A guide to understanding depreciation

Assets losing value over time is like the passage of time itself: it’s inevitable.

As the years go by, many assets decline in value—and your swanky new office equipment, cutting-edge computers and state-of-the-art office building are no exceptions.

It’s called depreciation (DEPN).

DEPN is also an accounting practice that enables your business to keep track of the wear and tear on its assets.

It can reduce your taxable income and provide a more accurate picture of your company’s financial performance.

In this article, we’ll cover the meaning of DEPN and why it matters. We’ll also outline various forms of DEPN and the commonly used formulas for calculating DEPN expenses.

What is depreciation?

DEPN is the process of physical (or fixed) assets losing value over time, resulting in their end value being lower than their purchase value. It represents how much value assets have lost over a period of time.

DEPN can occur in 1 of 2 ways:

1. Direct DEPN is from continued use of an asset, such as wear and tear whereas indirect DEPN may come about by the roll-out of a product upgrade or even inflation.
   

Almost all physical assets depreciate, except land, which increases (or appreciates) over time.

2. Non-physical assets also depreciate, but this is called amortisation.
3. This refers to intangible assets such as intellectual property, which includes copyrights, patents, and trademarks.
   

Why does depreciation matter?

As a small business owner, DEPN is important for tax and accounting purposes.

The main tax benefit is that DEPN allows your business to deduct the cost of assets from its taxable income not just over 1 year, but potentially several years—lowering your taxable income and, in turn, your tax liability.

Essentially, if you’re not allowing for DEPN, your business could potentially be paying more tax than it should.

And in terms of accounting, DEPN enables your business to create better financial reports.

DEPN gives you a clear indication of how much value your assets have lost over time and, if you fail to factor this into your revenue, you may be underestimating your costs.

By evenly spreading the cost of an asset over its lifespan, you don’t run the risk of over-inflating your profits when you bought the asset or understating your profits in the years that follow.

DEPN is also important in other situations, such as when you’re valuing your business or applying for a business loan, both of which consider the current value of your assets.

Depreciation terminology

To work out DEPN, you’ll first need to familiarize yourself with a few key accounting terms.

One term is useful life, which refers to the period of time during which an asset is productive. Once this time has elapsed, continued use is no longer cost-effective.

Another is salvage (or residual) value, which is the reduced value of an asset after its useful life—sometimes referred to as its “scrap” value.

This can be based on a previous professional quote or a percentage estimate of an asset’s value at the end of its useful life.

The penultimate term you should be aware of is the cost of an asset, which is the original purchase price of an asset including taxes and any set-up or delivery costs.

And the final term is book value, which is the value of an asset recorded on the balance sheet.

It’s calculated by subtracting DEPN from the cost of an asset.

How to calculate depreciation

There are 3 main ways to work out your annual DEPN expenses.

1. Straight-line DEPN

Straight-line DEPN is the simplest and most popular method for working out DEPN.

It’s often used for equipment that loses value—at the same rate each year—until it reaches zero.

For example, if your asset has a useful life of 20 years, its value would depreciate by 5% every year.

The formula is:

Cost of asset – Salvage value of asset / Useful life of asset = DEPN expense

Let’s say your company buys a top-of-the range computer for $5,000, which has a useful life of 5 years and its salvage value is $1,000.

Here’s the calculation:

1. Depreciable base = Cost of asset: $5,000 – Salvage value: $1,000 = $4,000

2. Annual DEPN expense = Depreciable base: $4,000 / Useful life of asset: 5 years = $800 per year

The advantage of straight-line DEPN is that it allocates the expense evenly over each accounting period, so it’s completely predictable.

A potential downside is that it’s not easy to accurately work out an asset’s useful life. It usually involves making an educated guess and, if you get it wrong, the asset may be overvalued for years to come.

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2. Reducing balance DEPN

Reducing balance DEPN is an accelerated form of DEPN, which is used when you’re handling an asset, such as a car or a van, that loses a greater proportion of its value in the early stages of its useful life.

The formula is:

Book value x (1/useful life) = DEPN expense

Assume the top-of-the-range computer you bought costs $5,000 with a useful life of 3 years and a DEPN rate of 40%.

Here’s the calculation:

Year 1

Book value: $5,000

DEPN: Cost of asset: $5,000 x DEPN rate: 40% = $2,000

End of year book value: Book value: $5,000 – DEPN: $2,000 = $3,000

Year 2

Book value: $3,000

DEPN: Book value: $3,000 x DEPN rate: 40% = $1,200

End of year book value: Book value: $3,000 – DEPN: $1,200 = $1,800

Year 3

Book value: $1,800

DEPN: Book value: $1,800 x DEPN rate: 40% = $720

End of year book value: Book value: $1,800 – DEPN: $720 = $1,080

A benefit of reducing balance DEPN is its greater accuracy than straight-line DEPN.

You’ll receive larger tax write-offs at the start of an asset’s useful life, when it’s at peak productivity.

One drawback is that this DEPN calculation can be a bit more complicated than other methods.

It normally involves setting up a DEPN schedule, which maps out the DEPN expense for each year of an asset’s useful life.

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3. Units of production DEPN

In certain circumstances, it’s more logical to work out DEPN by measuring how much work the asset does rather than how long it lasts.

Commonly used in manufacturing, the units of production method focuses on how many units a piece of equipment can produce before it’s no longer useful.

It assigns an equal DEPN rate to each unit of production.

The formula is:

(Number of units produced / Total estimated units) x (Cost of asset – Salvage value of asset) = DEPN expense

Imagine our top-of the range computer costs an eye-watering $50,000 with a salvage value of $5,000.

The total estimated units are 100,000 and the units produced in the period are 10,000.

Here’s the calculation:

1. Depreciable base = Cost of asset: $50,000 – Salvage value: $5,000 = $45,000

2. DEPN per unit = Depreciable base: $45,000 / Total estimated units: 100,000 = $0.45 per unit

3. DEPN for period = Units produced in period: 10,000 x DEPN per unit: $0.45 = $4,500

One advantage of this method is that, because it’s connected to the number of units a piece of equipment produces, the DEPN calculation is more accurate.

On the flip side, because the number of items the equipment produces will probably vary from one month to the next, you’ll need to have accurate record keeping. Unlike straight-line DEPN, these figures can’t be automated.

If you’re unsure of which DEPN method to use, your accountant can advise you based on the asset(s) you have in mind.

Final thoughts

DEPN provides a way for you to draw a correlation between the cost of a physical asset and its usefulness or ability to produce revenue from one year to the next.

Rather than recording the full expense of an asset at the point of purchase, DEPN allows you to allocate its cost over its useful life, which is advantageous from a tax and accounting perspective.

In addition to potentially reducing your tax bill and painting a clearer picture of your company’s financial health, DEPN can help you plan for future capital expenditure—ensuring that your assets are replaced or upgraded in a timely fashion.

Bearing all these potentially business-boosting benefits in mind will give you a newfound appreciation for DEPN.