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How to depreciate equipment

This article was co-authored by Michael R. Lewis. Michael R. Lewis is a retired corporate executive, entrepreneur, and investment advisor in Texas. He has over 40 years of experience in business and finance, including as a Vice President for Blue Cross Blue Shield of Texas. He has a BBA in Industrial Management from the University of Texas at Austin.

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Depreciation is a method accountants use to spread the cost of capital equipment over the useful life of the equipment. Recording depreciation on financial statements is governed by Generally Accepted Accounting Practices (GAAP). Accountants must follow these regulations when recording depreciation. Companies can choose from several different methods of recording depreciation. Methods based on time include straight-line, declining balance and sum-of-the-years’ digits depreciation. [1] X Research source From time to time, Congress amends IRS rules about depreciation to encourage investment in capital equipment. For example, Section 179 and Bonus Depreciation is a tax code that allows businesses to deduct the full purchase price of capital equipment, up to $500,000, in the current year. [2] X Research source

October 29, 2021

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Making an expensive purchase for your company of equipment or property can often mean a tax deduction for your business. Tax rules require you to spread the total cost of asset purchases you want to deduct as a business expense over its estimated useful life. To do so, you can use one of several ways to calculate depreciation. In this article, we will discuss what depreciation is and how to calculate it using four primary methods.

What is depreciation?

Depreciation is an accounting technique used to allocate the cost of an asset over time, usually its useful life, which is defined as an estimate of how long in years the asset is likely to remain in service — or useful — and generate revenue. When your company purchases an asset, you can deduct that cost as a business expense, but federal tax regulations require you to spread the total cost over its estimated useful life.

Depreciation shows the expense of using an asset over time and is unrelated to its physical condition. An example would be if you purchased a piece of machinery for your company at a total cost of $1,000. The average useful life of that piece of machinery is 10 years, so it would decrease in value by 10% each year.

Why would I use depreciation?

Depreciating assets means you may have more control over your finances because you can determine how much you’ll deduct in taxes for those assets each year. Depreciation can help you spread out a large expense for your company over multiple years instead of it showing up in your accounting books as one major expense in a single year.

How to calculate depreciation

There are four primary ways of calculating depreciation:

Straight-line depreciation: This is the most common method and is used to split the value of an asset evenly during its useful life.

Double-declining balance depreciation: This method is used to depreciate more of an asset’s value immediately after you buy it and less value later in its life.

Sum-of-the-year’s digits depreciation: This method is used to depreciate more of an asset’s cost in the earliest years of its useful life.

Units of production depreciation: This method is used to depreciate a piece of equipment based on how much work it does or will do.

Here is how to calculate depreciation of an asset using each of the four methods with an example for each one:

Straight-line depreciation

Smaller businesses often will use the straight-line depreciation method if they don’t have an accountant or tax advisor. To calculate using the straight-line depreciation method:

Subtract the salvage value from the asset cost.

Divide that number by its useful life.

The formula looks like this:

(Asset cost – salvage value) / useful life = Depreciation value per year

Here’s an example:

Your office buys an office cubicle system for $15,000. The salvage value of the system is $500, and it has a useful life of 10 years. To find out how much you can deduct in taxes each year, you use the formula:

(15,000 – 500) / 10 = $1,450

You can deduct $1,450 per year for the 10 years of the system’s useful life.

Double-declining balance depreciation

If you want to recover more of an asset’s early value, you may choose to use the double-declining balance method of depreciation. To calculate using this method:

Double the amount you would take under the straight-line method.

Multiply that number by the book value of the asset at the beginning of the year.

Subtract that number from the original value of the asset for depreciation value in year one.

Repeat the first two steps.

Subtract the new number from year one’s value to find year two’s value.

Continue repeating steps for subsequent years.

The formula looks like this:

(2 x straight-line depreciation rate) x book value = Declining balance per year

Here’s an example:

The $15,000 office cubicle system depreciates over 10 years, so its straight-line depreciation rate is 10%. For the first year of the system’s life:

(2 x .10) x 15,000 = $3,000

You can deduct $3,000 of the system’s value in its first year. For year two, the value is now $12,000 so for year two:

(2 x .10) x 12,000 = $2,400

You then can deduct $2,400 from the first-year value of $12,000 to find the second year value of $9,600. You would continue the process for years three through 10.

Sum-of-the-year’s digits depreciation

If you decide you want to recover more of an asset’s upfront value but with a more even distribution over time, you can use the sum-of-the-year’s digits method or SYD. To calculate:

Add up the digits in the asset’s useful life. If the life is 15 years, you add 1 + 2 + 3 + 4 + 5 = 15 is the SYD

Divide the asset’s remaining lifespan by the SYD.

Subtract the salvage value from the asset cost

Multiply the two numbers.

The formula looks like this:

(Remaining lifespan / SYD) x (asset cost – salvage value) = SYD depreciation the first year

Here’s an example:

Your office cubicle system costs $15,000, has a salvage value of $500, and will depreciate over a 10-year useful life. Adding the digits for the system’s useful life would be: 1 + 2 + 3 + 4 + 5 + 6 + 7 + 8 + 9 + 10 = 55

(10 / 55) x (15,000 – 500) = $2,610 for the first year deduction

Each year, the system’s lifespan reduces by one, so the second year equation would be:

(9 / 55) x (15,000 – 500) = $2,372 for the second year deduction

Units of production depreciation

Businesses that want to deduct a piece of equipment that creates a product can use the units of production method of depreciation. You can also use this method if you can measure usage of the asset in hours. To calculate using this method:

Subtract the salvage value from the asset cost.

Divide that number by the estimated number of hours in the asset’s useful life to get cost per hour.

Multiply the number of hours (or units of production) in the asset’s useful life by the cost per hour for total depreciation.

The formula looks like this:

(Asset cost – salvage value) / hours of useful life = Units of production depreciation cost per hour

Cost per hour x hours of useful life = Total depreciation

Here’s an example:

Jonathan’s House of Tabletops purchases a material cutting machine for $75,000. It has a salvage value of $6,000 and has a useful life of 90,000 hours. To find the units of production cost per hour:

(75,000 – 6,000) / 90,000 = $.76 cost per hour

To find the total depreciation of the machine:

.76 x 90,000 = $69,000

The machine will depreciate by $69,000 during its useful life.

Any sort of computer equipment used in your business or indirectly/directly produces income would classify as fixed assets until and unless it is included in the inventory of the business. Inventory is a current asset and it is not subject to depreciation, whereas computer equipment is a non-current asset.

This is because inventory generates economic benefits but has a useful life of less than a year whereas computer equipment generates economic benefits over a useful life of more than a year. Some examples of computer equipment are listed below:

  • Printer
  • Scanner
  • Pen tablet
  • Hard disk drive
  • Desktop
  • Personnel computer

According to the international accounting standards, any capital expenditure should be capitalized and booked as a non-current asset on the balance sheet. All of the non-current assets that entity records in its balance sheet including the computer equipment need to be depreciated regularly such as monthly and annually.

What is depreciation?

Depreciation is a quantitative measure of how much the asset has been used. It is a non-cash revenue expenditure annually reported on the income statement of every entity holding fixed assets.

There are 4 ways that an asset can be depreciated i.e.

  • Straight-line
  • Double declining
  • Sum of year’s digits
  • Units of production

We can calculate the depreciation of office equipment through any of these methods. However, the most appropriate methods would be the double-declining and sum of year’s digits since these methods charge higher depreciation in the early years of the useful life of the asset. Since office equipment loses its value rapidly due to obsolescence the most accurate methods would be the ones charging higher depreciation in the early years.

However, I’ll show you the depreciation of equipment through all depreciation methods. It is also important to note that the company needs to review the useful life and impairment of the computer equipment annually.

Calculation through straight line method:

Example: Ali bought a printer for his office at a cost of $5,050. He plans to sell the scrap at the end of its useful life of 5 years for $50. Calculate the annual depreciation Ali should book for 5 years.

The formula to calculate annual depreciation through straight-line method is:

= (Cost – Scrap Value)/ Useful Life

The annual depreciation expense for Ali would be $1,000.

Calculation through sum of year’s digits method:

Example: Ali bought a pen tablet for a cost of $7,000 having a useful life of 3 years. Ali depreciates his assets using the sum of the year’s digits method. Calculate the depreciation expense of Ali for 3 years.

The formula to calculate depreciation through sum of year’s digits is as follows:

= Depreciable Amount * (Remaining Useful Life at the Start of Year / Sum of Year’s Digits)

Calculation through units of production:

Example: Ali has a book-printing business and he depreciates his printer on unit basis. It was expected that the current printer has a capacity of 100,000 pages when bought 2 years ago at a cost of $10,000.

Ali had a total production of 35,000 pages this year. Calculate his annual depreciation for the year. The formula for calculating annual depreciation through this method is:

Depreciable amount * (Units Produced This Year / Expected Units of Production)

Where, depreciable amount is cost less scrap value, as mentioned above.

Hence Ali should book a depreciation expense of $3,500 based on the calculation shown below:

Calculation through double declining method:

Example: Ali purchased a scanner a year ago in 2018 for $8,500 and estimated scrap value of $500.

He has a policy of charging depreciation at a rate of 15% at reducing balance method. Calculate his annual depreciation expense for the year ended 2019.

Formula to calculate depreciation through double declining method is:

(Not Book Value – Scrap value) * Depreciation rate

Where, NBV is cost less accumulated depreciation.

Hence, the depreciation expense for 2018 was (8500-500) *15% = $1200.

The opening NBV for 2019 would be $7,300 (8500 – 1200). The depreciation expense for 2019 shall be $1,020 according to the working shown below: (7300 – 500) * 15% = $1,020

How to Use MACRS Depreciation

Depreciation is the loss of value over time for a physical item purchased for a business. The Internal Revenue Service (IRS) allows deductions for depreciation so that business owners can recover expenditures they made for the purpose of earning income.

Medical Equipment Useful Life

The IRS classifies items, called fixed assets, and assumes a period of useful life. Office furniture, for example, including desks, chairs, lamps and literature racks, are assumed to have a useful life of seven years. Computers and medical equipment are assumed to have a useful life of five years.

The Straight-Line Method

The straight-line method is preferred by many taxpayers to calculate depreciation because it is easy to calculate. Each year is the same over the useful life of an asset. Here is the formula for straight-line depreciation:

Straight Line Basis = (Purchase Price of Asset – Salvage Value) / Estimated Useful Life of the Asset

For example, say you purchased a piece of medical equipment for $10,000. The IRS allows for a five-year useful life of the equipment. After five years, the equipment has a salvage value of $500.

The straight-line basis equals $1,900 [(10,000 – $500)/5 years]. You can deduct $1,900 per year for the five-year useful life period, until $500 is left on the books as the value of the item.

IRS Section 179 Deductions

IRS Section 179 allows for some flexibility in taking deductions for depreciation, including depreciation on medical equipment. Suppose you have record earnings in the year you purchase the equipment. Suppose, too, that by significantly lowering your tax bill, you could purchase more equipment or hire more people. The IRS allows you to deduct the full cost of the purchase price of an asset in the first year. Doing so, however, means that there will be no deductions for depreciation of the asset in subsequent years.

Modified Accelerated Cost Recovery System

The Modified Accelerated Cost Recovery System (MACRS) allows you to take a bigger deduction for depreciation on medical equipment for the early years in the life of an asset. Table A-1 in IRS Publication 946 shows depreciation percentages allowed under MACRS for assets with a useful life of three, five, seven, 10, 15 and 20 years. The IRS uses the half-year convention for these assets, meaning that, no matter when the asset was put into service, it is assumed that the in-service date is mid-year. This assumption effectively provides an additional year of the depreciation deduction.

Medical equipment’s useful life is assessed at five years. The MACRS schedule for depreciation on that medical equipment is as follows:

  • Year 1 (second half of the year): 20%
  • Year 2: 32%
  • Year 3: 19.20%
  • Year 4: 11.52%
  • Year 5: 11.52%
  • Year 6 (first half of the year): 5.76%

For example, an asset costing $120,000 with a salvage value of $20,000 would see a depreciation of $100,000 over the depreciation period, as follows:

  • Year 1: $20,000 deduction
  • Year 2: $32,000 deduction
  • Year 3: $19,200 deduction
  • Year 4: $11,520 deduction
  • Year 5: $11,520 deduction
  • Year 6: $5,760 deduction

After 6 years, $100,000 of the purchase price of the equipment is recovered.

The Right Depreciation Method for Your Business

Depreciation allows you to reduce the amount of taxes owed in a year or over a period of years. Consider whether it is better to offset earnings in one year or over the useful life of an asset. Each of the depreciation methods described has both advantages and disadvantages. A new business, for example, might benefit from higher deductions in the beginning when earnings aren’t as high. An established business might employ the straight-line method to simplify calculations.