How to Calculate Depreciation Expense: Step-by-Step

Depreciation expense is an accounting method allowing businesses to spread the cost of a tangible asset over its useful life. This practice reflects the asset’s gradual reduction in value due to wear, obsolescence, or use over time. From an accounting perspective, depreciation helps to match the expense of using an asset with the revenue it generates, aligning with the matching principle. For tax purposes, depreciation is a deductible expense that can reduce a business’s taxable income, thereby lowering its tax liability.

Understanding Depreciation Basics

Depreciation involves systematically allocating an asset’s cost over its expected economic benefit period. This prevents the entire cost of a significant asset from being expensed in the year of purchase, which could distort reported profitability. It helps reflect the true cost of generating revenue over an asset’s operational lifespan.

Assets eligible for depreciation are tangible items used in a business or for income-producing activities. They must have a useful life exceeding one year and be subject to wear, decay, or obsolescence. Common examples include machinery, equipment, vehicles, buildings, and office furniture. Assets like land, inventory held for sale, personal-use assets, and most financial instruments do not qualify for depreciation.

Key Information Needed for Calculation

Calculating depreciation requires specific financial data. The asset’s cost, also known as its basis, includes the purchase price and all necessary expenditures to acquire and prepare it for use. Examples include sales taxes, shipping fees, and installation costs.

Salvage value, also called residual value, is the estimated amount an asset is expected to be worth at the end of its useful life. Determining this value often involves market research, industry standards, or historical data. If negligible or difficult to determine, it may be treated as zero for calculations.

The useful life of an asset represents the period, in years or units of production, over which it is expected to be productive. This can be estimated based on industry standards, company experience, or tax authority guidelines. Cost, salvage value, and useful life form the foundation for all depreciation calculations.

Common Depreciation Methods

Businesses apply various methods to calculate annual depreciation expense. The straight-line method is widely used for its simplicity and consistent expense recognition. It allocates an equal amount of depreciation expense to each year of an asset’s useful life. The calculation subtracts salvage value from the asset’s cost, then divides the result by its useful life in years. For example, a machine costing $50,000 with a $5,000 salvage value and a 5-year useful life would have an annual depreciation of $9,000 (($50,000 – $5,000) / 5 years).

Accelerated depreciation methods, like the double declining balance method, recognize a larger portion of an asset’s cost as expense in its earlier years. This assumes an asset loses more value or is more productive initially. A depreciation rate (typically double the straight-line rate) is applied to the asset’s book value each year, without initially subtracting salvage value. Depreciation stops when the asset’s book value reaches its salvage value, and switching to straight-line may be beneficial later to fully depreciate the asset.

The units of production method links depreciation directly to an asset’s actual usage or output, rather than a fixed time period. This method suits assets whose wear and tear are proportional to their activity. To calculate, the total depreciable amount (cost minus salvage value) is divided by the asset’s total estimated lifetime production units. This per-unit rate is then multiplied by the actual units produced in a period. For instance, a vehicle costing $40,000 with a $4,000 salvage value, expected to travel 100,000 miles, has a depreciation of $0.36 per mile. If it travels 15,000 miles in a year, the expense is $5,400.

Recording and Reporting Depreciation

After calculating depreciation expense, it is recorded in the company’s financial records. Depreciation is reported on the income statement as an operating expense. This expense reduces net income, reflecting the cost of using the asset to generate revenue. Depreciation is a non-cash expense, meaning it does not involve an actual cash outflow.

On the balance sheet, depreciation impacts asset value through accumulated depreciation. This contra-asset account has a credit balance and is presented as a deduction from the asset’s original cost. As depreciation accumulates, the asset’s book value (cost minus accumulated depreciation) decreases, representing its remaining value.

From a tax perspective, depreciation is a tax-deductible expense for businesses. Claiming depreciation reduces taxable income, lowering tax liability. This tax benefit helps businesses recover asset costs over time. Tax depreciation rules, such as those from the IRS, may differ from financial reporting methods.