Depreciation has several different meanings, depending on the context in which it's being used. Each type of depreciation is important to understand, especially if you are a small business owner or an investor in a company.
Understanding depreciation could help you potentially change your view on the outlook of a company, and in some instances even help you lower your taxes and save money. At its most basic, though, what exactly is depreciation?
When something depreciates, it reduces in value. This can be a tangible value reduction, such as a currency being worth less, or a property being sold for less than it was first bought. But it is also very often used as an accounting and tax term for when companies purchase assets with lifespans where their value is certain to decline.
In business accounting, depreciation is a method used to allocate the cost of a purchased asset over the period of time the asset is expected to be of use. This way, when calculating the business' net income for a fiscal year, they deduct a smaller amount of the cost over a number of years instead of one large deduction in the year it was purchased.
This is especially helpful for a company's financial statements if they have made a particularly expensive purchase this fiscal year, such as a new office building or costly machinery required to help produce goods. This can also be done if something intangible is purchased, such as a patent or a trademark. In these instances, it is known as amortization.
Why Should I Care About Depreciation?
There are plenty of reasons you should understand the depreciation of assets, particularly if you're starting a business or invest in one.
As a business owner, using depreciation when purchasing an asset can be extremely helpful. If something was purchased for $50,000, you can determine how long that asset will last, determine the depreciation expense per year, and the result is a smaller deduction for a larger net income. This is good for those looking to finish the year with a more impressive earnings per share figure. Certain forms of depreciation may allow for help with your business' taxes, as a larger yearly depreciation means less net income, leading to lower taxes.
As an investor, you may be inclined to look at the income statement or balance sheet of a company you have a stake in to analyze their current and future finances. The depreciation expense lets you know where the company is with that asset, and how close they are to needing replacement assets that will impact future net income.
Straight Line Depreciation
There are a few different methods of depreciation that a business can use. One of the more common ones, and more simple methods, is straight line depreciation.
Straight line depreciation can be helpful for accounting purposes because it doesn't involve as many variables and inconsistencies as other methods. The three things you need to know for straight line depreciation: How much the asset cost, how long you think the asset will be useful before it requires replacement, and the scrap value or salvage value, aka an estimation of the value of the asset at the end of that time period of usefulness.
Straight Line Depreciation Formula
For example, let's say your business purchased important machinery for $250,000. You estimate that this machine will be useful for 10 years, and that at the end of those 10 years its scrap value will be about $50,000. We can place these figures into the following formula: (Asset cost - salvage value)/Useful lifespan of asset.
So here, it would be (250,000-50,000)/10, aka 200,000/10, aka $20,000. That is what your annual depreciation expense for the machine would be instead of an upfront $250,000 expense that would put a significant dent in your company's net income.
Some businesses, though, prefer an accelerated depreciation method that means paying higher expenses early on and lower expenses toward the end of the asset's lifespan.
Why would a business willingly choose costlier early expenses on the asset? One reason is it can be a help come tax season. The first year of that asset's use, using an accelerated depreciation method will mean a lower net income than the business would have had with straight-line depreciation, but they believe the loss will be made up in taxes - that lower net income could mean lower taxes on it.
One of the notable examples of accelerated depreciation is the double-declining depreciation method. With double-declining appreciation, you are using parts of the straight-line depreciation formula, but focusing more on percentages than actual dollar amounts.
The other important type of accelerated depreciation is the "Sum-of-the-Years' Digits" depreciation method, or SYD. This also focuses on the percentage of the asset's cost you pay for the deduction expense, but takes into account how old the asset currently is.
Double-Declining Depreciation Formula
Let's return to the earlier example of a $250,000 piece of machinery that your company expects will last 10 years. With straight-line depreciation, you'd pay $20,000 each year until you can sell it for the salvage value.
For double-declining depreciation, though, your formula is (2 x straight-line depreciation rate) x Book value of the asset at the beginning of the year. The straight line depreciation rate is the percentage of the asset's cost minus salvage value that you are paying; here that is $20,000 out of $200,000, or 10%. Multiple that by 2 and the rate is 20%. You will deduct 20% of the asset's value each year.
In year 1, your depreciation deduction would be 20% of $250,000, or $50,000. Year 2, it would be 20% of the remaining $200,000, which is $40,000. Year 3, with $160,000 remaining on the machine, 20% of that comes to $32,000. Repeat this each year of the asset's lifespan until you reach the salvage value.
Sum-of-the-Years' Digits Formula
With the SYD depreciation formula, you'll be adding together the years the asset is of use. The formula here: (Years left on the asset/Sum of the years' digits) x (Original cost - salvage value).
Plug in the example we've been using into this equation. If it lasts ten years, the sum of the years' digits (10+9+8+7+6+5+4+3+2+1) is 55. The first year, it would be (10/55) x (250,000-50,000) aka 0.18 x 200,000 aka $36,000.
So consistently, you are dividing the number of years are left by 55 in this example, and then multiplying that by 200,000. In year 2, it would be (9/55) x 200,000, for a depreciation expense of $32,727.
Rental Property Depreciation
Depreciation isn't only important in business; if you are interested in owning or investing in rental property, you should know about it, too.
In the context of a rental property, depreciation is a tax deduction for the expenses used to purchase and enhance the property. The IRS allows you a depreciation expense for your rental property depending on certain circumstances. You have to own the property, and be using it as a source of income (aka renting it). The property must also have a useful lifespan that you can not only determine, but determine will be longer than one year.
If you meet all three of these qualifications, you can start deducting depreciation expenses once you begin using it for renting and it generates income for you. The depreciation stops if you stop getting income from the property; if you continue to rent it, it ends once the entire cost has been deducted.