When you purchase capital assets for your business, how do you record them on your company’s books? Although you might be tempted to record the entire cost on your income statement when you purchase it, don’t.
Accounting 101: The Nuts & Bolts of Depreciation
Instead, for assets you expect to last longer than one year, you’ll record the costs slowly over time based on how long you expect them to last.
This gradual allocation of expense is called depreciation. It’s a way of estimating how much of the asset has been used up in a year.
Depreciable assets include things like buildings, vehicles, and equipment, and there are a few ways to record their depreciation on your books.
Start With a Basis
The first step in calculating depreciation is determining the basis of the asset. The basis is just a fancy way of saying the cost.
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If you purchased the asset, the basis includes the:
- Purchase price,
- Sales tax,
- Delivery fees, and
- Installation costs
If the asset is real estate, include the following in the basis:
- Legal and accounting fees,
- Recording fees,
- Title insurance, and
Tip: If you buy real estate, you’ll need to segregate the cost of the land from the cost of any buildings. That’s because land isn’t depreciated — based on the theory that land doesn’t lose value as it ages.
Generally, an asset’s basis doesn’t change over time. But if significant improvements are made or there are losses or damage to the asset, the basis can fluctuate.
Estimate the Asset’s Useful Life
How long do you expect the asset to last and be productive for your business? That length of time is called the useful life.
Of course, useful life is an estimate. You’re not expected to know the exact lifespan of a piece of equipment. To help with these estimates, you could use the IRS guidelines for asset classifications.
For common classes of business assets, the IRS sets the following lives:
|IRS Property Class Useful Lives|
|5 years||Automobiles, office equipment, computers|
|7 years||Desks, file cabinets, chairs, safes|
|15 years||Improvements to land (e.g., fences, roads, sidewalks)|
|27.5 years||Residential real estate|
|39 years||Commercial real estate|
However, when recording depreciation on your financial statements, your business is free to use any reasonable useful life length. But when tax time comes, your tax professional will be required to use the IRS lives.
Choose a Depreciation Method
When it comes to calculating your book depreciation, you have a few options.
The straight-line method is the most common and the easiest way to calculate depreciation. This splits the depreciable basis evenly over the useful life.
For example, suppose your business buys a computer for $3,000 and sets the useful life to be five years. And you think the computer will have a salvage value of $500.
Salvage value is how much you think the computer will be worth when you’re ready to sell it at the end of its useful life.
For each of the next five years, you would write off:
$3,000 (basis) – $500 (salvage value) / 5 years (useful life) = $500 annual depreciation expense
This method is suitable for small businesses with simple accounting systems and procedures.
The double-declining balance (DDB) method is a form of accelerated depreciation that allows you to write off more of the asset’s costs in the first few years and less in the subsequent years.
How it works: In the first year of depreciation, you’ll take double the amount that you would use straight-line depreciation. And in each subsequent year, you’ll use that same depreciation rate and apply it to the asset’s book value rather than the original basis.
Note: Salvage value isn’t taken into account when using the DDB method.
Tip: An asset’s book value is its basis minus the amount you’ve already written off.
Example: Using the same computer example from above.
Since the computer is depreciated over five years, its straight-line depreciation rate is 20% (i.e., you write off 20% of the cost each year). In year one, using DDB, depreciation will be:
(2 x 20%) x $3,000 = $1,200
Now, the computer’s book value is $1,800 ($3,000 – $1,200).
Depreciation for year two is:
(2 x 20%) x $1,800 = $720
And so on and so on.
Units of Production
A more complex depreciation method involves using the estimated units the asset will produce instead of the useful life.
The units of production that the asset will produce can refer to something the equipment makes or the hours it’s in service. Because this method requires tracking the use of equipment, it’s generally only used for high-value machinery or equipment.
Sum of the Year’s Digits
Using the sum of the year’s digits is another accelerated method of depreciation where you’ll recognize more of the cost in the beginning years and smaller amounts in later years.
This method makes sense for assets that you expect to lose most of their value in the initial years of use.
Prepare a Depreciation Schedule
Now that you’ve settled on a depreciation method, you’ll want to create a depreciation schedule. It’s a table that shows how much each asset costs and how it will be depreciated over the years.
You’ll use the schedule when it’s time to prepare your depreciation journal entry.
Typically a depreciation schedule includes:
- A description of the asset
- Date of purchase
- Total basis
- Expected useful life
- Depreciation method
- Salvage value, if any
Special Tax Consideration. For income tax purposes, there are some special rules for depreciating assets. With Section 179 and bonus depreciation, you may be able to write off the entire cost of a capital asset in the first year.
The details are beyond the scope of this article. But consult with your tax professional to learn more.
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