Farwah Jafri | October 27 2021
If you have recently launched your business or have been running one for years, you must have a fair idea of how business assets and resources are subject to constant wear and tear. Nevertheless, have you considered how this decline in asset value over time impacts your income, expenses, and profits?
While small businesses can easily write off expenses, it is not possible to write off larger capital costs, also known as expenditures on fixed assets.
An asset that has a life expectancy of more than a year is considered a fixed asset. Fixed assets include tangible assets such as computer systems, office equipment, plant and buildings, and vehicles that are needed for long-term use and, therefore, purchased by all types of businesses. The question here is how the costs of fixed assets can be accurately allocated. This is where depreciation comes in.
Find out what depreciation is and how to calculate depreciation.
The monetary value of a fixed asset decreases over time due to several reasons, including continuous usage, wear and tear, or obsolescence. This decrease is measured as the cost of depreciation. For example, a fixed asset like a vehicle or a new computer will gradually depreciate from its original value over time, and this diminution will be considered as a non-cash expense in accounting.
Depreciation is vital for determining a company’s net annual income during an accounting cycle accurately. To further elaborate, let’s assume that a retailer purchases a truck for $60,000 on the first day of the current year, but the truck is estimated to be used for the next six years. It is not logical for the retailer to record $60,000 as an expense in the current year and then report zero expense in the next five years.
Alternatively, the business can record a $10,000 expense every year during the six years that the truck is estimated to be used. This $10,000 expense – which is going to be recorded in each of the six years – is called depreciation and signifies the gradual decrease in the recorded cost of the fixed asset in a systematic manner.
According to accounting professionals, the purpose of depreciation is to match the cost of the fixed asset with the revenues that it generates while they are being used in the business, or during its useful life.
For anyone trying to figure out how to calculate depreciation, there are four main depreciation methods, which we will explore in this article. However, before answering the question ‘how does depreciation work?’ you need to know the three main inputs that are required to calculate depreciation:
1. Useful life: An asset’s useful life indicates the estimated lifespan that it is considered useable or, conversely speaking, economically feasible for use in business. The length of time that a fixed asset can be utilized to generate income for the business, or the length of time this asset is likely to last, constitutes its useful life.
2. Salvage value: After the useful life of the fixed asset is over, the company may consider selling it at a reduced rate, or scrapping it altogether. If the business opts to sell the asset, the amount it will receive is known as the salvage value of the asset.
3. Cost of ssset: This is the full cost of the asset, including taxes, shipping, and installation expenses.
How to calculate depreciation? There are a couple of different methods that you can use for calculating depreciation.
Here is a quick rundown of the four main types of depreciation:
The Straight-Line method is typically the simplest way to calculate depreciation. It records equal depreciation expense each year throughout the entire useful life until the fixed asset is completely depreciated to its salvage value.
The formula used to calculate straight-line depreciation is:
Straight-Line Depreciation = (Asset Cost – Salvage Value) / Useful Life
The Double Declining Balance method is a slightly more complicated way to calculate and record depreciation. It is an accelerated form of depreciation, where a greater percentage of value is considered as lost in the primary years of the fixed asset’s useful life. This technique is particularly useful when assets are used more often during the first few years.
Learn how to calculate depreciation using this method through this formula:
Depreciation = (2 x Straight-Line depreciation rate) x (Book value at the beginning of the year)
Sum-of-the-Year’s-Digits (SYD) depreciation is yet another method that lets you charge a greater value of depreciation in the early years of the asset’s useful life and less in the later years. This technique is for businesses where one needs to recover the asset’s value upfront. It offers a more even distribution than the Double Declining method.
To calculate SYD depreciation, combine all the digits of the expected life of the asset to come up with a fraction that will apply to each year of the depreciation years. For example, the SYD for a fixed asset with a useful life of 4 years is 10: 1 + 2 + 3 + 4 = 10.
You divide the asset’s remaining useful life by the SYD, then multiply the number by the cost to obtain your depreciation value for the year. This might sound complicated, but in practice, it is quite simple to do so.
Below is the formula explaining how to calculate depreciation using the SYD method:
Depreciation: (Remaining lifespan / SYD) x (Fixed asset cost – salvage value)
The Units of Production Method is a simple way to depreciate an asset based on how many units it helped produced or the total production of the asset during an accounting cycle. The “units” here can mean anything from the products it produced or the hours used during its service.
This method is used by businesses that wish to take more depreciation into account in years when they use the asset more, and less depreciation when they use it less. Since this method requires keeping track of the overall usage of equipment and/or the total production during the year, it is generally only used for high-value machinery, plant, or equipment.
To know how to calculate depreciation using this method, you need to follow two steps and determine the units of production.
First, you need to calculate the per-unit depreciation:
Per-Unit Depreciation = (Asset Cost – Salvage Value) / Useful life in units of production
The second step requires you to calculate the total depreciation, based on the actual units that have been produced:
Total Depreciation = Per-Unit Depreciation x Units Produced
Depreciation gives you a much better awareness and understanding of the real cost of doing business. You need to know how to calculate depreciation to get a more accurate picture of your business’s profitability as it helps you calculate the value your assets have lost over time. If you don’t record depreciation properly or don’t record it at all, you are underestimating your fixed costs which will result in an overestimation of the annual profits.
Depreciation also plays an important role in taxation. The lower your profits are, the lower the amount of taxes you have to pay. So, if you fail to take depreciation into account, you might end up paying more when it comes to taxes.
If you have thoroughly read the above article, you must have a fairly good idea of how to calculate depreciation. However, depreciation is a highly complex domain and it is always best to engage the experts for help. While depreciation accounting enables a company to understand the true cost of doing business, accounting is a specialized field that business owners or managers cannot fully implement without the assistance of accountants and bookkeepers.
Farwah is the Product Owner of Monily. She has an MBA from Alliance Manchester Business School, UK. She is passionate about helping businesses overcome challenges that hamper their growth, which is why she is working at Monily to facilitate entrepreneurs to efficiently manage business finances and stay focused on growth.