For purposes of financial reporting and tax liability, businesses need to demonstrate how their 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 spreads their cost over their useful life. Depreciation is a methodical way to write off the cost of a 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 a business’s income statement and balance sheet, two of the company’s most important financial statements, as well as its annual tax liabilities. It can eliminate swings in profitability that would otherwise be caused by expensing major asset purchases upfront.
- Depreciation is the accounting process of allocating the cost of tangible, fixed assets over the time frame a company expects to benefit from their use.
- There are several methods to calculate depreciation, each requiring the use of hard data and 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 significantly impact a 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 of the word. Capital assets are items with a future economic benefit that are purchased or otherwise controlled by a business. Capital assets can be tangible (such as equipment and buildings), or intangible (such as patents or trademarks). Companies also have current assets, which are short-term and include cash/cash equivalents, inventory, accounts receivable, etc.
Depreciation is applied to certain tangible assets, known as fixed assets. A different cost allocation process, called amortization, is applied to intangible assets.
Fixed assets are a subset of tangible assets that are expected to last more than one year and decrease in value over time. For example, a computer is a fixed asset because it will likely be in service for several years and will decrease in value every year. Fixed assets are different from current assets like inventory, which are expected to be converted into cash within a year and are therefore not subject to depreciation. Fixed assets are sometimes referred to as capital assets, property plant and equipment, long-term assets or noncurrent assets.
Fixed assets tend to be higher-value items, but for bookkeeping purposes every company sets its own dollar threshold for determining whether an item should be treated as an asset that depreciates over time, instead of recognizing its full cost in the period that it was purchased. Recording an item as a fixed asset is also known as capitalization. However, for tax purposes, the IRS issues a threshold for what assets should be capitalized (see the difference 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 subject to depreciation. It is considered a non-depleting asset because it does not become obsolete, wear out or have a finite useful life.
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 use by the business and provides a clearer picture of business performance.
Depreciation is an example of the matching principle, one of the basic tenets of Generally Accepted Accounting Principles (GAAP), where expenses are recognized in the same period as the 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 any point in time, which could be subjective or difficult to measure. Calculating depreciation combines some hard facts (such as the initial cost of an asset) with some estimates (such as its 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&L statements of publicly traded companies. For example, Coca-Cola recorded more than $1 billion in depreciation expenses during 2019. An airline might record even higher annual depreciation expenses because it is depreciating a large number of very expensive aircraft, while a software company might only record a fraction of that amount 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 than for tax reporting.
Book depreciation is the amount recorded in a company’s general ledger and shown as an expense on a company’s P&L statement for each reporting period. It’s considered a non-cash expense that doesn’t directly affect cash flow.
Tax depreciation refers to the way a company reports depreciation on its income tax returns. Tax depreciation must be calculated based on specific rules set by the IRS.
The differences between book depreciation and tax depreciation mostly relate to the length of time over which an asset can be depreciated. However, the total depreciation expense over the entire life of an asset should be similar with both methods.
The IRS also sets guidelines for the threshold value above which assets should be capitalized for tax purposes (currently $2,500 or $5,000, depending on whether the company has an applicable financial statement). Items costing less than that amount are considered “de minimis” and can be fully expensed when they are purchased. Those guidelines change from time to time and businesses should monitor those changes.
Depreciation impacts both a company’s P&L statement and its balance sheet. The depreciation 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 an anticipated 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 (using the straight-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 hitting the 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 monthly depreciation expense and a rolling net asset value. The deprecation schedule is usually established when the asset is purchased, and it is used to compute recurring depreciation expense amounts. At the end of the schedule, the asset should be depreciated down to its salvage 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 a particular asset:
- Depreciable base: The original cost of the asset minus its salvage value. The original cost includes the amount paid for the asset as well as any costs incurred to put it into service for a specific use. The salvage value is an estimate of how much the asset could be sold for when it has been removed from service.
- Useful life: The estimated period that the asset can be in service before it will become obsolete or wear down. The useful life may be different than the asset’s physical life.
- Best method: The method used to calculate depreciation. This must be systematic and rational related to the nature of the asset. Some methods assume depreciation is a function of usage, while others are based on the passage of time. The selection 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 are other specialty methods that can be applied for specific situations.
These methods assume that an asset’s economic usefulness is the same each year of its useful life. Accurately estimating the useful life of an asset is particularly important when applying time-based methods.
Straight-line depreciation, a time-based method, is the simplest and most commonly used method of depreciation. It is calculated as:
(Cost – Salvage Value) / Expense Estimated Useful Life = Annual Depreciation
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 of hours it works, or other measures. Determining the most appropriate unit of productivity and then estimating production over the asset’s life are challenging but critical estimates for activity-based methods.
Units of Production method yields a depreciation expense that is tied to asset output, which is especially helpful for companies that have periods where productivity varies significantly. The formula for units of production is:
[(Cost – Salvage Value / Total Estimated Production)] x Units Produced This Year
= Annual Depreciation Expense
Decreasing Charge Methods (Accelerated Depreciation Methods)
This approach assumes that an asset loses more of its value in its early years. These methods generate higher depreciation expense early in the asset’s life and lower depreciation later, when repairs and maintenance expenses tend to be higher.
Sum-of-Years’ Digits method calculates depreciation using a declining fraction of the asset’s depreciable base, using the number of years remaining in the asset’s useful life. The declining fraction uses the sum of the years as its denominator: for a five-year life, that would be 5+4+3+2+1=15. The numerator is the number of years remaining at the beginning of the period.
The formula for any given period is:
(Cost – Salvage Value) 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 other methods in that it applies a constant depreciation rate to the rolling, declining book value of the asset rather than the original depreciable base. As a result, the depreciation expense is lower each year. The depreciation rate is a multiple of the straight-line method. Calculating declining balance depreciation is a two-step process:
Step 1: Determine the annual depreciation rate, using the straight-line method
1 / Useful life = Annual Depreciation Rate
Step 2: Apply the annual depreciation rate to the asset balance, net of accumulated 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 balance method, but sets the annual depreciation rate at double the straight-line depreciation rate. Once you account for that difference, use the declining balance method formula above.
For tax purposes, businesses must use a depreciation method prescribed by the IRS. For most fixed 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 an asset’s life, which in turn creates a higher tax deduction and lower taxable income on a company’s tax return.
MACRS uses the straight-line and double declining balance methods to calculate depreciation expense, but it requires that businesses base their depreciation schedules on useful lives that are determined and published by the IRS for various asset classes. A few examples of MACRS 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 salvage value. MACRS is not approved by GAAP because salvage values are ignored and because the IRS-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, consider the following example. Depending on the depreciation method selected, the depreciation expense recorded in the first year can more than triple.
A company purchases a new tractor for $50,000 in January, putting it into service immediately. 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 salvage value will be $5,000.
|Depreciation Method||Asset Cost||Salvage Value||Useful Life||Depreciation Expense|
|Years||Running Hours||Year 1||Year 2||Year 3||Year 4||Year 5|
|Straight-line||$ 50,000||$ 5,000||5||n/a||$ 9,000||$ 9,000||$ 9,000||$ 9,000||$ 9,000|
|Units of production||50,000||5,000||n/a||10,400||8,654||19,471||8,654||4,327||3,894|
|Actual running hours||2,000||4,500||2,000||1,000||900|
|Sum of the years’ digits||50,000||5,000||5||n/a||15,000||12,000||9,000||6,000||3,000|
|Double declining balance||50,000||n/a||5||n/a||20,000||12,000||7,200||4,320||1,480|
How Accounting Software Can Streamline Your Depreciating Asset Calculations
Even smaller businesses can have hundreds of fixed assets, each with its own depreciation schedule. Accounting software can help businesses track depreciation with less effort and a lower probability of errors because it eliminates the hassle and potential mistakes that come with juggling multiple spreadsheets. Accuracy is critical since depreciation reduces the value of assets on the balance 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 capital planning. Leading accounting software can not only calculate depreciation using various methods, but is integrated with a larger ERP suite that measures the performance of the entire business.