# What Is Depreciation and How Is It Calculated?

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Depreciation is a concept and a method that recognizes that some business assets become less valuable over time and provides a way to calculate and record the effects of this. Depreciation impacts a business’s income statements and balance sheets, smoothing the short-term impact large investments in capital assets on the business’s books. Depreciation is also important for figuring tax obligations. Businesses large and small employ depreciation, as do individual investors in assets such as rental real estate. A financial advisor is a good source for help understanding how depreciation affects your financial situation.

## Depreciation Basics

Depreciation is a way for businesses and individuals to account for the fact that some assets lose value over time. It allows accountants, bookkeepers, managers and owners of assets such as rental real estate to write off the cost of a fixed asset in a systematic manner over a period of years, corresponding to the asset’s useful life.

On an income statement, depreciation is a non-cash expense that is deducted from net income even though no actual payment has been made. On a balance sheet, depreciation is recorded as a decline in the value of the item, again without any actual cash changing hands.

Depreciation is applied to tangible fixed assets that lose value over time or can be used up. These include assets such as vehicles, computers, equipment, machinery and furniture. Land is not considered to lose value or be used up over time, so it is not subject to depreciation. Buildings, however, would be depreciated because they can lose value over time.

## Calculating Depreciation

In order to calculate depreciation, it’s necessary to have three items of information:

• Depreciable base. This is the original cost of the asset, less its salvage value. Salvage value is what the asset could be sold for as the business has gotten all the use out of it. For instance, a \$1,000 laptop might be worth \$100 after it becomes too old to be helpful to the business. Its depreciable base is \$1,000 minus \$100 or \$900.
• Useful life. This is the number of years before the asset becomes obsolete or worn out.
• Best method. There are a number of different ways of calculating depreciation, some based on passage of time and some based on how much the asset has been used.

The Internal Revenue Service specifies how certain assets will be depreciated for tax purposes. Individual businesses may choose various methods depending on their appropriateness, ease of use or other consideration. Often, one method is used one a tax return and a different one for internal bookkeeping.

A table showing how a particular asset is being depreciated is called a depreciation schedule. It will often show the asset’s date of purchase, cost, expected useful life, selected depreciation method, salvage value, current year dollar depreciation, total cumulative depreciation and net book value, which consists of the price paid minus cumulative depreciation.

## Depreciation Calculation Methods

A particular method of calculating depreciation may be selected because of the nature of the asset, the way it is used and the specific needs of the business. For tax purposes, the IRS specifies how depreciation is calculated. Here are some common approaches:

• Straight line depreciation. This method divides the item’s original value by its years of useful life, applying even amounts to each year. For example, a laptop with a \$900 depreciable value and a 10-year useful life would be depreciated at \$90 each year.
• Double-declining balance. This method allocates more depreciation to the early years of an asset’s useful life. To calculate this, double the depreciation rate used with the straight-line method and multiply that by its book value at the beginning of the year. The example laptop would depreciate \$180 the first year, which is 10% — the annual rate of straight-line depreciation – times double the \$900 depreciable value or \$1,800. The second year it would depreciate \$144, twice the \$720 remaining depreciable value times 10%. Each year depreciation would further decline.
• Units of production. Rather than the age of the asset, this approach looks at how much the asset is used. It starts by measuring the asset’s use such as the number of hours it has been in operation or the number of widgets it has produced. The formula subtracts the salvage cost from the asset cost and divides the result by the units produced. This method is harder because the units of production must be tracked, so it’s usually employed for more expensive machines and equipment.

Business can use some discretion in applying the above methods or internal use, but the IRS specifies how they will calculate depreciation when filing tax returns. This method is usually the Modified Accelerated Cost Recovery System. It assigns asset to specific classes, which determines the asset’s useful life. For instance, vehicles and computers have five-year lives, while residential rental real estate has a 27.5-year life.

Taxpayers use Form 4562 to report their depreciation expenses. IRS Publication 946 lays out the complicated rules for applying its depreciation methods. Many taxpayers rely on accounting or tax professionals or tax return software for figuring MACRS depreciation.

## Bottom Line

Depreciation provides a way for businesses and individual investors to measure the decline in value of tangible fixed assets over their useful lives. Depreciation is a non-cash expense that reduces net income on an income statement and, on a balance sheet, reduces the value of assets. Depreciation is an important concept for managing businesses and also for calculating tax obligation.