What is depreciation and how is it calculated?

Depreciation is the gradual decrease in the value of a company’s assets. There are a handful of ways that depreciation plays a role in the financial planning of a business, including properly assessing asset values for accurate (and potentially lower) company taxes.

To better understand how depreciation works, you’ll need to know which types of assets depreciate, the most common depreciation methods, how to calculate depreciation, and the impact that depreciation has on your financial statements.

• How does depreciation work?
• Common depreciation factors
• Example of depreciation
• What is a depreciation schedule?
• Common depreciation methods
• 6 ways to calculate depreciation
• How your depreciation method affects your income taxes
• Journal entries for depreciation
• Asset depreciation FAQ

How does depreciation work?

Depreciation is the process of assets losing value over time. Whether it’s a single computer and a desk or a fleet of trucks and a helicopter, every business needs to have assets in order to function. Just as a new car loses value when it’s driven off the lot, so do many of the assets needed to run a business. 

• Note: Different assets depreciate at different rates

Assets depreciate over time to allow the business to slowly write down the cost of the asset and receive a tax deduction for each year. If an asset was fully depreciated in its first year, the company would only have the tax benefits once. 

What is depreciation’s impact?

Having an asset lose value can actually be a good thing for a business because it can allow for future tax deductions.

• Asset costs can be offset by tax depreciation deductions
• Deductions can be applied to several years’ worth of tax returns through the depreciation process

The government encourages capital investment by allowing you to recognise the gradual depreciation of your company’s assets and use that loss of value as a write-off on your taxes.

Businesses get to benefit from capital investment twice: once from the use of the asset, and again from the tax deduction for the asset’s depreciation. Your country’s tax department allows you to spread the depreciation out over several years, allowing you to claim a deduction the entire time the asset is in use.

What are assets?

An asset is anything of value (either physical or intangible) that a company uses to run its business. 

• Physical assets can range from office equipment to machinery or vehicles. Physical assets depreciate through wear and tear or by becoming outdated.
• Intangible assets include trademarks, copyrights, patents, or intellectual property. Intangible assets can also depreciate, like when a patent or copyright is scheduled to expire.  

Depreciation for intangible assets is referred to as amortisation.

What kinds of assets can you depreciate?

In order for an asset to be depreciated for tax purposes, it must meet the criteria set forth by your country’s taxation office.

The asset must:

• Be owned by you
• Be used for business purposes/produces income
• Be used for at least one year
• Have a finite usage/runs out at a defined point in the future

Common examples of depreciable business assets include:

• Machinery
• Vehicles
• Office equipment
• Furniture
• Buildings (but not the real estate itself)

When a company purchases an asset, management must decide how to calculate its depreciation. Tangible (physical) assets depreciate, while you expense intangible assets using amortisation.

A patent, for example, is an intangible asset that a business can use to generate revenue. Most patents are only enforced for around 20 years. As each year passes, a portion of the patent reclassifies to an amortisation expense.

Land improvements, such as landscaping costs, also depreciate. However, the land itself does not depreciate.

Common depreciation factors

There are several depreciation factors a business can use to determine the reduced value of an asset: 

• Useful life: The number of years that the company will use the asset for the business.
• Salvage value: The dollar amount that the company can sell the asset for at the end of its estimated useful life. In many cases, the salvage value is zero.
• Depreciation base: The total cost that can depreciate over the asset’s useful life. 
• Calculate the depreciable base by subtracting the cost of the asset by its salvage value. The depreciable base can be calculated with this equation: Cost of the asset – salvage value = depreciable base
• Depreciation schedule: The schedule lists the dollar amount of depreciation per year based on the factors listed and the depreciation method.

Example of depreciation

An advertising agency buys 50 laptops for their staff. This is an expensive purchase, but the owner of the agency knows they can depreciate the cost of the laptops, meaning this one-time purchase will reduce the agency’s tax liability for several years. 

The agency spent $50,000 on laptops, with the understanding that the laptops will need to be replaced in five years. Each laptop costs $1,000 and, after five years, will have a salvage value of $100. The agency purchased 50 laptops, which will each depreciate by $900, leaving them with a total depreciation of $45,000.

• Asset cost: $50,000
• Asset lifespan: Five years
• Salvage value: $5,000 ($100 x 50)
• Total depreciation: $45,000 (over five years)

The agency has the option to depreciate all of the laptops in the very first year, resulting in one huge tax deduction, or to spread it out over several years. The agency chooses the method of depreciation that would benefit them the most.

What is a depreciation schedule?

The depreciation schedule is a chart that tracks how much value an asset will lose each year. A depreciation schedule will vary based on which depreciation method is being used. 

Depreciation schedules are often created on an Excel sheet and map out how much the business can deduct for their asset’s depreciation and for how long.

The depreciation schedule will include the following information:

• A description of the asset
• How much the asset cost
• The date it was purchased
• The total salvage value 
• How long until it completely depreciates

Common depreciation methods

The depreciation method you choose depends on how you use the asset to generate revenue.

If you use the asset heavily in its early years, you should choose a depreciation method that posts more expenses in the early years. If you expect to use an asset at the same rate year over year, the annual depreciation expense amount should be fixed.

6 ways to calculate depreciation

Calculating depreciation is a two-step process. First, determine an asset’s useful life, salvage value, and original cost. Then select a depreciation method that aligns best with how you use that asset for the business. These include:

• Straight-line depreciation method
• Double-declining balance method
• Book value, accumulated depreciation method
• The sum of the years’ digits method
• Units of production method
• Modified accelerated cost recovery system (MACRS)

1. Straight-line depreciation method

The most common depreciation method is straight-line depreciation. When using the straight-line depreciation formula, an asset depreciates by the same amount each year.

How to calculate the depreciation using a Straight-line method

Let’s say you need to determine the depreciation of a delivery truck. 

The truck costs $30,000. It has a salvage value of $3,000, a depreciable base of $27,000, and a five-year useful life.

• Truck cost: $30,000
• Salvage value: $3,000
• Depreciable base: $27,000
• Five-year useful life
• Straight-line depreciation: $5,400 per year ($27,000 / 5 years)

To find the annual depreciation expense, divide the truck’s depreciable base bythe useful life of the asset to get $5,400 per year. You find that you can sell the truck for $3,000 after five years because you subtracted the cost of the truck from its depreciable base.

2. Double-declining balance depreciation method

The double-declining balance method posts more depreciation expenses in the early years of an asset’s useful life. The double-declining balance method is an accelerated depreciation method because expenses post more in the early years and less in the later years. This method computes the depreciation as a percentage and then depreciates the asset at twice the percentage rate.

Double-declining balance depreciation example

Let’s say you need to determine the depreciation of a van using the double-declining balance method. The van costs $25,000. It has a salvage value of $3,000, a depreciable base of $22,000, and a five-year useful life. The straight-line depreciation method would show a 20% depreciation per year of useful life. The double-declining balance method would show a 40% depreciation rate per year.

• Van cost: $25,000
• Salvage value: $3,000
• Depreciable base: $22,000
• Five-year life span
• Double-declining balance depreciation: Deduct 40% from the current depreciable value each year ($8,800 for the first year, $5,280 for the second year, and so on)

The double-declining balance method:

• Is an accelerated depreciation meaning that expenses post more in their early years and less in their later years. 
• Computes the depreciation as a percentage and then depreciates the asset at twice the percentage rate.

3. The book value, accumulated depreciation method

This method uses an asset’s book value to compute depreciation. Book value is the cost of the asset minus its accumulated depreciation. Accumulated depreciation is the total amount of depreciation recognised to date.

Book value, accumulated depreciation example

Let’s say you want to find the van’s depreciation expense in the first, second, and third year you own it. Multiply the van’s cost ($25,000) by 40% to get a $10,000 depreciation expense in the first year.

The van’s book value at the beginning of the second year is $15,000, or the van’s cost ($25,000) subtracted from its first-year depreciation ($10,000). Now, multiply the van’s book value ($15,000) by 40% to get a $6,000 depreciation expense in the second year.

The van’s book value at the beginning of the third year is $9,000, or the van’s cost minus its accumulated depreciation ($16,000). Now, multiply the van’s book value ($9,000) by 40% to get a $3,600 depreciation expense in the third year.

Total depreciation expenses decline each year until the asset’s remaining book value equals its salvage value. At that point, depreciation expenses stop because the asset’s useful life is over. You can now sell the van for $3,000.

The book value, accumulated depreciation method does not subtract the asset’s salvage value before it calculates the 40% depreciation amount each year. That’s because the asset’s salvage value is addressed at the end of its useful life.

4. The sum of the years’ digits depreciation method

To use the sum of the years’ digits depreciation method, you’ll use a ratio. The numerator is the years left in the asset’s useful life, and the denominator is the sum of the years in the asset’s original useful life. The sum of the years’ digits depreciates the most in the first year, and the depreciation is reduced with each passing year.

The sum of the years’ digits depreciation example

Let’s say you have a machine that costs $30,000. The machine has a salvage value of $3,000, a depreciable base of $27,000, and a five-year useful life. So the sum of all the years in the asset’s original useful life is 15.

In the first year, the ratio is five-fifteenths. Multiply the $27,000 depreciable base by the first-year ratio to get a $9,000 depreciation expense in the second year.

In the second year, the machine’s remaining useful life is four years or four-fifteenths. Multiply the $27,000 depreciable base by the second-year ratio to get a $7,200 depreciation expense in the second year.

When you compute depreciation expense for all five years, the total equals the $27,000 depreciable base.

5. The units of production depreciation method

Many manufacturing companies use the units of production method. This method is useful for companies that have large variations in production each year. The units of production method calculates depreciation based on the number of units produced in a particular year. 

The units of production depreciation example

If you own a piece of machinery, you should recognise more depreciation when you use the asset to make more units of product. If production declines, this method reduces the depreciation expense from one year to the next.

Let’s say you have a machine that costs $50,000. The machine has a salvage value of $10,000 and a depreciable base of $40,000. It can produce 100,000 units over a five-year useful life.

To find the depreciation amount per unit produced, divide the $40,000 depreciable base by 100,000 units to get 40¢ per unit. If the machine produced 40,000 units in the first year of its useful life, the depreciation expense was $16,000.

• Machine cost: $50,000
• Salvage value: $10,000
• Depreciable base: $40,000
• Five-year lifespan
• Can produce 100,000 units over five years
• Depreciation is calculated by the 40¢ cost per unit of production and deducted from the depreciable value of $40,000
• If the machine produces 20,000 units each year, it will depreciate at a rate of $8,000 per year

6. The modified accelerated cost recovery system (MACRS)

MACRS is a depreciation method that posts depreciation expenses for tax purposes. It’s common for businesses to use different methods of depreciation for accounting records and tax purposes. Accountants must create a reconciliation report that explains the differences between the accounting and tax depreciation for a business’s tax return. 

How your depreciation method affects your income taxes

The type of depreciation you use impacts your company’s profits and tax liabilities. Accelerated depreciation methods, such as the double-declining balance method, generate more depreciation expenses in the early years of an asset’s life. As a result, the tax deduction for depreciation is higher, and the net income is lower.

You’ll need to understand how depreciation impacts your financial statements. And to post accounting transactions correctly, you’ll need to understand how to record depreciation in journal entries.

Journal entries for depreciation

A journal entry increases the depreciation expense and accumulated depreciation, also known as an asset account. Each asset account should have an accumulated depreciation account, so you can compare its cost and accumulated depreciation to calculate its book value.

While asset accounts increase with a debit entry, accumulated depreciation is a contra asset account that increases with a credit entry. This format is useful because the balance sheet will subtract each asset’s accumulated depreciation balance from its original cost.

Asset depreciation FAQ

Depreciation is a complex subject and it’s normal to have questions about the process. This FAQ section answers the most common questions about depreciation.

How are assets depreciated for tax purposes?

By reporting the decrease in an asset's value to your country’s taxation agency, the business receives a tax deduction for the asset’s depreciation. The business is allowed to select the method of depreciation that best suits its tax needs.

Assets can be depreciated via straight-line depreciation, accelerated depreciation, per-unit depreciation, sum of the years’ digits.

How does depreciation differ from amortisation?

Depreciation is different from amortisation because depreciation only relates to tangible assets, while amortisation relates to intangible assets. While an intangible asset can’t break down or wear out, its value can still be lost over time. Amortisation tracks the reduced value of the intangible asset (like a patent or copyright) until eventually, it reaches zero.

What’s the difference between depreciation and accumulated depreciation?

Depreciation tracks the decrease in an asset’s value year over year. Accumulated depreciation is the total depreciation of that asset for all of the preceding years. If an asset loses 10% of its value each year, for example, after three years, the accumulated depreciation would be 30%.

Understanding depreciation can help you improve your planning process

Properly accounting for depreciation helps you plan for asset purchases. Posting depreciation helps you monitor the current status of your fixed assets. To determine when you must replace assets, review each fixed asset’s detailed listing.

You can use accounting software to track depreciation using any depreciation method. The software will calculate the annual depreciation expense and post it to the necessary journal entries for you. An accounting solution can help you make more informed decisions to grow your business with confidence.