# How to Calculate Depreciation: The Ultimate Chip Stacking Guide Image

‘Thou shalt depreciate for all its worth’.

I think that had to be one of the commandments given from off the mountain.

If not then it should be.

As a small business owner you need to be especially mindful on how to calculate depreciation.

Calculating depreciation can sometimes give you an headache because their are various ways to calculate it and each on has its benefits and drawbacks.

We will address these benefits and drawbacks throughput the article below.

Here’s what happens to an asset over time: Let’s say you purchased a piece of computer equipment for your business at a cost of \$1,000. The average computer lasts 10 years, so it decreases in value 10 percent each year.

It’s important to remember that depreciation is just an accounting mechanism to show the expense of using an asset over time. It doesn’t have anything to do with how you purchased the item or its real physical condition.

For example, if you buy a vehicle for \$25,000, you calculate depreciation on the \$25,000, whether you paid for it with cash or credit. If you lease the vehicle, you can still depreciate it, depending on the type of lease.

Business assets are items of value owned by your business. Most higher-cost business assets are depreciated, because they decrease in value over time, either through use or through obsolescence. When an asset becomes obsolete, it may be from technology passing it by or from physical wear and tear.

The types of assets that are depreciated are called property, plant, and equipment (PPE). These items include buildings, improvements to your property, vehicles, and all kinds of equipment and furniture.

Land, however, is not depreciated because it does not decrease in value. Some assets have a residual or salvage value at the end of their useful life. This value is not included in the depreciation calculation.

IRS regulations as of 2018 allow your business to take the full cost of the item in the first year if the cost is \$2,500 or less. That means you don’t have to depreciate these types of assets.

How to Calculate Depreciation
Depreciation is calculated by taking the useful life of the asset (available in tables, based on type of asset, though you may need an accountant for this), less the salvage value of the asset at the end of its useful life (also determined by a table), divided by the cost of the asset (including all costs for acquiring the asset like transportation, set-up, and training).

The resulting value is called the book value of the asset. For example, the annual depreciation on a machine with a useful life of 20 years, a salvage value of \$1,000, and a cost of \$50,000 is \$2,450.

For accounting and tax purposes, the asset must be placed in service (set up and used) in the first year that depreciation is calculated.

If an asset is purchased in the middle of the year, the annual depreciation expense is divided by the number of months in that year since the purchase. For example, if the asset above was purchased in August, the first year depreciation would be \$1,021.84 (\$2,450/12 x 5).

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When the Asset Reaches Its Useful life
When an asset has been fully depreciated, it is considered to be “off the books” of the company. That doesn’t mean the asset isn’t still useful, but that the company cannot take any more depreciation expense on that item.

If the item has a salvage value, that value stays on the books until the item is sold or scrapped.

Different Ways to Calculate Depreciation
There are several methods used to calculate depreciation. The method described above is called “straight-line” depreciation, in which the amount of the deduction for depreciation is the same for each year of the life of the asset.

These are the other two common ways to calculate depreciation:

Double Declining Balance: This method includes an “accelerator,” so the asset depreciates more at the beginning of its useful life (used with cars, for example, as a new car depreciates faster than an older one).
Sum of the Years’ Digits: The number of years in the useful life are summed—for example, if an asset had a useful life of 6 years, the digits would be added: 6+5+4+3+2+1=21, then annual depreciation would be determined as follows:
Year 1 = 6/21 = 28.6% times the cost (or cost less salvage)
Year 2 = 5/21 = 23.8%
Year 3 = 4/21 = 19%
Year 4 = 3/21 = 14.3%
Year 5 = 2/21 = 9.5%
Year 6 = 1/21 = 4.8%
Accelerated Depreciation
Favorable tax plans are available to speed up the depreciation process so you can get more tax deductions faster. These plans come in two forms:

A tax deduction, called a Section 179 deduction, for the purchase of business vehicles and equipment
Bonus depreciation for the purchase of new business vehicles and equipment
Both of these accelerated depreciation features come with limits and qualifications, so check with your tax professional to see if you qualify.

How to Calculate the Useful Life and Salvage Value of an Asset
The IRS has classifications of assets and has calculated useful life on these classes. You can find a listing of the asset classes in IRS publication 946, or your CPA can help you to find these values and to calculate depreciation on your business assets.

Amortization vs. Depreciation
In accounting, the amortization process differs from the depreciation process mainly in that amortization is used for intangible assets, like intellectual property (copyrights, trademarks, patents).

Amortization is a way of spreading out the cost of such assets, so, for example, if one has a license that cost \$1,000 and will expire in 10 years, the annual amortization expense for the license might be \$100. This straightforward approach to breaking down the payments is known as the straight-line method.

Knowing how to calculate depreciation is a valuable skill that every business owner should have in some way or another.