The Comprehensive Guide to Calculating Depreciation

Depreciation lets you spread the cost of assets out over the time they’re being used, and affects both your business’s financial health and tax reporting.

In this comprehensive guide, we’ll get into different depreciation methods, providing step-by-step examples to help you understand and implement each one effectively.

This guide is also related to our articles on understanding journal entries in accounting, how to read a balance sheet, and double-entry accounting: the basics.

This list includes:

• Depreciation calculation
• Asset depreciation
• Depreciation methods
• Straight-line depreciation
• Double declining balance depreciation

Let’s begin!

Understanding depreciation terms

Here’s what you need to know before we get into any more detail:

• Asset cost: This is the total amount you pay for an asset, including purchase price, sales taxes, installation charges, and any other expenses to get it ready for use.
• Salvage value: Also known as residual value, this is the estimated amount you expect to recover from selling the asset after its useful life is over. This value is often a best guess and can be zero for many assets that depreciate fully.
• Useful life: This term refers to the period an asset is expected to be operational and contribute to business activities, based on manufacturer estimates, your past experiences with similar assets, and how much you plan to use it.
• Depreciation expense: This is the portion of the asset’s cost that you write off each year, reflecting its consumption and the benefit it provides to your business.

Allocating the cost of an asset over its useful life allows you to match the expense with the revenue it generates each year. By spreading the cost, you avoid significant fluctuations in financial performance.

Depreciation basics

Depreciation is how you account for the cost of a long-term asset over the time you use it. Unlike everyday expenses like rent or utilities, which you write off in the year they’re incurred, an asset like a piece of machinery, a vehicle, or office furniture spreads its cost over several years.

For instance, if you spend $10,000 on new equipment, recognizing the entire cost in the year of purchase could make your business appear less profitable than it is. Instead, depreciating the equipment over its useful life matches the expense with the revenues it helps to generate each year.

Depreciation primarily impacts three major areas of your financial statements: the income statement, the balance sheet, and the cash flow statement.

• Income Statement: Each year, the depreciation recorded reduces your profits on the income statement. This doesn’t mean cash is leaving your business; it just spreads the cost of your asset over its useful life. For example, if you depreciate that $10,000 piece of equipment over 10 years, you’ll record a $1,000 depreciation expense each year. This lowers your taxable income and, consequently, your tax bill.
• Balance Sheet: When you purchase an asset, it appears under assets on your balance sheet. As you depreciate the asset, its book value on the balance sheet decreases. This reduction reflects the wearing out, consumption, or other loss of value from using it in your business operations.
• Cash Flow Statement: Depreciation affects the cash flow statement indirectly. While it is a non-cash expense–meaning it does not directly impact cash flows–it affects the net income and must be added back to the net earnings in the operating activities section. Depreciation reduces net income, but since it’s not a cash outlay, it doesn’t affect the actual cash flow of your business.

You need to understand different depreciation methods to be able to choose the right one for your assets. Here are a few common types:

Straight-line depreciation: This method–involving an equal amount of depreciation each year over the asset’s useful life–is the simplest and most commonly used. For instance, if your asset costs $10,000, has a salvage value of $1,000, and a useful life of nine years, you would depreciate $1,000 each year (($10,000 – $1,000) / 9).

Declining balance method (DBB): The double declining balance (DDB) method is a form of accelerated depreciation. It allows you to write off more depreciation in the early years of an asset’s life and less later on. This method can be useful for assets that quickly lose value or become obsolete, like technology equipment. Depreciation is calculated by doubling the straight-line rate and applying it to the asset’s remaining book value at the start of each year.

These methods allow you to tailor your depreciation strategy to the nature of your assets and your broader financial goals, whether that’s maximizing tax benefits early on or spreading costs evenly.

It’s a good idea to consult a tax professional or accountant when determining the best method for your situation, as it can significantly impact your financial results and taxes.

Let’s look more closely at these main strategies.

The Straight-Line Method

The straight-line method of depreciation is straightforward: it evenly spreads the cost of an asset over its expected useful life. This method assumes that the asset will provide equal value each year until its eventual disposal or until it reaches its salvage value.

Formula

The formula for straight-line depreciation is simple:

Annual Depreciation Expense = (Cost of the asset – Salvage value) / Useful life of asset

Here’s what each part means:

• Cost of the Asset: This includes all costs to acquire the asset and prepare it for use.
• Salvage Value: The estimated value of the asset at the end of its useful life.
• Useful Life of the Asset: The expected period over which it will be productive for the business.

Step-by-step example with office furniture

Let’s say you purchase office furniture for $5,000 and expect it to last for 10 years, with a salvage value of $500 at the end of its useful life. Here’s how you would calculate the annual depreciation:

• Identify the cost of the asset: $5,000
• Determine the salvage value: $500
• Establish the useful life of the asset: 10 years

Now plug those numbers into the formula:

Annual Depreciation Expense = $5,000-−$50010 years = $450

This means that each year, you will depreciate the office furniture by $450. Here’s what that looks like:

• Year 1: You record $450 as depreciation expense on your income statement. The book value of the furniture at the end of the year will be $4,550.
• Year 2: Another $450 depreciation expense, reducing the book value to $4,100.
• Continue this process each year until the end of Year 10, when the book value reaches the salvage value of $500.

Using the straight-line method, the depreciation expense impacts your profit and loss by the same amount each year, which can help with budgeting and financial planning and is especially useful for assets like furniture, where the benefit it provides and its physical deterioration are relatively consistent over the years.

The Declining Balance Method

The declining balance method is an accelerated depreciation technique that writes off more of an asset’s value in the early years of its useful life. This approach can be particularly good for assets that quickly lose efficiency or become outdated, such as computer equipment or vehicles. The Double Declining Balance (DDB) method is a popular version of this technique, allowing for even faster depreciation than the standard declining balance method.

Formula

The formula for the Double Declining Balance method is:

Annual Depreciation Expense = Book Value at Beginning of Year × 2Useful Life of the Asset

Book Value at Beginning of Year: This is the current value of the asset at the start of the year after any previous depreciation has been subtracted.

Useful Life of the Asset: This is the same as in the original estimate.

An example of accelerated depreciation

Let’s say you’ve purchased computer equipment for $10,000 and determined a useful life of five years with no salvage value. Using the DDB method, the depreciation rate would be 40% per year (double the straight-line depreciation rate of 20%).

Here’s how you would calculate the depreciation for the first three years:

Year 1:

• Book Value at Start: $10,000
• Depreciation Expense: $10,000 × 40% = $4,000
• Ending Book Value: $10,000 – $4,000 = $6,000

Year 2:

• Book Value at Start: $6,000
• Depreciation Expense: $6,000 × 40% = $2,400
• Ending Book Value: $6,000 – $2,400 = $3,600

Year 3:

• Book Value at Start: $3,600
• Depreciation Expense: $3,600 × 40% = $1,440
• Ending Book Value: $3,600 – $1,440 = $2,160

As you can see, the depreciation amount decreases each year because it is calculated on a reducing balance. This means that the most significant depreciation hits occur in the first few years of the asset’s life. This can be advantageous if you want to reduce taxable income more significantly in the initial years after you purchase an asset.

Choosing between this and the straight-line method depends on your business needs, the types of assets you hold, and how quickly they tend to become obsolete or lose value. For computer equipment, which can become outdated rapidly, the DDB method often makes more sense, allowing you to align the book value of the asset more closely with its actual usability and market value.

The Units of Production Method

The units of production method ties depreciation to the actual usage of an asset rather than simply basing it on time, and is especially useful for equipment whose wear and tear is more closely related to how much it’s used rather than how old it is. For instance, manufacturing machinery might wear down more from production volume than from age.

Formula

The formula for calculating depreciation using the units of production method is:

Depreciation Expense = (Cost of the Asset-Salvage ValueTotal Estimated Total Estimated Production Capacity) × Units Produced This Year

• Cost of the Asset: This includes all costs to acquire and prepare the asset for use.
• Salvage Value: The expected value of the asset at the end of its useful life.
• Total Estimated Production Capacity: The total number of units the asset is expected to produce over its life.
• Units Produced This Year: The actual number of units produced by the asset in the current year.

Manufacturing machinery example

Say you’ve purchased manufacturing machinery for $100,000, with an estimated salvage value of $10,000 and a total production capacity of 500,000 units over its expected life.

Here’s how you would calculate the depreciation if the machinery produced 50,000 units this year:

• Determine the depreciation rate per unit:
  
  Depreciation Rate per Unit = $100,000−$10,000500,000 units = $0.18 per unit
• Calculate the annual depreciation expense:
  
  Depreciation Expense = $0.18 per unit × 50,000 units = $9,000

So if the machinery produced 50,000 units in a given year, you would record a depreciation expense of $9,000. This method provides a direct correlation between the asset’s use and the depreciation expense recorded in your financial statements.

Using the units of production method means that depreciation charges match the actual wear and tear on the asset, providing a fair and realistic view of its impact on your financials.

Comparing depreciation methods

Here’s a quick recap and comparison to help you decide which method is best suited for your assets and business strategy:

• Straight-line method: This method spreads the cost evenly across the useful life of the asset. It’s simple and predictable, making it a popular choice for assets that have a steady and reliable use over time, such as buildings or non-technical office equipment.
• Declining balance method: This one accelerates depreciation, particularly if you use the Double Declining Balance (DDB) method. This is good for assets like computers and machinery that lose value quickly due to technological advancements or heavy use in their early years.
• Units of production method: Ties depreciation to the usage of the asset rather than time. Ideal for machinery and vehicles that are heavily used in some years and less in others, as it aligns depreciation with actual wear and tear.

How do I know which one to choose? 

Choosing the right depreciation method depends on several factors:

Nature of the Asset: Consider how quickly the asset loses its usefulness. For high-tech equipment, an accelerated method might be more suitable. For assets that lose value more steadily, like office furniture, the straight-line method could be appropriate.

Business Cash Flow Needs: If you’re looking for higher tax deductions in the early years of an asset’s life to offset high initial earnings, an accelerated method could be the right one for you.

Financial Reporting: Consider what your managerial accounting strategy is. Smoother depreciation might make your profit margins look more consistent, which could be beneficial in dealings with investors or lenders.

Regulatory Requirements: Some industries have regulations that specify or limit the choice of depreciation methods, so do your research.

Tax I’m plications 

Depreciation plays a significant role in reducing your business tax liability. Each year, the depreciation expense you claim reduces your overall taxable income, thereby decreasing the amount of tax you owe.

For example, if your business earns $100,000 in revenue and you claim $20,000 in depreciation, your taxable income drops to $80,000, reducing your tax bill accordingly.

Here are some tax rules specific to depreciation that you should be aware of:

• Section 179 Deduction: This provision allows you to immediately expense the cost of qualifying assets in the year they are placed into service, instead of depreciating them over several years. For 2023, the maximum Section 179 deduction limit is $1,080,000, and it begins to phase out when more than $2,700,000 of assets are placed in service. This can significantly lower your tax bill in the year of purchase but requires careful planning to maximize benefits.
• Bonus Depreciation: Also known as additional first-year depreciation deduction, bonus depreciation allows businesses to deduct a significant portion of the purchase price of eligible business assets in the first year they are placed in service.

Both Section 179 and bonus depreciation can be powerful tools for managing cash flow and tax liabilities, especially for small businesses that invest heavily in equipment, software, or other tangible assets. These provisions can accelerate the return on investment and reduce the initial financial burden of large purchases.

You need to make sure you’re aligned with IRS guidelines when implementing depreciation strategies: you don’t want your business to get hit with penalties and costly audits. So make sure you understand the requirements and limitations associated with different types of depreciation deductions:

• Eligible Assets: Not all assets are eligible for depreciation, Section 179, or bonus depreciation. Typically, assets must be used in business operations and have a determinable useful life to qualify.
• Usage Criteria: For an asset to qualify for business depreciation, including Section 179 and bonus depreciation, it must be used predominantly (more than 50% of the time) for business purposes.
• Documentation: Keep detailed records of asset purchases, usage, and depreciation schedules so you can substantiate your claims in case of an IRS audit.

Navigating the complexities of tax rules can be daunting, so consider consulting with a tax professional so that your depreciation practices comply with current laws–and to take full advantage of available tax benefits.

Conclusion

Understanding and accurately calculating depreciation is important in managing your business finances effectively. It both helps spread the cost of an asset over its useful life and plays a significant role in tax reduction, impacting your overall profitability. You may want to consult with a financial advisor to tailor a depreciation strategy that fits your business needs and goals.

Next, check out our articles on bookkeeping vs. accounting, 21 best tax software, apps & tools in 2023, and 15 best accounting books to read in 2023.

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Author: Julia Kelly

Co-founder at Rigits

I write about how small business owners can better understand and utilize their financials for growth.

Julia Kelly