Why Depreciation Matters
Depreciation is a deductible business expense, which means that you don’t need to pay taxes on the amount of depreciation an asset accumulates in a particular tax year. It’s important to calculate depreciation to ensure you’re saving as much as possible on your business taxes. Calculating depreciation accurately will help you avoid an IRS audit or unnecessary penalties for mistakes.
Additionally, an accurate record of an asset’s depreciation will help you estimate how much you can expect to be reimbursed if the asset is lost, stolen, or destroyed and you need to file a commercial property insurance claim.
What Qualifies as a Depreciable Asset?
Any asset held by your company that loses value over time is considered depreciable property. Examples of depreciable business assets include:
- Computers, printers, and other office machinery
- Company-owned vehicles
- Manufacturing equipment
- Owned office buildings
- Property that’s rented out for income
Isn’t All Property Depreciable?
All assets lose value after they’re purchased, right? Not necessarily. When it comes to tax and accounting purposes, only certain assets are considered depreciable.
Only long-term assets are depreciated in accounting. Similarly, intangible assets, rented assets, and assets of immaterial value are considered non-depreciable or fixed assets.
Examples of non-depreciable assets include:
- Office supplies
- Web domains
- Personal vehicles used for business purposes
To claim a depreciation deduction, file Form 4562: Depreciation and Amortization. By recording the value lost for your depreciable assets in the tax year, you’ll lower your business’s taxable income and, in turn, reduce the amount of taxes you owe.
Using a Formula to Calculate Straight-Line Depreciation
Before calculating straight-line depreciation, be sure you’re familiar with the meanings of the following terms:
- Salvage Price: the price an asset can be sold for scrap
- Useful Life: the length of time an asset can be used for its original purpose
- Book Value: an asset’s purchase price minus its salvage price
- Depreciation Amount: the amount of value an asset will lose in a particular period of time
To calculate straight-line depreciation:
- Find the asset’s book value by subtracting its salvage price from the price you paid for the asset.
- Divide this number by the useful life of the asset. Our calculator measures asset lifespan in years, but you can switch to another time period (like quarters or months) if that’s more useful to you.
- Dividing the asset’s book value by its useful life will give you the amount that your asset will depreciate each year (or quarter, month, or other time period you’ve chosen to use).
- To determine your asset’s current value, multiply the depreciation amount per time period by the number of time periods left in the asset’s useful lifespan. For example, if you’re calculating depreciation in years and you plan to sell the asset for salvage in ten years, the current value is the 10x the yearly depreciation value.
Other Types of Depreciation
Though straight-line depreciation is used for the majority of assets, there are other methods for calculating depreciation that may be more accurate in particular situations. Below we’ve summarized the two most common alternative methods for calculating depreciation and reasons one might choose to use each.
Double-Declining Balance Depreciation
The double-declining balance depreciation method is used to accelerate depreciation so that the asset’s recorded value lost is higher toward the beginning of its useful life and lower toward the end of it.
Companies often select the double-declining balance method to record depreciation on assets that will lose most of their value early on in its life. For example, mobile devices and other tech equipment typically lose most of their resale value when newer models become available, even if the asset is still well within its useful lifespan.
To calculate double-declining balance depreciation:
- Find the asset’s yearly depreciation amount using the straight line depreciation method.
- Divide this amount by the asset’s book value (purchase price minus salvage price) to determine what percent of the asset’s original value will be lost in the first year. For example, if your asset costs $5,000 and can be salvaged for $1,000 after 10 years of usable life, the annual straight-line depreciation amount would be $400, or 10% of the asset’s book value of $4,000.
- To find the yearly depreciation amount using the double-declining method, multiply the value of the asset at the beginning of the year by twice the straight line depreciation percentage. In our example, the double-declining balance percentage would be 20%, so in the first year, an asset purchased for $5,000 would depreciate by $1,000.
- In subsequent years, the dollar amount of annual depreciation will change as the asset’s value at the beginning of the year decreases. At the beginning of the second year, our $5,000 example asset will be worth $4,000. Therefore, the second year’s annual depreciation using the double-declining method would be $800, or 20% of $4,000.
Diminishing Balance Method
The diminishing balance method is similar to the double-declining balance method in that it achieves greater depreciation toward the beginning of the asset’s lifespan and the amount of depreciation decreases in subsequent years. However, the diminishing balance method is unique in that its value decreases by a fixed percentage amount. The salvage price is found by applying the depreciation percentage for the number of years of the asset’s life.
The diminishing balance method achieves the same outcome as the double-declining balance method, but at a less aggressive pace. Companies might select the diminishing balance method for a tech asset whose company releases updated models every 10 years instead of every five.
To calculate depreciation using the diminishing balance formula:
- Multiply the asset’s fixed-percent depreciation by the purchase price of the asset to determine the amount of depreciation for the first year of the asset’s life.
- For subsequent years, multiply the value of the asset at the beginning of the year by the same percentage.
- To find the current value of the asset:
- First subtract the fixed percentage from 1 (for example, if the asset depreciates by 30% each year, this figure will be 70%).
- Next, raise this figure to the power of an exponent equal to the number of years elapsed in the asset’s life. For example, if you purchased the asset five years ago, you’ll multiply 70% to the fifth power (70%⁵ or .7*.7*.7*.7*.7, which comes out to 16.8%).
- Multiply the result by the purchase price of the asset to determine the asset’s current value. For example, if the asset’s purchase price was $1,000 five years ago and it has depreciated by 30% each year, its current value will be $168 or 16.8% of the original value.
- The salvage price of the asset will be the current value of the asset whenever you decide to sell the asset. For the example $1,000 asset, if you decide the asset’s useful life is 5 years, the salvage price will be $168. If you decide to sell the asset after 10 years, the salvage price will be $28.
Why Is Accurate Depreciation Important?
It’s impossible to maintain accurate financial records for your company without correctly calculating depreciation on your business assets. Incorrect depreciation can not only affect your taxes, which can cause you either to lose money by overpaying or to risk a potential audit and hefty fines, but it can also become a liability when reporting financials to shareholders and creditors. If you release an earnings statement and later have to issue a correction, for example, it can impact shareholder confidence and cause your stock price to drop. In a worst-case scenario, you could face penalties from the SEC.
Avoid these risks by ensuring your business assets’ depreciation is recorded and maintained accurately. Secure a second layer of protection by hiring an accountant with a comprehensive Accountant Professional Liability or Errors & Omissions insurance policy to handle your financial records. There’s no guarantee that a depreciation mistake will result in serious consequences, but with layers of protection in place, you can be confident you’re covered for any obstacles that come your way.