A large expense like a capital purchase of a vehicle or equipment makes an impact on your bank account. While tracking the cash flow of your business, it will look bad when you actually invested, which is a productive and healthy business activity.
Here’s where depreciation can help you. It considers the long-term implications of one-time big purchases of a business. Depreciation helps a business plan for the replacement of fixed assets while monitoring their value over time.
If you know about depreciation but want a quick way to calculate it, you can use a depreciation calculator. Key in the variables to get results instantly. In this post, we study depreciation, its implications, and the different methods of calculating it.
Explaining and calculating depreciation can be quite complex and confusing. You can understand it better by breaking it all down into simple terms. Let’s start with the definition.
Depreciation is when your goods decrease in value due to decay or wear and tear. The minute you drive your car out of a showroom, it decreases in value. Even if you sell at that moment, you won’t get the full value that you paid for it.
Take the example of Jacob Johnson. He owns a dance studio in Santa Monica, California. The studio is opened to all sections of society, including those from the LGBTQ+ community and other marginalized groups of society.
Jacob upgraded his studio by purchasing high-end sound equipment in 2018. Unfortunately, the pandemic of 2019 forced Jacob to temporarily close the dance studio and sell some of the equipment that was just about a year old.
To Jacob’s surprise, the money he got from selling his equipment was considerably less than what he had paid for it just a year ago, even though it was in prime condition. The reason for the drop in value was due to depreciation.
Even with no visible damage to capital goods, the deterioration is assumed and calculated accordingly. To gain a better understanding of depreciation, you would have to grasp the basic concepts.
There are three primary concepts of depreciation, asset cost, useful life, and salvage value. Let us consider each one separately:
You can only calculate depreciation on a fixed asset that will last for more than a year of its purchase. Any new machinery you buy for your factory should be considered a fixed asset and will be subject to depreciation.
You have to first note the purchase price. Whether you use finance or buy the asset upfront, you need to consider the total purchase price. In depreciation parlance, the purchase price is the cost of an asset.
Now, this is where the passage of time comes into play. There are some guidelines in place by the IRS on how long particular assets are likely to last. You can refer to this table of useful life timelines to estimate the life of your asset expressed in years.
The salvage value refers to the estimated value of an asset at the estimated end of its useful life. Like in Jacob’s case, the salvage value of his dance studio equipment would be its value if he sold it back to the dealer.
Salvage value is also called book value. But you won’t get much guidance from the IRS on salvage value. Rather, you must decide the reasonable figure to use in your depreciation calculations.
Now that you understand the three concepts in depreciation calculations, let’s move on to the different methods of calculating depreciation.
Although there are many ways to calculate the depreciation of assets, we feature the three most commonly used methods today. In all probability, any one of these methods should suit your requirement.
First, you need to consider the rate at which an asset depreciates. Then, choose the calculation method according. For instance, when you unbox a new computer, does it instantly lose considerable value?
You need to consider how rapidly the value of an asset is likely to fall. Depending on how the value falls, you can use the “straight-line” method, “declining balance” method, or the “sum of years” method.
The straight-line method is the most straightforward and popular method for calculating depreciation. This method is best suited for assets that depreciate gradually. It spreads the total depreciated value of an asset over its useful life.
We can apply this formula:
(Asset Cost - Salvage Value) ÷ Useful Life = Depreciation Per Year
A simple example with a new factory machine is as follows:
The original cost of the machine was $5,000. You hope for it to last for five years. If you sell it after five years, you estimate that you would get $1,000 for it. The straight-line depreciation method would calculate your depreciation cost as $800 per year.
($5,000-$1,000) ÷ 5 years = $800/year
You can find a straight-line depreciation calculator online for instant results.
When accelerated methods of depreciation come into play, it gets a bit more complicated, as in the declining balance method. Unlike in straight-line depreciation, where the amount is the same each year, in declining balance, the rate is the same.
For using this method, you have to understand another term – net book value.
The net book value and salvage value are the same. At the end of each year of the useful life of an asset, we consider it depreciated to a particular amount. After accounting for depreciation, the value that you are left over with is the net book value.
Coming to the method: in declining balance, we subtract to salvage value from the original cost and multiply the remainder by the depreciation rate. We divide 1 by the useful life of the asset to get the depreciation rate.
Here’s how to do it:
Let’s continue with our above example of the factory machine.
The useful life of the machine is five years, so your depreciation rate will be (1 ÷ 5 = 0.2) = 20%.
Net book value after one year = $5,000-($5,000 X 20%) = $4,000
Net book value after two years = $4,000-(4,000 X 20%) = $3,200 and so on.
The main advantage of the declining method is that you can speed up the depreciation if you see that the asset is deteriorating at a faster rate.
If you double the rate of depreciation, it is called the double-declining depreciation method. You can verify your results by an online double-declining depreciation calculator.
This method is also an accelerated method. Here, we add some of the useful life years. It shares a similarity with the declining method in that the depreciation rate and amount change from one year to the next.
Coming back once again to our factory machine. Since we assumed it to last for five years, we add up the number of years as follows:
5 + 4 + 3 + 2 + 1 = 16
Now, divide the digit of each year by the total sum as follows:
The first year: 5 ÷ 16 = 0.3125 = 31.25%
The second year: 4 ÷ 16 = 0.25 = 30% and so on.
If you multiply the residual value of your machine a particular year with the depreciation rate of the machine for that year, you will get the depreciation amount for that particular year.
Your business is likely to have many assets of different values and depreciation rates - all at different stages of depreciation. You can create a depreciation schedule to keep track of the depreciation status of all your assets.
A depreciation schedule is a table listing the number of assets that are depreciating, the stage of depreciation they are in, and the depreciation method is used. This schedule gives you the true picture of the health of your business.
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