At its core, depreciation is an annual tax deduction that allows you to account for the wear and tear, deterioration, or obsolescence of your business assets.
Depreciation is essentially a way for businesses to recoup the cost of assets over their useful life. Rather than claiming the total expenses in a single year, depreciation allows you to spread it out, matching the expense with the revenue generated by the asset over time.
Depreciation expense refers to the yearly deduction in an asset's value, while accumulated depreciation is the total depreciation an asset has accumulated over its life.
Think of depreciation expense as a single slice and accumulated depreciation as the whole pie you’ve gathered over time.
You can depreciate most tangible property (like buildings, vehicles, and equipment) as well as certain intangible property (such as patents or copyrights). However, land is a notable exception–it doesn’t wear out or deteriorate, so it’s not depreciable.
To qualify for depreciation, an asset must:
Let’s dive into the details.
Property Ownership: You must own the asset. Even if you’re making pyments on it, like a mortgage or vehicle loan, you’re considered the owner and can depreciate it.
Business Use: The asset must be used for business or income production. Assets used solely for personal activities aren’t eligible.
Useful Life: The asset must have a predictable lifespan. For example, a car or a machine has a measurable useful life, but land doesn’t–it doesn’t degrade over time in the same way.
Depreciation rate is calculated by dividing 100% by the useful life of an asset. For declining balance methods, this rate is adjusted to 150% or 200%, depending on the method.
Depreciation begins the moment an asset is “placed in service”—when it’s ready and available for a specific business use. This applies even if the asset is idle initially.
Different depreciation methods are available to suit different business needs and asset types. Here are the main ones you’ll encounter.
What is it: The simplest and most common method. Straight-line depreciation deducts an equal amount of depreciation each year over the asset’s useful life.
Who should use it: This method is great for assets that lose value gradually, life office furniture or buildings.
How to calculate it:
Formula: Annual Depreciation = (Adjusted Basis - Salvage Value) / Useful Life
Example: If you purchase office furniture for $10,000 with a salvage value of $1,000 and a useful life of 5 years, the annual depreciation would be:
(10,000 - 1,000) / 5 = 1,800
What is it: This accelerated method depreciates a larger portion of the asset’s value early in its life. It’s ideal for assets that lost value more quickly upfront, like vehicles or technology.
How to calculate it:
Formula: Depreciation = Adjusted Basis x Declining Balance Rate
Example: For a 3-year asset at 200% declining balance:
In future years, continue adjusting the basis, and switch to the straight-line method when it provides a higher deduction.
What is it: This accelerated method gives a larger depreciation deduction at the beginning of an asset’s life nd gradually decreases each year.
Formula: Annual Depreciation = (Remaining Life of Asset / Sum of the Years Digits) x Depreciable Base
where the sum of the years digits is calculated by adding each year in the asset’s useful life. For a 5-year asset, it’s 1 + 2 + 3 + 4 + 5 = 15.
Example: Suppose you purchase equipment for $10,000 with a salvage value of $1,000 and a useful life of 3 years.
With a 3-year useful life:
Sum of years’ digits = 1 + 2 + 3 = 6
What is it: Ideal for assets where usage affects wear more than age (e.g., manufacturing equipment).
Formula: Depreciation per Unit = (Adjusted Basis - Salvage Value) / Estimated Total Units of Production
Multiply this rate by the units produced each year for yearly depreciation.
Example:
If you purchase equipment for $10,000 with a salvage value of $1,000 and a useful life of 3 years.
If the equipment is estimated to produce 10,000 units over its life:
Depreciation per Unit = (10,000 - 1,000) / 10,000 units = 0.90 per unit
If Year 1 produces 3,000 units, depreciation expense = 3,000 * $0.90 = $2,700
Keep in mind that each method has different applications. To summarise:
MACRS (Modified Accelerated Cost Recovery System): Required by the IRS for most property. This system includes both the declining balance and straight-line methods and allows for accelerated depreciation.
Section 179 Deduction: Allows businesses to immediately deduce the full cost of certain assets, up to an annual limit. This is ideal for small businesses wanting to recover costs faster.
Some assets are not depreciable:
Depreciation Journal Entry: Every time you record depreciation, the journal entry will typically look like this:
This entry affects your income statement by increasing expenses and your balance sheet by reducing value.
Depreciation itself is an expense rather than an asset. However, accumulated depreciation is recorded as a contra asset on the balance sheet, reducing the book value of the asset over time.
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