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Depreciation is one of the most misunderstood accounting concepts. Many business owners think depreciation is nothing more than a calculation for tax purposes. Although your accountant will make a depreciation calculation as part of your tax return filing, there is so much more to this concept than a line on your tax return.
Here, we will take an in-depth look at what depreciation is, the four most common depreciation methods and when you would use each type, and even how you can use depreciation calculations to help you manage your business’s cash requirements.
Depreciation is a calculation used to reduce the value of a fixed asset over a period of multiple years. Many small business owners find the concept of depreciation confusing, because depreciation does not match cash flow. Instead, depreciation is a calculation made and an entry recorded into the bookkeeping on a recurring basis.
Depreciation assumes—correctly—that fixed assets lose their usefulness and value over time. This loss usually doesn’t coincide with when the purchase is made, even if the purchase is made over time by making installment payments. Like accrual basis accounting, depreciation matches expenses to a given time period, but depreciation isn’t strictly an accrual basis concept. Depreciation will appear on both cash basis and accrual basis financial statements.
Since it doesn’t affect cash, many small business owners don’t concern themselves with depreciation. Disregarding the impact of depreciation can be a costly mistake, though.
Business owners will sometimes make large asset purchases at the end of the year in hopes of reducing their taxable income. Although there are provisions in the tax code that allow you to fully depreciate certain assets in the year they are purchased—meaning you can write off the full purchase price of the asset as an expense and reduce your taxable income—this isn’t always the case. Purchasing an asset outright only to learn at tax time you cannot fully recognize the expense can lead to a shortage of cash and an inability to pay your tax liability.
Aside from the tax implications, failing to recognize depreciation properly will skew the value of your business. Depreciation impacts both the profit and loss statement (as an expense) and the balance sheet (as a reduction of the value of an asset). If you don’t properly record depreciation, the value of the assets in your business will be overstated, which could possibly lead you to believe your business is worth more than it actually is. This can be a shock if you attempt to get a business loan or sell your business.
There are four common methods of depreciation used in accounting. These accounting depreciation methods differ from the depreciation schedules used for taxes. They are still important to know in order to determine how to calculate depreciation from a managerial perspective.
The most common depreciation method is called straight-line depreciation. It is also the simplest depreciation method. In straight-line depreciation, you subtract the estimated salvage or scrap value of the asset at the end of its useful life from the cost of the asset, and then divide that value by the useful life of the asset. In other words:
(Cost of asset – Scrap value of asset) / Useful life of asset = Depreciation expense
For example, let’s say you purchase a piece of equipment for $260,000. You anticipate using the equipment for eight years, and you anticipate the scrap value will be $20,000. The calculation for depreciation of the vehicle under the straight-line method would be:
($260,000 – $20,000) / 8 = $30,000
In order to not skew your end of year financial statements, you want to make the depreciation entry each month:
$30,000 / 12 months = $2,500/month
Each month of the year, you would make the following journal entry:
Debit: Depreciation expense $2,500
Credit: Accumulated depreciation: Equipment $2,500
This will reduce your net income by $2,500 each month, and it will also offset the value of the asset on your balance sheet by $2,500 each month.
Note that we are not crediting the actual asset account on the balance sheet, but a separate account called “accumulated depreciation.” The accumulated depreciation account will have a negative balance, which offsets the value of the asset without changing it on the balance sheet. You will often see accumulated depreciation accounts as subaccounts of the different types of fixed asset accounts on the balance sheet.
The units of production depreciation method is similar to the straight-line depreciation method in that it is simple to calculate. Units of production depreciation is most often used for equipment that is expected to produce a certain number of items before it is no longer useful.
The formula for units of production depreciation is:
(Number of units produced / Life of asset in units) x (Cost of asset – Scrap value of asset) = Depreciation expense
Let’s say the equipment you purchased in the example for straight-line depreciation is a machine you will use to manufacture whatsits. The machine is expected to produce 120,000 whatsits before it is no longer useful. You pay $260,000 for the machine, and the scrap value is estimated to be $20,000.
Each year, you will determine how many units the machine produces. Let’s assume in year 1 the machine produces 2,000 whatsits, in year 2 it produces 4,000 and in year 3 it produces 8,000:
Year 1: (2,000 / 120,000) x ($260,000 – $20,000) = $4,000
Year 2: (4,000 / 120,000) x ($260,000 – $20,000) = $8,000
Year 3: (8,000 / 120,000) x ($260,000 – $20,000) = $16,000
You will continue this calculation yearly until the machine reaches its production capacity of 120,000 whatsits.
As with the straight-line method, you will want to divide the depreciation expense by 12 and record it each month so you don’t skew your financials in the last month of the fiscal year.
Double declining balance depreciation is an accelerated depreciation method. Accelerated depreciation methods are used when you are dealing with assets that are more productive in their early years. The double declining balance method is often used for equipment when the units of production method is not used.
The calculations for accelerated depreciation methods are a bit more complex than those for straight-line or units of production methods, and so usually business owners using accelerated methods will set up a depreciation schedule—a table that shows the depreciation expense for each year of the asset’s life—so they only have to do the calculations once.
Let’s say you don’t know how many units your whatsit manufacturing machine can produce, but you know it’s likely to last eight years. First, we will need to calculate the rate of depreciation:
100% / Life of asset = Depreciation rate
100% / 8 = 12.5%
We multiply the depreciation rate above by 2 because we are doubling the rate of depreciation:
12.5% x 2 = 25%
Once we have our depreciation rate, will multiply that rate by the beginning value of the asset to get the depreciation expense for the first year:
Beginning value of asset x Depreciation rate = Depreciation expense
$260,000 x 25% = $65,000
Finally, we need to calculate the value of the asset at the end of year 1:
$260,000 (beginning value of asset) – $65,000 (depreciation expense) = $195,000
The depreciation calculation for year 2 follows the same formula, except now your beginning asset value is $195,000:
$195,000 x 25% = $48,750
And the ending value for year 2 is calculated:
$195,000 – $48,750 = $146,250
You will continue with these calculations until you reach the scrap value of the asset.
Like double declining depreciation, sum of the years’ digits depreciation is an accelerated depreciation method. The formula is:
(Remaining life of the asset / Sum of the years digits) x (Cost of asset – Scrap value of asset)* = Depreciation expense
*The second part of this equation is the depreciation base
Let’s stick with our whatsit machine for this example. First, let’s calculate our depreciation base:
Cost of asset – Scrap value of asset = Depreciation base
$260,000 – $20,000 = $240,000
Next, we need to determine the “remaining life of the asset / sum of the years’ digits” piece of the calculation. The remaining life is just as it sounds: It’s the remaining life of the asset. For this example, in year 1 the remaining life will be eight years, in year 2 it will be seven years, and so on. The tricky bit of this equation is the “sum of the years’ digits” piece.
Here’s how the calculation would look in year 1:
8 (remaining life) / (8+7+6+5+4+3+2+1) (sum of the years’ digits) = 0.222
And now we multiply this factor by the depreciation base:
0.222 x $240,000 = $53,280
Our year 1 depreciation expense is $53,280. In year 2, our calculation would look like this:
7 (remaining life) / (8+7+6+5+4+3+2+1) (sum of the years’ digits) = 0.194
0.194 x $240,000 = $46,560
And our year 3 calculation would be:
6 / (8+7+6+5+4+3+2+1) = 0.167
0.167 x $240,000 = $40,080
You will continue with these calculations until there is no remaining life of the asset and you reach the asset’s scrap value.
The four depreciation methods above are used for managerial and business valuation purposes. And although it’s important to understand these depreciation methods, many small business owners will only record depreciation as it is calculated by their accountants for the tax return. This ensures the balance sheet matches the tax return, which in turn makes it easier to validate the accuracy of the financial statements.
Tax depreciation is different from depreciation recorded for managerial purposes. Tax depreciation follows a system called MACRS, which stands for modified accelerated cost recovery system. MACRS is a form of accelerated depreciation, and the IRS publishes tables for each type of property. You can learn more about MACRS depreciation and review the tables on the IRS’s website.
One often-overlooked benefit of properly recognizing depreciation in your financial statements is that you can use depreciation to plan for and manage your business’s cash requirements. This is especially helpful if you want your business to fund the acquisition of future assets rather than taking out a loan to acquire them.
Let’s look back at our very first example. Because we have taken the time to determine the useful life of our equipment for depreciation purposes, we can make an educated assumption that we will need to purchase a new piece of equipment within the next eight years. The earlier we can start planning for that purchase—perhaps by setting aside $2,500/month in a business savings account—the easier it will be to fund the replacement of the equipment when the time comes.
Calculating and recording depreciation isn’t difficult. The most difficult aspect of the concept of depreciation is determining which depreciation method to use. Your accountant can help you determine which depreciation method to use in your business.
Properly accounting for depreciation in your financial statements helps you ensure you have the most accurate view of your business’s value at all times. You can also use depreciation to help you plan for future cash requirements in your business. This helps you leverage one of the primary benefits of good accounting: being able to use your financials to make educated business decisions.