefullife. Accurately estimating the useful life of an asset is particularly important whenapplying time-based methods.

• Straight-line depreciation, a time-based method, is the simplest andmost commonly used method of depreciation. It is calculated as:

  (Cost – SalvageValue) / Expense Estimated Useful Life= Annual Depreciation

Activity Methods

Activity depreciation methods use productivity to measure the usefulness of an asset.Productivity can be determined based on the output that an asset produces, the number ofhours it works, or other measures. Determining the most appropriate unit of productivity andthen estimating production over the asset’s life are challenging but criticalestimates foractivity-based methods.

• Units of Production method yields a depreciation expense that istied to asset output, which is especially helpful for companies that have periodswhere productivity varies significantly. The formula for units of production is:

  [(Cost –SalvageValue / Total Estimated Production)]x Units Produced This Year

  = Annual DepreciationExpense

Decreasing Charge Methods (Accelerated Depreciation Methods)

This approach assumes that an asset loses more of its value in its early years. These methodsgenerate higher depreciation expense early in the asset’s life and lower depreciationlater,when repairs and maintenance expenses tend to be higher.

• Sum-of-Years’ Digits method calculates depreciation using adeclining fraction of the asset’s depreciable base, using the number of yearsremaining in the asset’s useful life. The declining fraction uses the sum oftheyears as its denominator: for a five-year life, that would be 5+4+3+2+1=15. Thenumerator is the number of years remaining at the beginning of the period.

  Year	Remaining Life in Years	Depreciation Fraction
  1	5	5/15
  2	4	4/15
  3	3	3/15
  4	2	2/15
  5	1	1/15
  sum of the year’s digits	15

  The formula for any given period is:

  (Cost –SalvageValue) x (Useful Life – Depreciation Period + 1) x 2
  /
  Useful Life x (Useful Life + 1)

  = Annual Depreciation Expense

• Declining Balance method works a bit differently than the othermethods in that it applies a constant depreciation rate to the rolling, decliningbook value of the asset rather than the original depreciable base. As a result, thedepreciation expense is lower each year. The depreciation rate is a multiple of thestraight-line method. Calculating declining balance depreciation is a two-stepprocess:

  Step 1: Determine the annual depreciation rate, using the straight-linemethod

  1 / Useful life= Annual Depreciation Rate

  Step 2: Apply the annual depreciation rate to the asset balance, net ofaccumulated depreciation at the beginning of the period.

  Annual Depreciation Rate × (Cost – Accumulated Depreciation)= Annual Depreciation Expense

• Double Declining Balance method is similar to the declining balancemethod, but sets the annual depreciation rate at double the straight-line depreciationrate. Once you account for that difference, use the declining balance method formulaabove.

Tax Depreciation

For tax purposes, businesses must use a depreciation method prescribed by the IRS. For mostfixed assets, the IRS says businesses must use the modified accelerated cost recovery system(MACRS) method. MACRS generates higher depreciation expenses in the early years of anasset’s life, which in turn creates a higher tax deduction and lower taxable income onacompany’s tax return.

MACRS uses the straight-line and double declining balance methods to calculate depreciationexpense, but it requires that businesses base their depreciation schedules on useful livesthat are determined and published by the IRS for various asset classes. A few examples ofMACRS useful lives are:

• Tractors: 3 years
• Airplanes: 5 years
• Computers: 5 years
• Land improvements: 15 years

Additionally, MACRS fully depreciates the asset to zero, regardless of potential salvagevalue. MACRS is not approved by GAAP because salvage values are ignored and because theIRS-determined useful lives tend to be shorter than those estimated using GAAP principles.

Comparing the Types of Depreciation

To illustrate the impact of different depreciation methods on a company’s P&L,considerthe following example. Depending on the depreciation method selected, the depreciationexpense recorded in the first year can more than triple.

A company purchases a new tractor for $50,000 in January, putting it into serviceimmediately. Based on past experience, it estimates the tractor will last about five years,or about 10,400 running hours. At the end of five years, the company estimates the salvagevalue will be $5,000.

How Accounting Software Can Streamline Your Depreciating Asset Calculations

Even smaller businesses can have hundreds of fixed assets, each with its own depreciationschedule. Accounting software canhelp businesses track depreciation with less effort and a lower probability of errorsbecause it eliminates the hassle and potential mistakes that come with juggling multiplespreadsheets. Accuracy is critical since depreciation reduces the value of assets on thebalance sheet and affects numbers on the income statement as well as tax liability.

By automating depreciation calculations for fixed assets, businesses can redirect employees,and the accounting team in particular, to focus on higher-value tasks such as strategic capitalplanning. Leading accounting software can not only calculate depreciation usingvarious methods, but is integrated with a larger ERP suite that measures the performance ofthe entire business.